It can happen to anyone. At a Fourth of July picnic, a brother-in-law asks you to chip in on a business venture. Or someone you know needs help with a mortgage down payment.
Some investors see an investment opportunity in private lending. Perhaps it’s a chance for a steady income that would be hard to match with a traditional holding like bonds or dividend-paying stocks.
“With interest rates at historic lows, investors are very definitely looking at private lending as a potentially higher yielding alternative to traditional bonds and CDs,” says J.R. Robinson, owner of Financial Planning Hawaii in Honolulu.
Lending sites play a role. He believes most deals are conducted through peer-to-peer lending sites such as Prosper and Lending Club rather than between individuals who don’t know each other. Such sites pool investors’ money to enable larger loans and spread risk. Prosper advertises an annual investment return of 6.8 percent, while Lending Club says returns range from 5.25 to 8.57 percent, depending on risk.
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Whether you lend to an individual directly, or use a crowdsourcing platform, lending entails risk. Your interest earnings could fall short of expectations, you could lose principal, or see a valued relationship shredded as you wrangle over money, broken promises or business strategy.
“Only investors with money to lose should be involved in this market,” says Amos J. Richards, an attorney who has participated in various crowdfunding ventures.
Reasons for private lending. But for some, private lending is a winner, a way to compete with traditional lenders, like banks. There are several reasons an individual might turn to a private lender.
As a private lender you can offer more favorable terms than traditional lenders. You might accept less collateral, a higher loan-value ratio or no down payment, for instance. Or you could have looser income requirements, allowing someone you trust to take on more debt than a bank would. Or you could approve a borrower with a short work history or who relies on an uneven income from self-employment or commissions and bonuses — factors that can cause a traditional lender to say no.
A need to network. But unless you’re approached by someone you know, it can be difficult to link up with a trustworthy borrower, says Sacha Ferrandi, founder of Source Capital Funding, a San Diego-based firm that matches investors with borrowers needing cash for real estate.
“Finding borrowers or brokers is one of the most difficult aspects of the industry,” he says. “Private lending is a very relationship-based industry, and the best way to start is to leverage local brokers that already have a network set up.”
Ferrandi also recommended networking “with local clubs such as the Rotary Clubs, investment clubs and real estate associations.”
Business brokers typically work with buyers and sellers, much as real estate brokers help homeowners and buyers, but many business brokers can help put a business buyer or owner together with a private lender or potential partner. Find them on the internet by searching “business broker” and your location.
Friends, family and the internet. Many businesses, even ones that become household names, start with private lending from friends and family. Often, a startup will issue shares to early investors that may give them rights superior to those of later investors in matters like voting or receiving assets if the business fails.
“In the more traditional marketplace, friends and family lending is more common than (deals between) unknown parties,” says Phillip Laycock, partner in New York-based Grassi & Co., an accounting firm that participates in such deals. “However, with the proliferation of online lending, wherein anonymous investors can lend to anonymous borrowers, that trend is shifting.”
Examples include Microventures, Kiva and AngelList. In addition, services like Lending Karma and LoanBack help lenders formalize agreements with individuals, Robinson says.
“I recently worked with a client who is formalizing a loan to her sister to pay for expensive surgery,” he says. “She is using LoanBack.com to manage the terms. It’s a pretty efficient and inexpensive solution — far less expensive than enlisting an attorney.”
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Online crowdfunding services tend to be set up to produce steady income for the lender, Laycock says. “The rates are typically high unless the nature of the relationship is close. They vary … but one might expect something in the range of 8 to 15 percent on up to legal limits, for this type of lending.”
Investor earnings are typically taxed as ordinary income, he says.
Also, a lender should have a thorough understanding of the business or asset being funded, Laycock says.
“The lender either needs to know the borrower and have knowledge of business and strategy, or of the assets on which the lending is based, or have confidence in those rating the credit-worthiness of the borrower,” Laycock says. “Much of private lending is related to real estate transactions. So knowledge in this area is highly important.”
Points to consider. Whether lending in a face-to-face deal or through a service, one should think clearly about key elements of the deal, experts say:
Is this someone you can count on to live up to obligations? What’s his or her track record and credit history? Is the borrower offering a good opportunity or looking for a bailout?
Have clear goals and realistic expectations. How much could you make on another investment? Are you considering this because it’s a win-win opportunity or would the loan be an act of friendship?
How will you make money? Will you simply count on interest earnings? Or will you share in the venture’s profits or get a percentage of the gain when the business is eventually sold? Will you be on the hook for losses?
What collateral will you have? If the borrower defaults will you be able to take possession of the property or business? Would you be able to go after the borrower’s other assets or future income?
What professional help do you need? It might be smart, for instance, to have an accountant review the borrower’s finances and tax returns. You might need a lawyer to draw up the loan agreement, and maybe an appraiser to see whether the property or business being acquired with your money is worth enough to serve as collateral.
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“Never lend to anyone, including your friends and family, without a legal agreement,” Ferrandi says.
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Private Lending Presents Opportunities for Investors originally appeared on usnews.com
