How to Earn High Returns Through Private, Hard Money Mortgage Lending

Private mortgage lending is a misunderstood and underrated investment opportunity. Cash investors are often dissatisfied with their returns from traditional vehicles, but private lending can deliver double-digit interest rate returns. A moderate to high risk tolerance is required, but the risk can be effectively calculated and managed.

This article is an overview of the world of private, “hard money” mortgage lending. This discussion is geared to investors considering mortgage lending as diversification alongside other tactics. Investors who learn about private lending and execute on that knowledge can build wealth more quickly through this investment path less taken.

What are Private and Hard Money Loans?

To start, the distinction between “private” and “hard money” lending is worth a brief discussion. Though the terms are fluid and subject to interpretation, the following are commonly accepted definitions. A private lender is an individual or entity who offers to lend money on their own terms, generally on a “one-off” basis, to borrowers they already know.

Hard money lenders tend to be more organized, system-driven and engaged in lending as a regular investing strategy. They’re more in the business of lending than private lenders, with established lending criteria and terms. What private and hard money lenders have in common is, they’re not banks. For purposes of this article, the distinction is insignificant, so I’ll use “private” and “hard money” interchangeably.

Why is There a Hard Money Market?

A common question is why is there demand for hard money lending? Most institutional banks lend to consumers buying their homes. When they do offer investor loans, prospective borrowers often fail to qualify under the lending criteria for a variety of reasons, including credit rating, debt to income ratio or having too many outstanding mortgages on other properties.

These bank limitations create a market demand for private lending. Because hard money borrowers lack alternative funding sources and their deals are considered riskier than owner-occupied mortgages, the free market generates much higher interest rates and fees than consumer lending. These loans usually produce double-digit interest-only returns plus origination fees as a percentage of the principal balance (“points”).  

Hard money borrowers usually seek funds for “flips” involving a bargain purchase, renovation and quick turn resale. Others buy and hold as a landlord. Private lenders secure their loans with a mortgage on the property, as any bank would. Few private lenders will accept anything but a first mortgage lien position. In some cases, the deal is deemed so “safe,” that they are willing to lend with a second mortgage. No matter how safe the deal may seem at origination, taking a second mortgage position is usually too risky to be worthwhile. 

I’ve been a private lender since 2006 and the only deal for which I’ve lost money was my first loan. I was too eager to get in the game, ignored the voice inside my head, and accepted a second mortgage position. There appeared to be a safe equity cushion in relation to the first mortgage, but it was near the top of the real estate market before the crash. My borrower eventually defaulted on their first mortgage, continued paying me for a while, then stopped paying everyone. I consider that deal my “tuition” for valuable lessons learned. Fool me once…

How to Structure and Underwrite Private Lending Deals

As a private lender, your main concern is summarized by three letters—LTV. Your deal’s Loan to Value ratio is paramount. The lender needs to determine the fair market value (FMV) of the collateral property and lend an amount as a percentage of that value. There are other underwriting factors to consider, but LTV reigns supreme.

Some hard money lenders require prospective borrowers to get appraisals. Though a licensed appraiser's FMV is likely the most accurate value opinion, requiring an appraisal is widely considered conservative and unnecessary for this secondary market. It will drive away lending opportunities. 

Investors work a volume business making offers on multiple properties and not closing on all of them. To require prospective borrowers to buy appraisals for each purchase under consideration would have a painful compound effect. If other lenders don’t require an appraisal, you won’t close many deals by insisting on them. 

Instead, there are free online valuation platforms include Zillow, Trulia and others. In some Florida counties, such as Orange, the County Property Appraiser’s website provides comparable sales data within the same subdivision or area. 

Another good tool is a comparable market analysis (CMA) by a realtor with access to the Multiple Listing Service (MLS). The MLS has a wealth of data to generate useful CMAs. It’s worthwhile to build strong alliances with realtors who can help their private lender friends evaluate opportunities.

Instead of getting appraisals, you can use these other valuation tools and work more LTV cushion into the deal by adjusting down the amount of the loan you’re willing to make. It’s also important to require the borrower put down some money to have “skin in the game.” 

What’s Your Comfort Level?

Private lenders' risk tolerance levels are reflected in the LTV. A loan is generally considered safe and conservative up to about a 60% LTV, though opinions vary. A private lender can go as high up from there as they deem fit, but the higher the LTV, the riskier the deal. 

The 2008 market crash should never be far from any lender’s mind. During that run-up, banks abandoned all sensible underwriting standards, including accepting high LTVs. An example was the practice of “80/20” loans. This means the borrower got 100% financing, with one bank lending 80% of the home’s value and another (or sometimes the same bank) lending the other 20% through a second mortgage line of credit.

When the bottom fell out of the market, there was no equity cushion to protect the banks’ positions. That’s why so many lenders ended up taking short sale payoffs and the corresponding bad “haircut.”

Private lending is considered equity-based, rather than credit-based. Every private lender should develop their own underwriting criteria and credit worthiness is relevant to a degree. Hard money lenders, however, should feel comfortable with the prospect of foreclosing in the event of the borrower’s default, or they shouldn’t be in this game. That’s why LTV overshadows credit.

A good rule of thumb is to lend the money only if the lender would feel good about buying the mortgaged property for the principal lent plus estimated legal fees and other carrying costs from taking back the property. Absent another market crash of Biblical proportions, the lender is likely to come out ahead with a safe LTV, but they need to stomach the risk of default. If you want the security and comfort of FDIC-insured deposits, accept their returns. The private lending rewards come with higher risk and you can’t have it both ways.

Private loans are made to entities that buy properties, usually limited liability companies or land trusts. To mitigate the risk of default, get a personal guaranty from the individual behind the entity, in addition to a promissory note and mortgage from the buyer/borrower. This allows the lender to pursue someone’s personal assets in case the property in foreclosure is worth less than what’s owed and the entity is broke.

How to Find Private Lending Deals

In Florida, private lending is largely unregulated for loans to other investors in a B to B model. If you avoid actions such as holding yourself out as a lending business, marketing, and doing a high volume of deals, you won’t need to get licensed. The purpose of this article is to give an overview of, and demystify, hard money lending as part of a diversified investment portfolio, rather than providing a blueprint for a full-time lending business.

The way I got started in the business is a path available to anyone. Get to know people in the market while building a grass roots network of investors who borrow hard money. Across Florida and the U.S., there are real estate investor associations (REIAs). This is the watering hole where real estate investors congregate. Join and meet people.

Prospective lenders can also build relationships through social media platforms, Meet Up groups and knowing private lending referral sources. Real estate agents and mortgage brokers have referred me deals. Attorneys and accountants can also refer clients seeking private money.

Most private lenders avoid consumer lending for good reasons. Nuclear energy may be a more regulated industry than consumer mortgages, but that’s about it. Should an investor stumble upon a primary home lending opportunity, however, it can be done with full legal compliance. The way to do it is through an alliance with a licensed mortgage loan originator (MLO). 

I have helped clients structure consumer loans as the investor funding the deal alongside an MLO generating the necessary paperwork and checking off all the required boxes. Though this can be done right, the better course is to cut your teeth on B to B loans before ever considering a consumer deal.

If you have a moderate to high investment risk tolerance and money to put to work for strong returns, consider making hard money lending part of your portfolio. The risk can be effectively calculated and managed with proper investment analysis, the necessary legal documents and a knowledgeable trusted advisor to guide you. Contact me at the law firm of Widerman Malek to help you with legal services, advice and connections when you’re ready to make money in this lucrative space.