We talk a lot in other Lending Guide articles about due diligence as it pertains to evaluating a loan. This is where we get into detail about exactly what that looks like and the factors involved, including how private lenders evaluate deals and the time value of money.
You’ve probably already got a solid handle on how to decide if a real estate deal is right for you. (If you’re new to investing, head over to our friends at Think Realty for some free advice). But how about how private lenders evaluate deals?
You’ll save yourself a lot of time and headache if you know what a lender cares about and how they arrive at decisions.
When it comes to how private money lenders evaluate deals, they care about:
- Whether it’s worth it to loan you money.
- That you will repay their money.
- What they get if don’t repay their money.
Whether it’s worth it: the time value of money
Time value of money is why investors invest. Time value of money is also a core principal of finance that, due to its obviousness, is easy to overthink. It’s the idea that people, being reasonably assured that they will receive the same amount of money either way, will always choose to receive it now rather than later. Money you have now has potential earning capacity between now and later. (Bird in the hand anyone? Anyone?)
The private lender will use a time value of money calculation to decide between competing loans. They will also use it to figure their opportunity cost to waiting for a better deal. This calculation considers:
- The lender’s average rate of return (their opportunity cost) over a given time
- Their anticipated cash flow
- The cash flow’s timing
Time value of money formulas can vary from lender to lender, so we won’t get into them here. Rather, take this example to illustrate why time value of money matters to lenders:
John has $10,000. He sticks it under a mattress today and forgets about it. Meanwhile, Jane has $10,000. She invests it at a 10% interest rate.
Jane has additional risk (well, unless John’s house burns down). But a year from now the investment comes through and she has $11,000. Jane made the better decision; John now has $1,000 less than Jane. Add in inflation in our not-quite-real-world example, and John has lost money – his buying power is now less.
Moreover, let’s say all John really wanted was to have $10,000 in a year. A year ago, he could have invested $9,090.91 at a 10% interest rate to come out at that same $10,000 while also keeping $909.09 in fun money. John, why did you put $10,000 under a mattress?!
How private lenders evaluate deals: your credit and capacity
- Your borrowing history. This includes your credit score and credit history.
- The current factors in your life that may contribute to the likelihood of you defaulting on the loan. This includes your debt to income ratio, your income stability, your experience in the kind of project for which you’re using the money, etc.
While private money will cost more than banks, as with any loan you should expect to pay even more if your credit history or current financial circumstances look risky on paper.
If you know you have bad credit or your current circumstances look a bit shaky on paper, the best thing you can do for your chances is be honest and direct about it. Private lenders understand it’s the nature of the business they’re in, and they’re very good at solving problems (and have most definitely seen worse).
If you can offer an explanation that helps mitigate negative factors, absolutely provide that to the lender. If a lender has a solid basis for believing that these issues will not affect your ability to repay the loan, it can go a long way toward helping your costs.
What they get if you don’t pay: your collateral
Private lenders will use a combination of the following methods to determine what your subject property is worth:
- Broker price opinion
- Automated valuation model
- Personally visiting the property and surrounding neighborhood
High-impact information may never come to your attention through normal valuation processes. There is no substitute for research that reveals current or future circumstances that can dramatically affect your investment and chances of getting a loan. This process is called using multiple points of value.
Beyond that, after the lender has determined your collateral’s value, they will weigh it against your other loan factors to determine the loan to value they are willing to extend. And always remember: how private lenders evaluate deals will change from lender to lender. Just because one lender thinks your deal is a bad bet, doesn’t mean the same is true for all. If you do find yourself running in the same issue over and over, ask what you can do to resolve it. You may also be able to add something to the deal to sweeten the pot, so to speak. How private lenders evaluate deals can change with a little negotiation.