Private investors seeking alternatives to the stock and bond markets will find refuge in the world of private lending. (Also known as hard money lending.) If you are careful and diligent, you can earn solid returns while minimizing risks as a private lender.

But, like any endeavor, the returns are better when investing in private money loans because it requires a little more knowledge, a little more effort, and a bit more patience, than just pushing a button to buy or sell a stock.

Private Lending — What’s Involved?

At its heart, investing in hard money loans is a lot like investing in a bond which returns a fixed yield and pays off at maturity. If you make a loan to a borrower for $100,000 at 8% interest, and require interest-only payments, youll likely earn $8,000 income each year. And if the borrower does not default, the loan will pay off at or before maturity and the original principal will be returned.

When researching how to be a private lender, you will discover a few things that make the private loan investment considerably more involved than a bond investment.

Liquidity Do not consider becoming a private lender if you need the money before the maturity date. Even though most loans payoff, many do not pay off as expected. You can sometimes sell loans using an online loan exchange such as LoanMLS, or brokered to another private investor via a hard money loan broker. But even performing private money loans are typically sold at a discount. If you want to sell notes, even if it is performing, be prepared to take a haircut.

Collateral Valuation The underlying collateral for a hard money loan is very important to the overall security of the transaction. Carefully evaluate the value of the collateral and use several sources to make your valuation. A common mantra among private lenders is to drive the comps yourself. That means do not just look at photos on an appraisal and assume you have an accurate value. Take the appraisal and get in your vehicle and drive to the subject property as well as each comparable and make the determination for yourself if you think the value is realistic. Consider multiple sources of value. In addition to an appraisal and driving the comps yourself, consider using an Automated Valuation Model or a Broker Price Opinion as well. Some properties are easier to comp than others.

Advances Sometimes loan investments require that investors advance additional funds for a variety of reasons. Advances may be required to cure delinquent property taxes, cure a senior lien position, hire an attorney, pay to defend bankruptcy claims, or even remodel a property if a foreclosure takes place.

Do not invest in hard money loans without leaving yourself a cash cushion. Be conservative and leave yourself plenty of liquidity in your personal finances to handle unexpected circumstances.

Title Make sure you obtain title insurance which insures your lien position as a lender and offers fraud protection against forgery. Title insurance is not like homeowners insurance. If you suffer a loss with your homeowner policy, you submit the claim and get a quick reimbursement. Title insurance is an indemnity policy and as such you are reimbursed for a proven loss only and not the potential for a loss. The result may be that even though you will eventually lose money due to a title issue, you may not receive reimbursement for months, or even years later.

Borrower Credit Carefully reviewing the borrowers credit application and capacity to make monthly payments is the key to a successful loan investment. Private money loans are often made based on the collateral, but the best loans are those that give equal weight to the borrowers past credit track record and capacity to make payments and repay the loan when a balloon payment is due, or when the loan matures.

Private Lender Insurance You will need to make sure the property owner has appropriate fire and liability insurance in the amounts you desire as an investor. The insurance company must also be notified to include the investor as an additional insured on the policy so in the event of loss, the check is sent to you first.

Documentation Documenting the loan, creating the appropriate security documents and disclosures to the borrower is complicated and time consuming. There are a myriad of state and federal regulations to be followed, and a violation of these regulations could invalidate the loan and result in lost interest and/or fees.

Private Lending Loan Servicing

Once a loan has been originated, payments need to be collected from the borrower, and various tax, regulatory and informational statements need to be sent regularly to the borrower.

Hard Money and Foreclosure

If a borrower does not pay, investors must be prepared to foreclose on their collateral. This will be an involved process which requires a significant amount of expertise and expense.

As you can see, investing in loans is not as easy as it may seem on the surface and certainly more involved than buying a publicly traded bond. So, how to invest in private money loans? How do you get started? How do you take the plunge? The answer is: very carefully. Learning the private money lending business takes time. But once you understand the nuances and study the business, it can provide returns substantially greater than the bond markets.

There are professionals in the business of helping investors make loan investments. In the past, they have been referred to as hard money lenders, loan brokers, or mortgage loan originators. The term private money lender (PML) is becoming more popular and describes a professional business person who is highly skilled at originating private money loans.

The best part about using a PML to invest in loans is that the fees are typically paid by the borrower and therefore you get the expertise without paying for it. Well, at least not paying for it directly. You pay for it because of the additional fees you would likely collect if you originated the loan yourself. For example, if the borrower was willing to pay 3 points up front for a $500,000 construction loan, you may earn the entire $15,000 fee up front as the sole investor and originator. If you use a PML, you may still get a piece of that commission; typically 1 point.

If youre just starting out, the services of a PML are invaluable and they will help walk you through the transaction. Most investors who are not real estate professionals maintain life-long relationships with their private money lenders just as a business executive would maintain a relationship with an investment advisor. When you work with a private money lender, you should know about different ways you can invest in loans and the pros and cons associated with each.

Originate New Hard Money Loans

The new loan can be for the purchase or construction of a new property by the borrower or for the rehab or refinance of existing debt on a property the borrower already owns.

A new loan to a new client offers the possibility of a continued lending relationship with current and future profits. In this scenario you are lending specifically to one party and have control over origination, documentation requirements, terms, servicing etc. You will not have potential liability for a previous originator or servicers mistakes. If this is a new loan made to a previous client you have the previous performance history readily available.

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