The year was 1996 and I was sitting across the desk from the man that would not only teach me about private lending but would become a mentor, investor and friend. The question was asked “do you know what a mortgage is?” to which I nervously replied “no”. I had heard the word before but at the ripe age of 18 years old I had not yet had a mortgage nor did I understand what they were or why they were needed. The man went on to share with me that he and his friends were providing money to people that were not able to get the money they wanted from a bank for a variety of reasons. These people would provide a piece of real estate as security and they would borrow money at interest rates that were 1.0% per month to 2.75% per month plus fees. He went on to share with me that these opportunities were considered high risk and were generally less than 6 months in length. From from time to time he would have to foreclose (another foreign term to me at the time) but because he was always lending less than what a property was worth he had never lost his money or the money of his friends.
Since I was first hired by a private lender the market for non-bank financing has exploded. But why? Why do people consider borrowing money from individuals and companies that charge higher interest rates and fees? Here is a short list that by no means covers all of the reasons but addresses the big ones:
1. Timing – many times a borrower has either run out of time to arrange bank financing OR needs some time to arrange their affairs so that they can qualify for bank financing.
2. Ease of use – the conditions and due diligence (think paperwork) imposed by private lenders can be lighter than that of a bank. Further, private lenders will work often times work quickly to get a transaction funded.
3. Common sense – one of the largest frustrations I hear from borrowers is the lack of common sense that banks use to approve and fund a deal. Private lenders realize that because of their size and structure they can afford to take a more common sense approach to lending money. They take time to know a borrower and the understand the security being offered because that same private lender will be the one who has to foreclose or clean-up the file if it goes bad. They are not one step removed from the borrower like a banker might be.
The above reasons represent my experience of why people use a private lender and why borrowers are prepared to pay higher interest and fees. It comes down to “opportunity cost”. I appreciate that there are numerous private lenders that prey on people in desperate situations but that is not unique to private lending. Every marketplace has it share of advantage seekers and predators. Private lenders fill a void and borrowers have to make sure they have a plan for repaying the money they borrow and this is true whether they borrow from a bank or from a private lender.
“There’s no such thing as a free lunch.” – Milton Friedman
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