When it comes to real estate investing, sometimes traditional lending won’t cut it.
It’s slow. It’s based on creditworthiness. And it can come with restrictions that aren’t investor-friendly.
In many cases, financing your project through a private money lender makes more sense.
In this guide, we’ll look at:
- The benefits of using a private money lender versus a bank loan.
- The types of loans private lenders offer and which projects they work best for.
- What private money lenders look for in a deal.
But first, a definition.
What is a private money lender?
A private money lender is a private party or organization that makes loans for different types of real estate projects.
This could be someone you already have a relationship with, like a wealthy family member. Or it can be an organized third-party, like a hard money lender with established loan approval criteria.
Unlike banks and other traditional lending institutions, private lenders are asset-based. That means when considering a loan, they focus less on your buyer credentials and more on the property’s value and cash flow potential. For a short-term loan, they may not even pull your credit score or look at your income history.
Private loans use the real estate asset as collateral and are often willing to take on more risk than banks. Due to the added risk, they charge higher interest rates.
Types of private money loans
Some of the most common types of private money loans are:
Each private lender sets their own criteria and loan offerings, and they’re often designed for certain types of real estate projects. To give you some examples, let’s look at how different Longleaf loans work.
Benefits of private money lending
While conventional mortgages may make sense for normal homebuyers, private money loans are designed for investors. They offer:
How private lenders screen potential borrowers
Flexibility. Private lenders set their own lending criteria, have fewer constraints than banks, and can adjust terms and conditions on a case-by-case basis. Distressed properties with investment potential may not be eligible for a traditional or government-backed mortgage. But hard money lenders are more likely to take the risk.
Speed. The best real estate investment opportunities don’t stay on the market for long. You’re competing with all-cash buyers. And if you wait for the traditional loan process (30 to 60 days), deals will get snatched up under your nose. Hard money lenders can get you funded in as little as 48 hours so you can close as quickly as possible.
Lower down payment. Most private lenders will want some money down, but it’s often less than you’d need for a conventional loan. Private lenders calculate the minimum down payments on a short-term loan as a percentage of the after-repair value of the property. So if you find a good real estate deal and plan to add value rehabbing it, you’ll need less money down. The less money you invest out of pocket, the higher your returns.
Interest-only payments. Unlike a traditional mortgage, many hard money lenders offer interest-only loans. That means you’re only required to make interest payments each month and don’t have to pay down the balance itself. If you’re flipping a house, you’ll have fewer holding costs compared to a traditional mortgage.
Fewer hoops to jump through. Banks require stacks of paperwork proving your income history and creditworthiness. Their strict approval process can involve tedious back-and-forth that can draw out for months. Private lenders focus on the property’s value, which requires significantly less paperwork and hassle.
While a private lender is more flexible and accommodating than a traditional financial institution, they won’t lend to just anyone.
They consider several factors to help them decide if loaning you money is a worthwhile investment, such as:
Experience level. Do you have a track record of successful projects you can share? New investors can still get a loan, but you may have to do extra research, put more money down, or pay a higher interest rate. It’s best to start small. Once you have a few wins under your belt, it’ll be easier to qualify for larger deals or more complicated rehabs.
Credit score. Each private lender has their own credit score policies. At Longleaf, we consider credit history for long-term rental loans, but not for short-term loans. And unlike banks, we can get comfortable working with lower credit scores if there is a good story behind it and the loan value makes sense.
Secondary income. Do you have a day job? Or are you a full-time real estate investor? If you have a Plan B to cover your monthly payments, your project is a safer investment for lenders.
Plan and exit strategy. Do you have a well-researched plan? How will you ultimately pay off the loan? If your exit plan is refinancing with a traditional mortgage, your private lender will want to see proof that you would qualify for such a mortgage. In this case, your credit score would come into play. If you don’t qualify, you may be able to use a rental loan instead.
Commitment. A larger down payment shows you’re willing to put skin in the game and not ditch the project. While not always necessary, it can strengthen your loan application and qualify you for lower interest rates.
