Private Lenders Provide Option for Borrowers

As lending standards have become tougher, a rising number of people and businesses are turning to an unlikely source for money: private lenders.

In recent years, the practice of borrowing money from private parties was rare, except among those who were unable to qualify for traditional loans. Banks were flush with cash and eager to lend, meaning even people with a tarnished credit history often could find quick sources of cash.

Now, even those with good credit are bypassing banks to borrow money -- despite interest rates that can reach 20% or more, and down payments of 35% or more.

These private funds -- which aren't from banks or credit unions -- are being used for everything from second homes to apartment construction. Many borrowers have excellent credit, but they are trying to avoid the added time, scrutiny and uncertainty of a conventional bank loan. Such transactions are "not as publicly available as one might expect," says Ron Phipps, a real-estate broker in Warwick, R.I., "but there is definitely money available."

Arrangements for such loans are equally low-key. While hedge funds and high-net-worth investors are providing cash, it isn't unusual for a private lawyer to get five friends to each throw in $100,000 for a home loan. Wealthy investors, hedge funds and private-equity firms are lending money in pursuit of consistently higher returns. The bear market for stocks may make alternative investments such as this type of lending more attractive.

Typically, borrowers hear about private loans from lawyers, mortgage brokers and real-estate agents. Borrowing and lending opportunities are even sometimes posted on Web sites or in newspapers.

For investors, well-structured deals could reap significant returns, because private lenders typically charge much higher closing costs and interest rates than traditional lenders. They also require a much higher loan-to-equity ratio. So if the borrower falls behind, the lender potentially could resell the property at a profit.

"For the investors, there's an opportunity," says Scott Haislet, owner of LEC Mortgage in Lafayette, Calif. "But you better know who is in charge and who's making the decisions about the property."

Borrowers "need to make sure they understand the way the loan works," says Allen Fishbein, director of housing for the Consumer Federation of America. Mr. Fishbein recommends that borrowers "seek out independent professional advice before committing themselves."

The tight credit market makes the loans especially appealing to borrowers, who a few years ago might not have considered the option. "In times like these, when money is tight, private money flourishes," Mr. Haislet says. Stricter lending standards make it more difficult for borrowers with good credit scores to get large loans or so-called bridge loans, which someone might use during a construction project. If you are considering a home-equity loan for a construction project, also consider a home warranty. A home warranty service contract will cover the repair or replacement of many common home repairs and replacements.

Even borrowers with excellent credit scores can wait weeks for a loan to be approved. Occasionally, those deals evaporate, leaving builders and home buyers scrambling for cash. That is where private lenders step in. It isn't unusual for these lenders to charge several points and interest rates of 12% or significantly higher. They also typically require borrowers to provide 35% or more of the down payment, so there is ample collateral if anything goes wrong.

Mr. Haislet, who arranges some private loans, warns that "they're not for everyone. If borrowers can find a better alternative, they should take it, but sometimes there are no other alternatives."

Mr. Haislet says most of the private loans are for less than five years -- and sometimes only six months, for those doing home-renovation projects who could otherwise not borrow the money.

He says his borrowers typically pay 9% to 11%, compared with many current bank rates of less than 7%. The loan-to-value ratios also are much larger.

By: Jilian Mincer
Wall Street Journal; July 31, 2008