As Lending Standards Tighten, Some Borrowers Turn To Private Lenders

For years, the practice of borrowing money from private parties was fairly rare, except among those who couldn’t qualify for traditional loans. Banks had tons of cash and were eager to lend.

But today, even folks with good credit are bypassing banks to borrow money -- despite interest rates that can reach 20% or more, and down payments of 35% or more.

These private funds -- which aren't coming from banks or credit unions -- are being used for everything from second homes to apartment construction. Many borrowers have excellent credit, but they are trying to avoid the added time, scrutiny and uncertainty of a conventional bank loan.

Arrangements for these loans are pretty low-key. While hedge funds and high-net-worth investors are providing cash, it isn't unusual for a private lawyer to get five friends to each throw in $100,000 for a home loan. Wealthy investors, hedge funds and private-equity firms are lending in pursuit of higher returns. 

Typically, borrowers hear about private loans from lawyers, mortgage brokers and real-estate agents. Borrowing and lending opportunities are even sometimes posted on Web sites or in newspapers. 

For investors, well-structured deals could bring significant returns. Private lenders typically charge much higher closing costs and interest rates than traditional lenders. They also require a much higher loan-to-equity ratio. So if the borrower falls behind, the lender potentially could resell the property at a profit.

Even borrowers with excellent credit scores can wait weeks for a loan to be approved. And if those deals evaporate, builders and home buyers are left scrambling for cash. That’s where private lenders step in. It isn't unusual for these lenders to charge several points and interest rates of 12% or more. They typically require borrowers to provide 35% or more of the down payment, so there is enough collateral if anything goes wrong.

– By Ed Coury, Senior Editor and Midwest Bureau Chief for the Wall Street Journal Radio Network, Dow Jones & Co., and a reporter for WWJ Newsradio 950.