Getting money from private lenders is surprisingly easy, once you understand how to find and talk to them, but there’s another very important aspect of private money that touches on legal issues that you need to know about. Let’s go over a few of the basics of how to handle private money right, once you get it:
1. Touching the Money.
2. Co-mingling funds.
3. When do the payments start and end?
1. Touching the Money
Sometimes when people hear the kind of interest I pay, they get so excited about loaning me money that they want to hand me a big check right on the spot. This is not the correct or legal way to handle the situation.
I know that some of you are so eager to launch this new phase of growing your business that you really want to grab that first check, but don’t do it.
Here is why: you have promised the lender that the money is secured by real estate. So, legally, you shouldn’t be in possession of unsecured money. Until there’s a deed ready to secure it against, don’t hold it, don’t put it in your bank account—don’t touch it at all.
This is the correct procedure: have a quick meeting of the minds with the private lender, and then when you have a deal ready to close, have your attorney prepare the mortgage and note, sign it, and send it to the title company that is closing the deal, and have your lender wire their money to the closing agent for closing. Nice, neat paper trail and well-informed lenders.
2. Co-mingling private lender funds
Here is a common scenario: You will have two lenders who each have a small amount to loan. With the combined amount, you have enough funds to cover the purchase and/or rehab of a particular property.
Question: Can you just put the money together and have them share the first mortgage? The answer is no. But you can still use their funds if you take additional steps as I’ll explain below.
My usual procedure is to give each lender a separate mortgage on a property. One lender gets a first mortgage, and if I need additional funds, I can give another lender a second mortgage after explaining to them that the first mortgage holds a stronger position. Larger amount of money gets the 1st mortgage, and the smaller amount of money gets a 2nd mortgage.
You can “pool” money from different lenders, but only if you if you do some paperwork with your state, and possibly the SEC. There will be a fee—sometimes a large one—but if you know and follow the rules, then you can pool money and put all private money lenders in a shared 1st position. If you haven’t done the legal work to allow this, do not co-mingle or pool investor money.
3. When do the payments start and end?
This is a little tricky for some real estate investors to understand. The best way to structure this is to start paying interest from the day of closing to buy. Then interest and payments stop on the day of close to sell.
The thing is, at the time of sale, you will find many private lenders will want you to hold on to the private money so you can keep paying them interest.
Don’t. Again, what you should be dealing with is money secured by real estate, so never keep the money in the gap between properties. There are all sorts of legal and practical pitfalls to this: the money might end up getting spent on something else, for instance.
Besides, why would you want to keep the money? Often, real estate investors think they’re being smart, because by holding on to it, they know that the lender won’t loan it to someone else, and it will be available for their next deal. Have no fear. The lender will be begging you to take their money on the next deal. Your job is to get them that next deal.
When I pay back lenders upon selling a property, I ask them if they want to loan their money on another property. Nearly all will say yes and then, their interests start again at the next closing to buy.
On short-term loans, I came up with “Alan’s Rule of Thumb”. If I have someone’s money for less than 90 days, on a house I wholesale, for instance, I pay a minimum of 90-days interest on all loans on properties sold under 90-days. I just feel it is fair to the lender since they took the time to move their money for a short period of time.
The lesson here is to run a professional operation and have your handling private money rules in place.
You’ll be much happier—and safer—in the long run.