Location. Some private investors only work in certain geographies. If your project falls outside their zone of coverage, they won’t be able to help you.
This screening process is quicker and more informal than a bank’s mortgage process. But despite the speed, it’s still helpful to get pre-approved for your hard money loan. Armed with a Proof of Funds or Pre-approval Letter, sellers are more likely to accept your offer.
Short-term residential loans
Short-term residential loans can be used for fix-and-flips, bridge loans, and in some cases, new construction.
There are no minimum credit score requirements, loan terms last from 6 to 24 months, and you can close in as little as 48 hours.
Interest rates vary from 10% to 13%. But since these are interest-only loans, you don’t have to pay down the principal each month. This helps keep holding costs low while you work towards your exit strategy.
Long-term rental loans
Long-term rental loans are most comparable to traditional mortgage loans — just with fewer hoops to jump through.
The most common is a 30-year fixed rate rental loan, but you can also find adjustable rate options with interest-only periods.
Rental loan rates are slightly higher than conventional mortgages, but they have fewer requirements and allow you to close in as little as two weeks.
Private lenders are flexible and offer several repayment options, so you can work with them to find something that fits your needs.
Pre-approval is quick and easy:
- Start by filling out a pre-approval form with preliminary information such as your contact info, work experience, real estate portfolio, and credit stats.
- Reach out to your lender to chat about your project and the loan process.
- Provide any documents they ask for to complete the application process. These might include identification, entity documents, proof of liquidity, and a real estate schedule.
If you meet their criteria, they’ll issue a Proof of Funds you can submit with your offer. This reassures the seller that if they accept your offer, the deal won’t fall through due to a lack of funding.
What do hard money lenders like to see in a deal?
Even though your property acts as collateral, private lenders want you to succeed. They’d much rather earn interest on a successful property than being hassled with foreclosure and selling a failed project.
Because of this, each lender does their due diligence, setting criteria to determine which deals are worth the risk.
First and foremost is the value of the asset. If you ditch the project, will your lender be able to recoup their investment by selling it as is?
To manage this risk, lenders set a maximum loan-to-value (LTV) ratio, which is the loan amount divided by the after-repair value (ARV) of the property. The higher the LTV, the riskier the loan.
For new construction projects, lenders look at the loan-to-cost (LTC) ratio. This is similar to the LTV, but compares the loan amount to the cost of construction.
They also consider the debt-service coverage ratio (DSCR), which is the property’s potential cash flow divided by its expenses. A DSCR greater than one means the property generates enough cash flow to cover the loan’s interest payments, taxes, and insurance. And the higher the DSCR, the less risky the loan.
To give you an example of how this works in practice, here are the criteria we use for short- and long-term real estate loans at Longleaf.
Short-term loan requirements
Loan size: Up to $750,000
Property value: $100,000 minimum
FICO: No requirements
LTV: Up to 70% ARV
LTC: Up to 95%
Long-term rental loan requirements
Loan size: Up to $2 million
Property value: $100,000 minimum
Lease: Unleased can be accepted, and no seasoning requirements
FICO: 660 minimum
LTV: Up to 80% (as is)
DSCR: 1.10 minimum
How to find the best hard money lender for your project
The best time to find a hard money lender interested in working with you is before you find a deal. You can start building connections even if you don’t have all the details figured out. That way, when you find a time-sensitive deal, you’ll know exactly who to call to fund it.
Start by networking in real estate investor Facebook groups and investor networking events. Instead of trying to figure everything out yourself, ask other seasoned investors for their private lender recommendations.
Once you have a list of potential lenders, give them a call to see if they offer the types of loans you’re interested in. Experienced private lenders know a good deal when they see it. And if this is your first project, they may be able to give you valuable insights to help you avoid any potential pitfalls.
To start your search, feel free to reach out to Longleaf via phone (979-200-2823) or email. We’re happy to steer you in the right direction!