What Are the Risks of Working With Private Lenders?

Working with a private lender can offer several advantages compared to traditional lending institutions. Quick access to funds, lending criteria flexibility, and streamlined underwriting are just a few of them. But like everything else, private lending and hard money loans come with their own risks. To know them is to manage them. So let’s talk about the risks of working with private lenders and how real estate investors can minimize their on their bottom line.

Bait-n-Switch

Among all risks of working with private lenders, bait-n-switch is perhaps the most common. It refers to a deceptive practice where a private lender initially presents one set of terms or conditions to entice borrowers but alters those terms later and often right before closing.

I will be the first to admit that this risk is hard to manage. Private lending is less tightly regulated than traditional lending that funds consumer mortgages. Hard money lenders are not lending to consumers, and many regulations designed to protect consumers do not apply to them. Fewer regulations result in the ability to think outside the box, stay flexible, and move fast. But in some cases, it can also lead to questionable business practices. Increasing rates and not disclosing fees until the very end of the process – when a real estate investor is forced to accept these higher costs or to lose a property – are two most common examples of the bait-n-switch tactics in private lending.

How do you recognize the signs that you might be at risk of bait-n-switch in private lending?

• Your private lender is asking you to pay the upfront application fee. I hear that some private lenders are charging close to $1000 for applications. Once the borrower pays the fee, they are at the mercy of the lender, who can change their rates or fees with little fear of losing that borrower.
• Your private lender offers you rates way beyond anyone else. The rates will very from a private lender to a private lender, but let’s be realistic. If you found a lender who offers you a rate significantly lower than a prevailing market rate, something is fishy.
• Your private lender does not spend time prequalifying you or asking detailed questions about yourself or your investment opportunity. The rates vary not only from lender to lender but also from borrower to borrower. At New Funding Resources, borrowers with more verifiable experience in real estate investing are eligible for lower rates than someone just starting out. Why? Because they represent lower risk. However, we don’t just throw those best rates around only to tell a less experienced borrower they don’t qualify for them.
• Your private lenders has few or no reviews. I am going to make this section brief. Best rates and terms around. A lender with no record of delivering on its promises or a reputation of any kind. Unregulated industry in general. Are your alarms ringing too, or is it just me?

Now let’s talk about ways you, as an investor, can manage these types of risks of working with private lenders. It’s one thing to be cost-conscious and another to be hyper-focused on pricing at the expense of everything else. Let’s say you called me today and asked about my rates. You: “What are your rates?”. Me:”4%!” Did you really get any viable information? Do you know the requirements you need to meet to qualify for this pricing? Are you even eligible for a loan? What are the loan terms? What are the other expenses?

The truth is being hyper-focused on pricing opens you up for being taken advantage later in the process. Instead, start your conversation with what it takes to get a loan with this particular lender. What do they consider a good deal, and whom do they consider a good borrower? What does their underwriting process consist of? What is their reputation in the industry? How can they help you make money as a real estate investor? For more information on how to avoid bait-and-switch, read our artcles on selecting a private lender and hard money scams.

Private Lending Risk #2 – High Costs of Carrying the Loan

Private lenders take a significant risk in providing high-leverage loans on distressed properties. They compensate for this risk by charging interest rates that are higher than rates on conventional mortgages. What that means for you as a borrower is that time is literally money. The longer you hold the loan, the more you pay the lender in interest. The more you pay in interest, the smaller your profit will be. You can see this difference by using our hard money loan calculator. For example, if you borrowed $250,000 and are paying your lender an 11% interest rate, the difference between holding a loan for 3 months versus 12 months will be over $20,000! That is quite a chunk of cash, don’t you think?

That means that one way of managing the risks of working with private lenders is to shorten the time you have a loan with them. How do you do it? By having a solid business plan, selecting the right contractor, and managing that contractor well. The faster you move, the more money goes into your pocket, not your lender’s. And let me add one more thing. As a private lender, we don’t want you to carry our loan beyond a certain point, either. This is why the most common loan term we offer is twelve months. Private lenders make more money when their borrowers repay their loans relatively quickly, so lenders can deploy those funds elsewhere.

To help you combat the high cost of private lending by moving fast, you can also read this articles: How Fact Can You Pay Off Your Hard Money Loan.

Construction Draw Disbursement and Management

If you have studied the private lending industry, you probably know that private lenders typically hold all or a part of the construction budget in escrow account. The borrower receives the construction funds in a series of draws as they complete different stages of renovation. Just like it takes two to tango, a smooth flow of draws depend both on the performance of the borrower and the private lender.

