Much of the advice on private money loans are focused on how to get qualified for them. While it’s certainly an essential topic, an equally important subject is how to ensure your success once you obtained that funding. So, how to work with private lenders to ensure your success? Let’s face it – your ultimate goal as an investor is to maximize your profits. Repaying your private money loan as quickly as possible is a necessary milestone in meeting such a goal. By moving through your rehab efficiently, you can save thousands of dollars. In contrast, every additional month your loan is outstanding will cost you a pretty penny in carrying costs such as interest payments, taxes, and insurance. If you fail to repay a loan within a term agreed (typically twelve months), you might also incur default fees and interest. All of them would take an additional chunk out of your profits.
So what are the steps you need to take to work with private lenders efficiently and profitably?
Have adequate reserves
Private lending is all about leverage. A private lender is expected to finance most of the expenses involved in buying and rehabbing an investment property. However, to manage their risk, private lenders often require their borrowers to invest some of their own funds. It helps to ensure that the borrower is acting responsibly by having their own capital on the line.
Reserves are a portion of your capital that remains with you after you’ve made the required contribution to the transaction. It’s definitely the best practice to have some money left in your account for the duration of the loan. Why? Because having no financial cushion might slow down your rehab process or put you in a situation when you cannot make payments on your loan.
Let’s assume your rehab budget has been estimated at $40K. If you discover additional issues that need to be fixed or a contractor hits you with a change-order, you will have to dip into your reserves to make up the difference. If you don’t have sufficient reserves, you may find your whole project stalled until you procure the needed funds. Meanwhile, you continue to occur all expenses associated with owning a home and servicing your private money loan.
Another common example of why you need reserves is monthly payments to your private lender. Your monthly payment, of course, depends on your loan amount and but it often falls between $1,000 and $2,000. If you don’t have savings to dip in, you will have no choice but to dramatically curtail your lifestyle for the duration of your loan.
Write detailed scope of work
Scope of work might not seem like the most important document before closing, but it’s the key to your overall success. It will dictate how you pay your contractor. It will also guide when and how your private lender releases the construction funds back to you. In other words, the scope of work is your blueprint to accomplishing and paying for your rehab. To work with private lenders effectively, you must have an effective statement of work.
We’ve written quite a bit on the topic of how to develop that effective scope of work. Be as detailed and specific as you can be. Work closely with your contractor to determine what’s included and not included in it. Make sure that you discuss the payment schedule and never make large payments in advance. Make sure that you are working closely with your private lender to align your expectations of what needs to be accomplished for your next draw to be released. Above all, avoid making significant changes to your scope of work without consulting your lender first. We do our best to accommodate the changes and be flexible, so it’s always helpful to discuss any changes to your statement of work before you make them and not after the fact.
Invest in LLC’s name
LLCs have become one of the most popular business entity types for purchasing real estate. Owners often prefer to form an LLC when purchasing real estate so that the LLC becomes the legal owner of record and not the individuals. Most private lenders require their borrowers to purchase their investment property in the name of their LLC. By investing in LLC you’re protecting your own assets as well as your lender’s collateral.
Let’s assume an unpleasant scenario that someone gets injured in a property you’re renovating. If you own that property in your personal name, the injured party can always go after your personal assets. In contrast, if your title is in LLC’s name they can only go after your LLC’s assets. Equally importantly, the property held in an LLC’s name will not be subject to liens and judgments imposed on your personally. The best thing about LLCs is that they are affordable and easy to create. You can read here how to create an LLC in Maryland, Washington, DC, and Virginia.
Develop a solid exit strategy and stick with it
An exit strategy is your plan on how to repay a loan. The most common exit strategies are to (1) renovate and sell your property (fix and flip), (2) to renovate and refinance with a conventional lender into a long-term rental loan (buy and hold), (3) to refinance with another hard money lender to allow for more time and money to finish your rehab (hard money refinance). Obviously, strategies number 1 and 2 are preferred by both borrowers and private lenders.
There are several reasons why you need to have a clearly defined investment strategy early on. First, you need to decide what kind of renovation you will be doing. If you are selling the property, you might go after the maximum visual impact. It might include new modern appliances, light carpeting and paint, white and pristine kitchen. These things look amazing but might quickly deteriorate if not maintained properly. If you are planning on renters, figuratively speaking, your property should be more of a workhorse than a show horse. You need to plan for a renovation that is able to sustain wear and tear as gracefully as possible.
The second reason you need a clear exit strategy is that refinancing with a conventional lender might not be feasible for all borrowers. Private lenders like New Funding Resources use very different underwriting criteria. For example, we do not verify your income and do not have minimum credit score requirements. Conventional lenders do not offer such flexibility. If you are interested in keeping a property as a rental, let your private lender know during the underwriting process. They can guide you through the process of what you need to qualify for a conventional loan. They also can recommend lenders that might be able to help you with your refinance.
Stay personally involved
Working with a private lender is different from working with conventional lenders you might be accustomed to. If you have a mortgage on your primary residence, you rarely need to communicate with your lender – aside from mailing your mortgage payment each month. This is not the case when you work with private lenders.
The ultimate goal for a private lender is the same as yours – that you repay your private loan on time and on terms agree on. A good private lender will stay in close touch with its borrowers to ensure that the renovation process goes as planned. And so should you as a borrower. Make sure that you communicate any changes to your scope of work, your exist strategy or any challenges you might have early on. First, your lender will find out about them sooner or later. Secondly, your lender might have some suggestions on how to address the situation that is fair and balanced to all parties.
To work with private lenders profitably, you need to move fast. Manage your risk by having plenty of reserves and buying in an LLC’s name. Avoid ambiguity and misunderstandings between the parties by writing a kick-butt statement of work. Define your exit strategy and work towards it. A clear plan is critical and communication is the key.