Private Money Lending for Real Estate Investments

Private money lending usually means borrowing from an individual, such as a relative, colleague, or another investor, instead of a bank. You and the lender set the rate, term, and payment schedule yourselves, and the loan is secured by a promissory note and a mortgage or deed of trust recorded against the property. The limits come from law, not a lender's guidelines: your state's usury cap on interest, securities rules, which can apply to any note you offer and become more likely when you raise money from several people, and prohibited-transaction rules when the money comes from someone's IRA.

For how private money compares with bank, DSCR, and other loan types, see tips for getting approved for an investment property mortgage.

How a private money loan differs from a hard money loan

The two terms overlap, and some lending companies call themselves private money lenders. In general, a hard money lender is a business that lends against property: it publishes rates and points, sets loan-to-value limits, and closes many loans a year. This article covers the other kind: a person lending their own savings, often once or a few times, on terms you negotiate one-on-one. Hard money loans covers the business version.

Federal Truth in Lending rules treat a loan to buy, improve, or maintain a rental you will not live in as business credit. That means the Loan Estimate, Closing Disclosure, and ability-to-repay rules do not apply to a private loan on an investment property. Apart from state laws such as usury limits, the documents you sign set the terms and protections for both sides, so they need to be complete.

Where private lenders come from

• People who already know you. Relatives, friends, coworkers, and business owners with savings who want a fixed return secured by real estate.
• Other investors. Members of a local real estate investors association who would rather lend than manage tenants.
• Self-directed IRA owners. People whose IRA custodian allows the account to make loans. The rules for this source are below and in self-directed IRAs for real estate.

Approach people one at a time with a specific property and a written term sheet. A public pitch for a fixed-return note program, such as social media posts or a website, is general solicitation, which changes how securities law treats the offer.

The documents that protect both sides

Close through a title company or real estate attorney. The lender wires money to escrow with written instructions for when it can be released, such as after the deed of trust is signed and sent for recording and the title company is ready to issue the lender's policy. Have a lawyer in the property's state draft the note and security instrument, since foreclosure procedure and required language vary by state.

A sample term sheet

You buy a house for $180,000 and need $40,000 for repairs. A private lender agrees to lend $150,000 at 9% interest, interest only, due in 12 months, with no prepayment penalty.

• Monthly interest: $150,000 x 9% / 12 = $1,125
• Total interest if the loan runs the full year: $1,125 x 12 = $13,500
• You owe $150,000 at month 12, paid from a sale or a refinance

Also settle these before closing: whether the lender gets an extension fee if the work runs late, who pays title and recording costs, how often you send updates and photos, and what happens to the loan if you sell early.

Usury limits: the most interest you can agree to

Each state sets its own maximum interest rate, called a usury limit, and many apply different limits by loan size, borrower type, or purpose. New York is one example:

• Most loans are capped at 16% a year.
• Loans of $250,000 or more that are not secured mainly by a one- or two-family home are exempt from the 16% cap.
• Charging more than 25% a year is criminal usury unless the loan is $2.5 million or more.

Your state's limit may be higher, lower, or waived for business loans. Ask the attorney drafting the note to confirm the cap that applies, whether an LLC borrower can rely on it, and how points, extension fees, and default interest count toward it.

When raising money from several people becomes a securities offering

Under the Supreme Court's test in Reves v. Ernst & Young, a note is presumed to be a security unless it strongly resembles an ordinary loan. The Court's list of notes that are not securities includes a note secured by a mortgage on a home and a short-term note secured by a lien on a small business's assets. Courts compare four things: why each side entered the deal, how widely the note was offered, what the public would expect, and whether other regulation reduces the risk.

A single loan negotiated with one person you know, secured by a recorded lien on one property, looks like a loan. Pooling money from several passive lenders into one note, or offering notes to many people to fund your projects, looks like raising capital, and the notes are likely securities. Then you must register the offering or fit an exemption. The common one is Rule 506(b):

• No general solicitation or advertising.
• Unlimited accredited investors: individuals with net worth over $1 million not counting their home, or income over $200,000 ($300,000 with a spouse or partner) in each of the last two years and a reasonable expectation of the same this year.
• Up to 35 non-accredited investors in any 90-day period, who must be financially sophisticated and receive disclosure documents and financial statements.
• A Form D notice to the SEC within 15 days after the first sale, plus any state notice filings.

Talk to a securities attorney before you offer a note to anyone you do not know well, and before you take money from more than one lender for the same project. If several partners are buying a property together instead, see creative financing strategies for partnership terms.

Borrowing from someone's self-directed IRA

An IRA can lend money if its custodian allows it. The note and deed of trust name the IRA (for example, "ABC Trust Company, custodian for the benefit of Jane Smith IRA"), the custodian sends the funds, and your payments go to the custodian, not to the account owner.

Federal tax law bars any loan between an IRA and a disqualified person. For a borrower, that means the IRA cannot lend to:

• The IRA owner, or the owner's spouse.
• The owner's parents, grandparents, children, grandchildren, or the spouses of children and grandchildren.
• A company or partnership that is 50% or more owned by any of those people.

Your parent's IRA cannot lend to you or to an LLC you own. A sibling's, cousin's, or friend's IRA can, because those relatives are not on the list, as long as you have no other role with that IRA, such as managing it or providing services to it. The loan also cannot benefit the IRA owner personally: the owner cannot take a fee or any other payment for arranging it, and cannot use the loan to help a business of their own.

If the owner engages in a prohibited transaction, the account stops being an IRA as of January 1 of that year and is treated as paying out its full value. Everything except the owner's after-tax contributions (basis) becomes taxable income to the owner. Confirm in writing that no one in your deal is a disqualified person for the lender's IRA before the custodian funds.

If you have no private lender lined up, seller financing lets the property's owner act as your lender instead.