Hard Money vs. Private Money and How They Work
A friend asked me to explain the difference between Hard Money and Private Money and how to use them both. It’s a really good question as a lot of people talk about these casually but don’t break down the differences between them or the logistics of actually using the money.
Some would say that Hard Money is more expensive but that’s not always the case. Some would say that Private Money is from friends or family and that’s not always the case either. I generally divide them down the middle by whose money they are lending. Private lenders are typically lending their own cash or retirement account funds. Hard money lenders may be lending their own money but are probably pooling funds and lending other people’s money too. This is more regulated by the S.E.C. as I understand it—when they are pooling funds. The professional hard money lending institution probably has guidelines that they follow in regards to their maximum LTV (loan to value) and draw fees etc. They will scrutinize the deal and if they are experienced and ethical will help a newer investor underwrite a deal. If the hard money lender doesn’t want to do the loan, you might want to reconsider.
A private lender could be just about anyone. It could be a co-worker, a church member, a family member, or even someone you meet at a meetup. These are all examples of people in our circle that have lent money to us. They may have experience in real estate or they may have made their money in other industries and just want to diversify into real estate and receive some great returns backed by hard assets. This means that they may not be able to underwrite as well as the professional hard money lender. This also means that you should be very certain of your numbers and have contingencies planned for overages etc. You are taking on a huge responsibility when you work with other people’s hard-earned money. If you over-deliver to your lenders, they will come back to lend again. And they may actually start to “nag” you about when you will have another deal for them to invest in. This is a great problem to have.
The terms of the loans with hard money lenders can vary by lender but they are competing with one another so the variance won’t be too drastic in a given market. Some will offer lower rates and/or points after doing multiple deals with them. Currently in San Antonio I am seeing hard money terms in the ballpark of 2-3 points and 12-14% interest. Draw fees are the fees paid to release portions of the rehab dollars (if they are lending the renovation funds too) after portions of the work are inspected and deemed adequately complete. These are usually a couple hundred dollars each time. In full disclosure we have never used hard money.
Private money has been our best source of capital; but only after we had done some deals the old fashioned way of buying them with conventional loans and paying for the rehabs out of our savings. Private money can be borrowed with almost any rules you and the lender agree to. They can be interest-only or amortizing. They can be short-term or long-term. Low interest or high interest. Monthly payments or all interest due at the end. The only limit is what the two parties can agree on. There are also usury laws which might apply if you were to get into the really high interest rates but that’s not likely because you’d just use a hard money lender if the best private money rates you could find were that high.
We started borrowing at 10-13 percent interest, interest-only loans. We would do a year term most of the time. At first we borrowed less than the purchase price and would fund the rehab ourselves so that the lender’s LTV (loan to value) would be very low and thus their loan would be very safe. After that we would borrow the full purchase and rehab and we would deposit the rehab money into a bank account which meant we didn’t have to pay draw fees. The lack of points on the front end, lower interest for the term, and no draw fees, make this money favorable from my perspective.
I would absolutely use hard money if I needed it while my private lenders’ money is invested elsewhere. I would also use it if it helped me gain experience and build my track record to show future private lenders.
It is important to know that the amount a hard money lender loans you will likely be some percent of ARV or after repaired value. This means that if their limit is 70 percent ARV, they will lend 70,000 on a house with an ARV of 100,000. So you will need to buy the house below this price and account for the repairs that will be needed or fund the repairs out of your own funds. Ideally you’ll get the house somewhere around 70 percent of ARV MINUS repairs. So, in this case, if repairs were estimated 20,000 you’d pay 50K. This is 100,000 X .70 = 70,000 70,000 – 20,000 = 50,000 purchase price.
The way you get the actual money will be different. With a hard money lender, they will likely want to loan to your LLC because it helps them avoid some of the regulations of Dodd Frank. The LLC helps to prove that the property is not intended to be used as a primary residence, and thus is exempt from Dodd Frank rules. This means you will need an LLC. They will likely scrutinize the deal details such as ARV, comps, and repair estimates to decide if they want to do the loan. Then they will fund through the closing process at your title company. They probably have promulgated documents through attorneys that protect them well. And they will tell you what their procedures for draws are. They are likely to include a physical inspection by an inspector. Some companies will allow photographs to document work completed and release a draw.
With private money, I recommend having an attorney write up the loan documents to include amount, rate, term, etc. Then allow the lender to read and approve the note before closing day to address any issues that may arise or answer any questions. Then the lender can take certified funds or wire funds to the title company and the escrow officer will handle the process of closing. It was a bit nerve wracking for us the first time we had 100,000 dollars of someone else’s money and we were responsible for giving them a return on investment and a return of their investment. We grew more and more comfortable with the process and private money has allowed us to grow much faster than we could have otherwise. Word starts to spread with private money and people who have lent to you will tell friends about the great returns they are getting. Don’t be surprised if you eventually have more private lenders than you have deals. This is a great problem to have.
With any of these lenders, they are trusting you but you also need to vet them and trust that they will do their part by delivering funds when and where agreed. If your lender flakes and the deal falls through, it reflects directly on you. We take pride in doing exactly what we say when a seller agrees to sell to us. We depend on lenders to make this happen. This is sometimes overlooked in the lender/borrower relationship. You each need each other. The lender is not slave to the borrower, in this case. You each provide something of value to the other.
I hope that this has demystified hard money and private money and helped you see how you can use them in your business. Please let me know if you still have questions. Remember money is needed to build our businesses and it helps us live a comfortable life but there are so many more important things in life. So go find some private money or hard money lenders and get to work but, as always, “keep the main thing the main thing!”