Let’s start with the responsibilities of a private lender in managing the escrow. Basically, there are two. Responsibility #1 is to disperse the construction escrow as agreed in the draw schedule, with possible reasonable changes that do not significantly alter the nature of that schedule.

The second responsibility of a private lender is to disperse the draws in the reasonable time after the borrower requests it. To do so, the lender typically sends someone to the property to examine and report back on the progress. Based on the report, the lender disperses the draw, makes a modification to it or declines to release the money all together.

To manage construction draws efficiently, your private lender needs to be fair, responsive, quick, and have a streamlined decision-making process. If the lender fails in any of these areas, you will face delays and escalating costs. As discussed in the section about bain-and-switch, it’s not all about upfront costs and interest rates. In reality, many other elements of your private money transaction significantly affect your bottom line and increase the risk of working with private lenders. The draw management by the lender is just one example.

The second party responsible for efficient draw management is you, the borrower. Your responsibility is to renovate the property according to the scope of work you submitted to your lender and to follow the draw schedule agreed upon at closing. What are the risks that you can encounter on your end? Most commonly, it’s the inability to complete the work required to receive the draw due to initial underestimation of costs or contractor issues. A borrower in this unfortunate situation finds herself locked in a vicious cycle: she needs money to finish the required work but is not eligible for more funds unless she finishes all this work. The best way to mitigate this common risk of private lending is to have sufficient savings (reserves) you can dip into to finish the job. For more details, read our article about the importance of reserves in private lending.

Unrealistic Exit Strategy

The unrealistic exit strategy is my favorite pet peeve simply because it’s so easy to mitigate by being simply … realistic. Let me explain. I am speaking to those borrowers who aspire to be landlords but cannot fit into the rigid underwriting standards of a conventional loan. At New Funding Resources, we don’t verify your income and do not have minimum credit score requirements. It makes it possible for a broad spectrum of investors to fix and flip a property. However, if your goal is to keep your newly renovated home in your real estate portfolio, you need to be able to refinance our private loan with a conventional lender. Conventional lenders DO verify your income, and they DO have minimum credit score requirements. So if you don’t fit their criteria, you are out of luck.

The good news is that the conventional lending criteria are well-known to those in the lending industry. Our underwriters can tell you with a high degree of confidence whether you can qualify for a conventional loan. If you do, you can choose between flipping a property or holding it in your real estate portfolio. If you don’t qualify for a conventional loan, you still can be a successful flipper but not a landlord, at least for now. Selling or refinancing a rehabbed property is called “the exit strategy” and refers to how a borrower ultimately repays a hard money loan.

Unfortunately, some of our borrowers with less than stellar personal borrowing profiles switch their exit strategy from “sell” to “refinance” once we finance their investment property. Almost always, this decision is based on a preliminary conversation with some loan officer promising to refinance them with a mysterious lender. You can probably guess what happens later: months and months of waiting for that refinance to come through while the clock and the interest rate on your loan are ticking. The best way to manage these types of risks of working with private lenders is to be realistic. To make the most money on your real estate investment one thing you need to do is to face the facts, choose the right exit strategy and stick to it.

Aggressive Collection Practices

Many sources cite “aggressive collection practices” as some of the risks of working with private lenders. It is essential to understand that while the collection practices vary from lender to lender, they only affect borrowers whose loan is in default.

What does it mean to default on your loan? The documents you sign with the lender at closing should describe the terms of your loan agreement with that lender, including what constitutes a default. The most common reason for a borrower’s default is failure to make payments for several consecutive months.
Once a loan is in default, a lender may start collecting a default interest on your loan and may initiate the foreclosure process against your property.

There is nothing new or draconian here. Every type of mortgage – including the one on your primary residence – will default and might ultimately be foreclosed for severe non-payments. However, since private lenders have more limited recourse against default than traditional lenders, they might be forced to initiate foreclosure as the only way to collect the funds due to them.

That said, let me assure you that every legitimate private lender dreads dealing with default and foreclosure. It’s stressful, time-consuming, and expensive. The lender has every incentive to help borrowers get back on track with making timely monthly payments. For more information on how to manage the risk of default, you can read our detailed article on late payments and default-avoidance.

Managing Risk of Working With Private Lenders: Summary

Working with private lenders, investing in real estate, or borrowing in general is not without the risks. The question is how you manage those risks. To summarize, there are at least seven ways to mitigate your risks of working with private lender.

• Learn more about private lending industry in general
• Conduct due diligence and select the right private lender
• Select the right contractor and proactively manage the rehab process
• Have ample savings to carry you through rough patches
• Be realistic in selecting the exit strategy
• Thoroughly understand the terms of your loan including what constitutes default
• Proactively communicate with your lender if you are unable to make a payment