How Private Money Lending Works

Private money lending involves an individual or private organization providing a loan to a person or business, often to fund real estate investments. These loans are commonly used by investors who buy properties to renovate and either sell or rent out. Private money lending is not subject to the same rules that govern banks and other licensed lenders. As such, the terms are typically more flexible and the process can move faster.

A financial advisor can help you decide whether a private money loan makes sense for you.

Private Money Lending Basics

The defining characteristic of private money lending is that the money for the loan is provided by an individual or a private organization. Often, the lender is a family member or friend of the borrower. When the private money lender is an organization, it is not a bank or other licensed lending organization.

Private money lending is not subject to the same regulations that govern other lenders. However, the business is not completely unregulated. Private money lenders do have to follow state usury laws that limit the amount of interest that can be charged. They may also be limited in the number of loans they can make.

Interest rates on private money loans tend to be higher than loans from licensed lenders. From 15% to 20% is typical. However, in the case of a loan from a friend or relative, they may also be lower than market rates. Private money loan payments may be interest-only for the term of the loan, with a single large balloon payment at the end.

Qualifying for a private money loan is different from qualifying for a regular loan. The lender is likely to focus as much on whether a specific deal makes financial sense as on the credit history or score of the borrower.

Terms on private money loans are often short, just six to 12 months. But they may also be payable over up to five years. They generally require a down payment and often are secured by the property. The lender will typically require a written plan describing how the money will be spent.

Private money lending is similar to hard money lending. They are both often used in real estate investing and involve getting financing from somewhere other than a bank. Hard money lending, however, is more similar to mainstream lending, such as from a bank and less like friends-and-family financing via private money loan. It may be harder to qualify for a hard money loan.

Pros of Private Money Lending

Private money loans are more flexible than traditional financing. Borrower qualification guidelines are fewer and less strict, especially when the lenders are friends or family members. One key difference is that private money lenders are more likely than others to be willing to finance the acquisition of distressed property in need of significant repair. This allows investors who are short of cash to purchase low-priced properties and pay for renovations that increase the value of the properties.

The flexibility of private money lending also makes it faster. A borrower can get the money to do a deal in days, rather than waiting several weeks to get funded by a conventional mortgage.

Cons of Private Money Lending

A couple shaking hands with a private money lender.

Private money lending also carries added risk for both borrower and lender. Private money lenders are taking more risk due to their less strict qualification guidelines. To compensate for the added risk, private money lenders charge higher interest rates than other lenders. This can make it harder for borrowers to turn a profit on deals. Also, because loans are typically short-term, a borrower has to be able to sell or refinance the property relatively quickly, before the loan comes due.

It can be more difficult for borrowers to find private money lenders, since they may not advertise like banks and more established lenders. Talking with friends and family is one way to find sources for loans. Borrowers may be able to identify other potential private money lenders through professional networking, social media such as LinkedIn, internet searches and real estate investment events.

How to Find a Private Money Lender

Finding a private money lender can take more effort than securing a traditional mortgage. But investors have several practical avenues to explore. Networking is often the most effective approach. Many private money lenders operate through word of mouth. So it can be beneficial to talk with other real estate investors, contractors, real estate agents and financial professionals can uncover leads.

Local real estate investor associations (REIAs) are another valuable resource. These groups frequently host meetings, workshops and networking events where investors can meet private lenders who are active in the community.

Online lender marketplaces also provide opportunities to connect with private money lenders. However, borrowers should be cautious when working with someone they haven’t met in person. A careful review of the lender’s website, references and track record can help determine whether they are reputable.

Red flags may include requests for large upfront fees, vague or overly aggressive promises, or pressure to skip due diligence steps. As with any financial transaction, take time to verify the lender’s credibility. Doing so can help protect you from scams and unfavorable loan terms.

How to Structure a Private Money Loan Agreement

Private money lending is often less formal than traditional financing. As such, it’s important to create a clear written agreement that protects both the borrower and the lender. At minimum, the contract should outline the loan amount, interest rate, repayment schedule and any fees. Both parties should also decide whether the loan will be interest-only or amortizing, as this determines how payments are structured over the life of the loan.

Many private money lenders prefer interest-only payments with a balloon payment at the end. However, borrowers need to ensure they have an exit strategy such as selling the property or refinancing to repay the balance before it comes due.

Collateral requirements are another key element of the agreement. Most private money loans are secured by the property being purchased or renovated. And the lender may request additional documentation such as renovation plans, contractor estimates and financial projections. Including these details in the contract helps ensure that both parties share an understanding of the project’s scope and expected timeline.

Even when the lender is a friend or family member, it’s wise to have an attorney review the document to make sure all state and federal requirements are met. A properly structured agreement can help prevent misunderstandings and reduce risk for everyone involved.

Bottom Line

Private money lenders are individuals and organizations that provide money to investors, usually for real estate loans. Private money lending is less regulated but more costly than other sources for loans, such as banks. Many private money loans come from friends and family, but organizations may also be private money lenders.

Tips for Borrowing Money

Talking your financing plans over with a financial advisor can increase the chances you’ll make the best decision. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area. You can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Any type of loan can be tricky, especially if it’s a loan you personally guarantee. And if you don’t pay them back fully or on time then there is the possibility that you hurt your chances at borrowing more in the future. It’s important to understand as much as you can about personal loans before moving forward with private money lending.