When it comes to real estate investment strategy, there are many opportunities to receive funding for a project. Two of the most common sources for investment property financing are private lenders and traditional bank loans, also known as a mortgage. Before choosing which type of real estate lending works best for your project, it’s important to understand the differences between a private lender and a bank mortgage.
Private Lending vs Bank Lending
While each provides money, a smart real estate investor should know the differences between the two. Banks are traditionally less expensive, but they are harder to work with and more difficult to get a loan approved with. Private lenders tend to be more flexible and responsive, but they are also more expensive.
What is a Bank Lender?
Banks are in the business of taking in funds from depositors, paying them a very low interest rate (if any) and lending money out to borrowers at slightly higher rates and making a profit from the spread between what they are paying and what they are collecting in interest.
When needed, federally chartered banks can borrow money from the federal government, at a very low rate. Again, the bank can lend these funds out at a higher rate and derive income from the funds.
What is a Private Lender?
Private lenders are generally funded by investors, or by banks, or both. Private lenders are in the business of taking funds from private investors and making private business purpose loans with those funds.
The investors expect a decent return from their investments, and interest rate from money borrowed from banks is significantly higher than the banks are being charged for the funds. These factors raise the private lender’s expenses, which is then passed on to the ultimate borrower.
Private Lender vs Bank Mortgage Comparison
Banks are frequently harder to deal with than private lenders. Banks are subject to significant state and federal regulations, as well as programs set forth by governmental and quasi-governmental agencies such as Fannie Mae, Freddie Mac, the Veterans Administration, and the Department of Housing and Urban Development. These regulations often dictate what businesses a bank can lend to and what borrow profiles should look like.
Private lenders, while still subject to state and federal laws, are significantly less regulated and can be more flexible in the types of loans they make and who their customers are.
Accordingly, it is generally easier to get approved by a private lender than a traditional bank, as private lenders are able to customize each loan based on a set of internally set criteria, such as credit scores, loan to value ratio and debt to income levels.
Bank approvals are program or computer driven with little discretion available to the lender. Private lenders generally take a more common sense approach to understanding issues and overcoming them.
In addition, banks tend to look at financial histories and credit through easily traceable and documented income sources, making it very difficult for self-employed borrowers to qualify for bank loans.
Private lenders will be more creative and investigative in qualifying income and may be willing to overlook background flaws upon explanation.
Private Lenders:
- Higher Interest Rates – More Expensive
- Faster
- Easier Approval Process
- Less Regulated – More Flexible
- More Customizable Loan Options
Banks:
- Lower Interest Rates – Less Expensive
- Slower
- More Scrutinized Approval Process – Including Financial History and Credit Audit
- Subject to Significant Government Regulations – Less Flexible
- Strict Loan Options Due to Regulations
Selecting a Lender For a Real Estate Investment
It is important to remember that the difference in pricing between a bank lender and a private lender is generally not significant when dealing with a short term loan.
Bottom line, banks are a great option if you have a simple, straightforward property to finance. However, a private real estate lender is more likely to finance a loan on a challenging property, in a shorter period of time.
For those looking to immediately invest in property, a private lender will close your loan faster, with less aggravation to the borrower. This will allow the borrower to grow their business faster, which makes the extra short term costs of a private lender worthwhile.
Choosing the type of lender that is best for a real estate investor is not simply a matter of the least expensive option available. A borrower that will not qualify for a bank loan can waste weeks, or even months waiting for a decision from a bank when they could have been approved and moved forward with a private lender in a matter of days.
In the end, the least expensive loan at the beginning may be the most expensive in the end.
Learn more about the loan process by reading our “Step-by-Step” Guide to Borrowing.
Once you decide which type of lender is right for you, use our House Flipping Calculator to see how much flipping a house will cost!
