Banks will not lend money on damaged properties. Damaged properties cannot get insurance. And banks don’t lend on properties with no insurance. Banks lend based on a set criteria. A typical conventional loan is an 80/20 loan meaning you put down 20% and you borrow 80%. Naturally there are many other types of loans but they are all based on a percentage of the contract price.
Let me say that again.
How Do Banks Loan Money?
They loan based on a percentage of the contract price. NOT based on the value of the property. If the contract price is too high then the property will not appraise and the bank will not lend. But what happens if the price is too low? The banks formula states that they loan 80% of the contract price if the property appraises. So regardless of how cheaply you purchased the property the bank will only loan you 80% of that amount.
Look at this scenario as an example:
==> Let’s say a house is listed on the market for $100,000 and is worth $100,000
==> A buyer signs a contract with a seller to purchase the house and an appraisal is ordered.
==> If the property appraises (meaning the appraisal is at or higher than the contract price) then the bank issues a loan.
==> The bank loans a percentage of the purchase price. So if the purchase price is $100,000 then the bank loans $80,000.
But what happens if you can buy this property for $80,000? Will the bank loan you the entire $80,000?
The answer is an emphatic no.
What about if you could buy this property for $40,000? Would the bank loan you $40,000. No they would loan you 80% of the contract price REGARDLESS of what the property is worth.
Do you see how ridiculous that is?
So how does this apply to you as an investor?
Why Bank's Won't Loan On Some Properties?
Look at all the bank owned properties and short sales on the market. These are all cash only deals meaning you cannot get a mortgage to buy them. You have to pay all cash. Since banks won’t loan on these properties you have to either have the cash or borrow the cash. Why banks won’t loan on these properties is a combination of three things:
1. Condition of the property (most bank owned properties are vacant or damaged)
2. Banks loan based on contract price and will not loan if a property needs repairs
3. Bank needs to move these properties quickly to a cash buyer
Why Investors Need Private Lenders
So what can you do if you find a $100,000 house (once fixed up) that you could purchase today for $60,000? Well if you have the cash then it is easy you pay cash and purchase the house.
But what do you do if you don’t have the cash to buy real estate? What if you don’t have $60,000 sitting in your checking account? Even if you have perfect credit you CANNOT get a bank loan. Remember that banks that sell these bank owned properties and short sale WILL NOT accept a mortgage.
So the only way you could buy this property if you don’t have the cash is to borrow the money from a private lender. A private lender is basically an individual that loans their own money on a property in exchange for receiving a mortgage and a note on the property. They basically act as the bank and the mortgage is exactly the same as if you borrowed from Bank America, Wells Fargo or any other bank. The only difference is the interest rate is much higher.
The prevailing interest rate on hard money loans is anywhere from 12% to 14%. Most private lenders such as myself, loan based on what is called the ARV formula which looks like this:
After Repair Value (ARV the value of the house after it has been repaired)
- **Multiplied by 65%
- **Less the Repairs (amount it costs to fix the property to make it sellable)
- **Less the down payment of the borrower.
So as an private lending example:
If you came to me with a property that would be worth $100,000 once you had fixed it up and made it ready for sale. And this property required $10,000 in repairs. Then the maximum I would loan would be 65% of the $100,000 less the $10,000 in repairs less a small amount down (say $5,000).
So in this example if you were a savvy investor and you knew how much I was willing to loan you would offer $55,000 to purchase the property ($65,000 less the $10,000 in repairs).
If you came to me to borrow the money I would lend you $50,000 and ask you to put down $5,000. I would do this just so that it wasn’t too easy for you to walk away from the loan.
You would be required to pay for all of the repairs (labor and material), closing costs, insurance, and all fees in addition to putting down the $5,000. I would give you a note and mortgage to sign just like the bank does. The interest rate would be 14% per year. You would pay me interest of $7,000 per year ($50,000 x 14%) in monthly payments of $583.33. At the end of the year you will have to give me the $50,000 loan back.
If for any reason you cannot or do not make timely payments then I would pursue a foreclosure lawsuit against you (just like the banks do). When I finally get the property back I could fix it and sell it or keep it as a rental or do anything I want with it. If you pay on time and fix and sell the property you can make a very healthy profit. Even if your fees and interest were $10,000 you would still make a profit of $25,000. Considering that you only invested $10,000 in repairs, $10,000 in fees and interest and $5,000 in down payment you would make $25,000 on a $25,000 investment. That is a 100% return on your money. And you could do that within 6 months!
Annualized that is a 200 percent return. So you can see why people would want to borrow private money!
Why Would Someone Become A Private Lender?
But why would I as a private lender loan it? Well I am making 14% interest for doing absolutely nothing. And I have collateral (the property) since I have the mortgage and note on the property.
So what are my risks?
Well I am loaning you $50,000 on a $100,000 house. If you didn’t pay me I could get the house back from you via the foreclosure process. And then I could fix it and I could sell it and make the profit. That doesn’t sound bad at all. And if you did pay me I make 14% on my money. Since last I checked CD’s are paying less than 2% and my checking account is paying less than 1%.
I would say that 14% sounds like a fantastic return. Especially since it is PREDICTABLE.
I hear people talking about the stock market going up 21% last year. But what people don’t talk about is when it goes down. I quit the stock business in March of 2,000 when the Nasdaq Stock Market was at 5,000. Today 15 years later the Nasdaq Stock Market is at less than 5,000. That means there has been ZERO return over 15 years.
So if you had invested $100,000 back in 2000 in the NASDAQ today you would still have that $100,000. But the scary part is that you would have had to watch it go down by 70% before it came back. And like most investors you would have gotten scared and sold after you had lost a significant sum of money.
Compare that to investing $100,000 as a private lender at 14%. You would make $14,000 a year in interest every single year. At that rate of return your money would double every 5.14 years. That means that 15 years later your $100,000 would be worth close to $800,000.
Why on earth would anyone pick the unpredictability of the stock market over that? Because some guy with a logo of a bull on his card told you to invest in stocks? Have you ever wondered why Wall Street Companies have big high rises in Manhattan? Because they fleece the little guy. They want you to buy and sell as much as possible so they can make more money. And if you want to sit then they want to charge you fees. And yes they still charge you fees even when they lose your money.
So I ask you a very simple question. If you have savings, why on earth are you not a private lender? Do you know of any other investment that will give you 14% return consistently and will also offer you COLLATERAL?
I can tell you for a fact that you will not get that kind of return from stocks, bonds, and mutual funds consistently. And you won’t have any collateral either. Remember General Motors, Delta Airlines, and Block Buster Video? They all went bankrupt. And investors in their stocks and bonds lost everything.
Private Money Lending really is a secret. It’s a well kept secret in real estate investing and I like it that way. You won’t read about it in the Wall Street Journal or hear about it on CNBC. But when it comes to my money – I feel way more comfortable putting it in private lending than the stock or bond market.
Did you know that you can lend with your IRA or 401k too? 14% tax free. Show me a financial advisor that can beat that.