When you become a private money lender, you get to be the bank. Before you make money like a bank, you should learn to protect yourself like a bank. That doesn’t mean buying a vault…unless you keep that much cash on hand.

I’ve talked a lot about the advantages of being a Private Money Lender (PML), and they are many:

• You make many times the interest you would on a CD or other bank instrument.
• Your investment is secured by real property—something tangible.
• You’re in a debt position, as opposed to an equity position, if something goes wrong with the borrower.
• Lenders get paid before equity stakeholders when the property is liquidated.
• And many, many more.

Today, I want to give a bit of cautionary advice.

There is always risk in lending to other people. I never lend to people I don’t know, and I would advise you not to. Take the time to develop a relationship before you lend your money. Get to know how they do business. Get to know their ethics. Bluntly, do you trust them? If the answer to that last question is no, run back to your bank!

Join a local Real Estate Investors Association (REIA). They may be called networks, clubs, or associations. No matter what the one in your area is called, it’s a good place to meet and evaluate rehabbers. You’ll also meet other lenders who can tell you a lot about the rehabbers. One of the first things you’ll learn is that there is always more money chasing the deals than there are good deals. But it’s better to walk away from a good opportunity than to invest in a bad one. Take the time to learn to tell the difference before you commit your money.

Now once you decide to loan your money, there are steps you should take to protect yourself. And honestly, you’re protecting your borrower, too.

• Review the deal yourself to ensure the numbers make sense.
  It’s not rocket surgery. You don’t have to be an expert in rehabbing or the real estate market. If someone says that a house in a $100,000 neighborhood will be worth $200,000 after they’ve finished with it, something’s wrong. Likewise, if they say they need $10,000 to completely renovate a 2500 square foot home with a hole in the roof, something’s wrong. Those are extreme examples, but you get the idea.

• Have your lawyer draft or review the promissory note.
  The promissory note sets out the the interest rate you’ll be paid and the terms of repayment. If you haven’t worked with the borrower before, you may want to insist on monthly  interest payments, just to keep an eye on them. If you are confident in their ability and integrity, it’s easier on everyone to wait until the project is done and collect from the title company at the sale. There’s much less accounting involved that way.

Seriously? You thought you were done with homework when you graduated? If you’re going to invest and protect your money, you still have a lot of homework to do. Just now instead of As, you’ll be collecting dollars.

• File a lien on the property you are lending on.
  Always file the lien or make sure the closing agent does so. All liens against the property have to be settled before the property can be sold (or at closing the sale). If you’re putting up the money for the purchase of the property you want to be in first position. That means when the property sells, you get paid before anyone else, including especially before the property owner. If you’re funding all or part of the renovation, you may be in second or higher position. Liens are paid in the order they were filed; the higher the position, the more people get paid before you.
  That’s not necessarily a problem. We recently sold a property that was so expensive, there were five lenders. A bank was in first position because we were able to buy the property well enough. But the renovation was expensive, and nobody wanted to put up that much money and not be in first position. When the property sold, everyone was paid at closing, and we still put almost $60,000 in the bank.
  Not being in first position is simply a risk factor. Understand that risk and how much risk you’re willing to take. Higher risk generally means a higher interest rate on the loan.

• Make sure you are listed as a named insured on the builder’s risk or other insurance on the property.
  If something happens to the property, being a named insured means that you have to sign off on any payments from the insurance company before the rehabber can cash the check. It’s always better to know what’s going on. And that leads to my final point.

• Always make sure you have a good line of communication with your borrower.
  That can take many forms. You may want to schedule regular phone calls or emails. We put regular updates on this blog, and that satisfies most of our borrowers. It doesn’t matter how you communicate, just make sure you do.

But the most important thing is to know the person you’re lending to and be careful. As a late night comedy show put it a long, long time ago, “Always cover your assets.”