Seven things to consider before lending money

A well made loan ensures the safe return of your money plus reasonable interest.  A poorly made loan can leave a hole where your money used to be, or worse!

Is the borrower gainfully employed?

If your borrower doesn't have a job, how are they going to repay the loan?  If the money is to start a business, see the next question.  If not, you'd better make sure they have some form of income they can divert into loan payments to you.  Lending money because someone doesn't have enough only works for the predators that use up and discard their borrowers.  For any responsible lender, a borrower with "insufficient" income is a poor candidate for a loan.

Does the borrower know the business?

If the money is to start a business, their plan had better include a way for the loan payments to get paid each month.  They also better have a solid background in the industry and a proven track-record of success in that industry.  Loaning money so someone can try something "they've always wanted to do" is a terrible idea.  If they don't know what they're talking about from actual experience, keep your money safely in your bank account.

Is the borrower a stable person?

Does your borrower speak clearly and amicably to you?  If you get the feeling this person is on the verge of a breakdown, talking around the subject, hiding something, easily angered or depressed, you should think twice before handing out your cash.  Dishonesty or mental illness can sap your portfolio of the rewards you should be getting.  Unless you're running a charity, avoid borrowers that cover up the truth or bounce between emotional states.

Is the borrower asking for too much or too little?

In your experience as a lender, does the need for the money and the amount match up?  Has the borrower provided a clear path to how money will be spent that makes sense to you?  If a borrower is asking for $5000 to open a new restaurant, they're not being serious about the real cost to open up shop.  Borrowing $50,000 to buy a car is a sign the borrower is not financially mature enough to drive something that expensive in the first place.  So unless the restaurant is a gumball machine or the car is a combine, pass.

Are they family or friends?

Many lenders are family members that loan money out of compassion.  Loaning money creates a master-slave relationship between lender and borrower.  If there's any chance the relationship won't survive the stress of a looming financial obligation, don't do it.  Better to say no and keep a friend than to lose money and friend.

Check references!

Still not sure if the candidate is worthy?  Request a list of references and ask these other people about the borrower.  If you get the impression the borrower is a jerk, or that everyone is lying to you, you have your answer.  If you get sincere people telling you how wonderful your person is, you're all set.  People tend to be extra nice when providing a reference.  If you get any indication that there might be something wrong, weigh that heavily.

Can you get some kind of surety or collateral?

It might be a worst-case-scenario, but if your borrower will put up collateral you have at least some guarantee that your money won't be completely lost if things don't work out.  Whether a car title, mortgage, appliance, jewelry, or something else, a little collateral helps ensure the borrower will pay on time and you have a "Plan B" if things go bad.

Once your borrower's intentions are thoroughly vetted, invest that cash with confidence that it'll return.  Nothing can compensate for proper diligence before the loan is made.

Diversified Lending by Industry

The same way an index fund helps to mitigate risk by balancing investments across many types of businesses, lenders can help ensure performance by making loans across a multitude of industries.

This is the second post about loan diversity.  Post One: Short and Long Term Loans

The mid to late 2000s was a disaster for many real estate lenders.

I was among the millions of people deeply affected by the recent "mortgage crisis" for two reasons.  Watching the fission of the market as both investor and borrower, I got to see how overeager borrowers combined with overeager lenders to create the critical mass of debt.

In the fallout that ensued, hundreds of mortgage companies would be bankrupted, bailouts would be given, and the industry would have to take a long hard look at its practices.  Billions of dollars simply vanished from lenders' bottom lines.  It was a difficult time.

TrailsWeb made most of its money by way of association with the real estate industry.  We sell Moneylender Professional to lenders around the world, a major percentage of which are real estate investors.  We also worked closely with AZNORTH Development, Inc., a mid-sized real estate developer and investor in Flagstaff, AZ.  We created highly customized market valuation software and investment opportunity maps, among many other software projects.  In 2006 TrailsWeb saw an 80% drop in total revenue.  By the end of 2011 the company had moved into my home office and I got an hourly software development contract with the State of South Dakota to keep the servers running.

For borrowers the story was a little different.

I was almost a casualty as a homeowner/borrower as well.  Foreclosures were rampant 100 miles away in Phoenix.  I had been in foreclosure for eighteen months before borrowing some money to reinstate my mortgage ten days before my home was to be auctioned.  I was about to go back into foreclosure again when I found work in South Dakota.  Taking advantage of the by-now-popular loan modifications, my interest rate was dropped to less than 3%.

I bought my house nothing down based on my credit score and stated income.  Often unable to pay even the first mortgage, the second mortgage went without payment for two years.  When I finally offered 20% of the principal balance (never mind two years of interest) as settlement in full, they jumped at the opportunity.  I immediately gained $40,000 in equity by not paying for my house!

In both of these situations, the lenders took a loss of one form or another to their bottom line.  And there are an unsettling number of users of Moneylender feeling sour about their mortgage and home equity loans.

Many parts of the economy survived the slowdown unscathed.

The auto industry was definitely hurting for a few years, and as new car sales slowed, used cars filled more of the market demand.  A good portion of Moneylender's users invest in auto loans on used cars - often because they operate a dealership or affiliate with one.  Many of these lenders saw new demand for their loans and could required higher rates or be more selective with their borrowers.

