In the low interest rate environment we are currently in, private money lending offers an excellent alternative to traditional fixed income investments.
You can invest your money in private money loans, and earn a much higher rate of return than you can at a bank, with a bond, or even in high yield “junk bonds”.
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What are Private Money Loans?
“Private money loans” is a blanket term that is generally used to describe loans from non-bank sources. Loans can be provided by individuals or organizations, and while they may incorporate some of the characteristics of traditional bank lending, the terms are usually entirely different.
Private money loans can be available for a number of purposes, including personal loans, business loans, and real estate loans. Business loans in particular are common private money loans, since it is somewhere between difficult and impossible for small businesses to get a loan from a bank under any circumstances.
In addition, small businesses are too small to raise capital by floating bond issues, the way major corporations typically do.
Private Money Loans vs. Bank Loans & Bonds
While private money loans usually serve the same purpose as bank loans and bonds, that’s where the similarity ends. For starters, both bank loans and bonds tend to be standardized from one institution to another.
The reasons for this are simple – both bank loans and bonds are heavily regulated, and both are set up with the prospect of selling them on the secondary market.
Private money loans, by contrast, are loosely regulated at best, and are rarely sold between lenders or investors. Private money loans can also vary from one lender to another.
In many cases, you will find that the type of loans that are available at one lender are not available at others. You may also find a private lender offering loans that are completely different from anyone anywhere.
Bank loans and bonds rely on standard criteria and verification. For example, bond issues must generally be SEC-compliant, while banks have standard guidelines in relation to credit quality, income documentation, and collateral.
With private money lending, loan criteria and documentation run the gamut. For example, some private lenders may require credit scores and full income documentation.
But others, who make loans based on collateral or business cash flow – both very common private money loan practices – may be completely unconcerned with credit scores or formal income documentation.
For this reason, private money loans are often available to people and businesses who are completely unable to get bank loans.
Private money loans do have one thing in common with bonds, in that both involve investors investing their money in a specific debt instrument, to a very specific borrower.
This is unlike banks, where the bank is the direct lender to the borrower, and the investor merely invests money into the savings instruments issued by the bank, in the form of savings accounts, money markets, and most commonly, certificates of deposit.
Why Make Private Money Loans?
This gets to why private money loans are an excellent alternative investment. Almost universally, private money loans provide a higher rate of return than either bonds or bank investments – and usually by a very wide margin.
For example, while you may get no more than a 1% return on a one-year certificate of deposit – if you’re lucky – or a 3% return on a 30 year US Government Treasury bond, you can easily get a double-digit return on a private money loan. And with certain types of private money loans, it is even possible to get triple digit returns.
This is possible precisely because the clientele served by private money lenders does not have the ability to borrow from banks, or to float the bond issues. The high interest rates that they will pay will likely be the only viable source of capital they will have available.
It is also possible to get additional compensation by making a private money loan. For example, charging origination fees or points is a typical practice in the industry.
If you make a loan for $100,000, that requires the borrower to pay four points, you will earn $4,000 on your investment as soon as the loan is made.
Many private money loans also require prepayment penalties. Those penalties will allow you to collect income, even if the loan does not run to full-term.
Still another benefit that private money loans can be notoriously short in duration. The typical term of a private money loan is anywhere from three months to five years.
That means that you will not have to tie up your money for decades in order to get a higher rate of return, such as what might be available on bonds.
The Risks of Making Private Loans – and How to Limit Them
The lack of standardization in private money lending means that such loans do carry a significantly higher risk of default. That means that though a loan may include a 30% interest rate, there is more than a remote possibility that you will not pocket that return – or even your original principal investment.
This also increases the risk that you will have to take legal action against the borrower in order to recover your original principal, and any unpaid interest or fees.
This is never a pleasant experience, and holds the possibility that you could lose your entire investment in the event that the business you are lending to fails and/or files for bankruptcy protection.
If you are going to make private money loans, you should protect yourself against this risk.
There are ways to do this, including:
- Diversify your investment capital across several different loans
- Make sure that each loan requires a personal guarantee from the borrower, which will enable you to legally pursue the borrower’s other financial resources in the event of default
- Don’t invest beyond your knowledge base – since private money loans are typically made to small businesses, restrict your lending activities to businesses that you are familiar with
- Invest through an intermediary where possible
The last item is one that we will discuss in more detail in the next section.
Ways to Invest in Private Money Loans
There are various ways that you can invest in private money loans. The simplest way is to be a direct investor.
If you have capital to invest, and you’re interested in lending it to certain businesses, you can simply take out an ad in a a newspaper or on Craigslist, advertising that you have capital available to lend. In that case, you and the borrower can work out whatever terms that you can agree upon.
Angel investing (a.k.a., venture capital) is another route. While we generally think of angel investors as people who take equity positions in small businesses, they can also make loans.
In order to participate as an investor, you generally have to meet certain minimum financial requirements, such as a minimum net worth of $250,000.
These platforms bring borrowers and investors together, and as a result they offer investors a large selection of loans (or “notes”) to invest in.
The investing/lending process on these sites is simple and easy for investors. You can open up an account, put your money on deposit, and then invest in various notes for little as $25 per note.
That means that if you have a $25,000 investment, you can literally diversify across 1,000 notes. In addition, both platforms offer you the opportunity to sell your notes before they come due.
You will sacrifice a large amount of the investment earnings when you use P2P lending platforms. Rates of return are more typically in the very low double-digit range – which is still a lot better than what you can get at a bank.
But you will more than make up the loss of income with easier investing, greater liquidity, and a wider selection of potential loans to invest in.
Despite the high interest rates that are charged by private money lenders, the practice is growing dramatically in recent years. This is due in large part to the fact that banks have tightened credit requirements, and are especially reluctant to lend to small businesses.
You can participate in this trend – and earn much higher returns on your money – as long as you understand the risks, and take the steps necessary to minimize them.