As the real estate market led the rest of the economy into a downturn, much of the displaced labor force sought continued education.  Lenders offering loans for tuition, books, and other school related expenses saw a healthy boost to their markets.  Some lenders played it safe with low-yield ultra-secure federally back student loans, while others collected moderate rates on personally guaranteed notes.

Small businesses rose up and prospered in the wake of the failing mortgages as a counterpoint to other businesses struggling.  As builders stopping pumping out new houses, handymen stepped in to maintain the existing housing inventory.  Realtors stopped selling houses and inspectors started valuating foreclosed properties.  Some small business lenders made stable loans to innovative entrepreneurs in the new marketplace.

And, in spite of the gloom on the horizon, the unemployment rate went from around 5% to just over 10% during the recession, meaning most of the well qualified borrowers who received loans from private lenders were able to continue paying, unaffected.  These borrowers are made up of constituents from every industry in our country.

Lenders in several markets mitigate risk, loss and fluctuation.

By holding a variety of notes, lenders can achieve the stability of a stock index fund.  All while maintaining personal and involved authority over the assets invested.  In Arizona, to be a professional lender you have to pay between $2000 and $10000 for the license.  If you've paid the money to be in business as a lender, I think it's worth it to take full advantage of the myriad lending opportunities.

Diversified Investing - Short and Long Term Loans

Investing is a delicate balancing act of risk vs. reward.  Too much risk and you might not get your principal back, too little and inflation will devour the fruits of your labors.  Diversification of investments is a well known practice which aims to maximize returns while mitigating the risks.

Having worked directly with hundreds of lenders over the years, I've seen an impressive variety of loan structures.  People are lending money for some of the most amazing reasons, and the returns vary from paltry to obscene.  Non-profits are lending without interest while ultra-high-risk lenders attempt to double their money in two months.

In this and the blog posts to follow, I hope to share my opinion on how lenders have succeeded in making a living by lending money.

Diversifying Your Loan Portfolio with Loans of Variable Lengths

Balancing stability, profitability, and cash flow is tricky for a private lender.  We need to ensure we have enough cash coming in to pay the bills and make new loans.  We don't want to have our money tied up in unproductive long-term loans, nor do we want borrowers to miss payments because the amount due is too high for shorter terms.

Creating a selection of loan products with varying terms can help you find the perfect match for each borrower.

Short Term Loans

Short term loans are excellent for borrowers with strong, steady income that require more capital for a prudent expense than they currently have.  One ideal situation includes an honest, hard-working borrower preparing for a large, non-frivolous expense.

For example, a very hard working friend of mine wanted to start a company, and in his good fortune he got an incredible deal to buy all the equipment he needed for $9000.  He came to my group of investors to see if we could lend him the cash.  We were more than happy to, since he already had a job where he was earning enough money to repay the debt, and the equipment was easily worth quite a bit more than the loan.  We made this loan, and the borrower chose an eighteen month term.  We charged a comfortable 14.9% interest and the deal was struck.  The borrower was very ambitious and his marketing savvy helped him repay the loan ahead of schedule.

Our short term lending allowed him to create a business.  Our money plus a reasonable profit was returned quickly so we could award it to the next deserving borrower.  Many lenders make fast, effective short term loans to responsible borrowers.  Examples include loans for unexpected bills, large but prudent purchases, loans to businesses to temporarily add inventory or buy assets, home renovation or remodel. 

Long Term Loans

Long term loans allow us to have consistency and to recover the expense of making the loan better than short term loans.  If a loan is well made, why would you ever want it to end?  And the early stages of the loan are rife with lucrative interest.

I've worked with many lenders who are also real estate investors.  When selling a property to a financially capable and thoroughly vetted buyer, they carry back a second mortgage.  (A "carryback", for anyone not familiar with the term, is when someone buys a house but only pays for part of it at the closing of the sale.  The seller agrees to take payments on the balance which is thereafter considered a second mortgage.)  This type of lending is very popular with real estate investors and sometimes non-investors find themselves playing the role of lender in order to get a house to close.

The loans typically run for ten to fifteen years and range from $5,000 to $200,000.  The interest rates are a little lower than short term loans - somewhere in the 8% to 11% range.  Of the payments made in the first year, typically 80% or more of the total cash received is profit.  Long term loans can really help your portfolio grow in size because the majority of the original capital is still invested but all the interest received can be readily made into new loans - significantly raising the amount of invested funds in the portfolio.

Long term loans require a deep assessment of the borrower before we hand out our hard earned cash.  If they're going to enjoy the fruits of our labor for ten years or more, we expect those fruits to multiply and ultimately be returned to us safely.  Once we're confident our borrower knows the nature of money and is prepared to make good on the commitment, we can watch our investments grow substantially from the long, steady and profitable repayment of the loan.

In addition to seller carryback financing, other popular longer-term loans include: automotive loans, educational loans, financing business purchases, and real estate mortgages.  Some of the more exotic lenders I've met have invested long-term in oil wells, wind farms, vacation properties, and multitudes of fascinating business ventures.  Whatever industry we know the best, there's probably a way our money will help someone else so that we both profit.

A good blend of short and long-term loans can provide us with a healthy rate of return, consistent cash flow, and opportunities to reinvest funds in a variety of scenarios.  Being flexible with the length of loans we make, we open ourselves up to greater opportunities to invest wisely.

More on Diversified Lending: Diversified by Industry