As a private lender since 2007 my most important job is to fund safe, profitable loans and not lose capital. I know thousands of other private lenders that, although have good intentions, make undisciplined decisions and all tend to lose money the same way. They focus too much on only the after repair value, ignore the day one numbers, don’t focus on the quality of their borrower and wake up underwater when a borrower can’t execute properly and eventually walks away from an incomplete project.
The first mortgage lender is supposed to take the LEAST amount of risk in any real estate deal. Not the most. Not an equal share. The least. That means the borrower speculating on the property takes the most risk. Any equity investors take more risk than you. You sit in the safest position because your collateral is a top priority position in the property.
That is how it is supposed to work. But too many lenders flip this equation upside down by chasing volume with aggressive leverage. Then they wonder why their portfolio bleeds.
What You Will Learn
- Do You Actually Need Loan Loss Reserves?
- Why As-Is Value Matters More Than ARV
- The 20% Rule That Protects Your Capital
- Case Study: The Light Default That Paid Off
- Case Study: The Two-Year Nightmare
- Using Your Default Rate as a Tool
- Why Communication Beats Aggression
- Taking the Negotiated Exit
Do You Actually Need Loan Loss Reserves?
Banks keep loan loss reserves. A percentage of their portfolio sits in cash to absorb losses to principal. For a company like Kiavi with a billion dollars outstanding, that could mean $50 million parked on the sidelines. Their business model assumes defaults will lose money.
At Hard Money Bankers, we keep very limited loan loss reserves. The plan is to never lose principal. Period. And the reason that works is because we do not lend at high leverage like inexperienced private lenders and the institutional guys do. Some lenders will even lend up to 90%+ LTC (loan to cost). Bad idea..
Here is the reality. If you want to do high leverage lending, you need loan loss reserves built into your model. Your defaults will lose money. That is a certainty, not a possibility. But if you underwrite conservatively, you probably will need much less reserves. You will still have defaults, but defaults become headaches rather than catastrophes.
At any given time, we have a couple dozen loans in some phase of default. Some are just one loan payment behind, while others are in early stages of the foreclosure process and every once in a while we take a property back as an REO. But we know how they back out if everything goes according to plan. An incomplete property (even at a low LTV) is risky and might involve additional work. . A completed property in default is usually in a very good situation.
Why As-Is Value Matters More Than ARV
Most private lenders obsess over the after repair value. They underwrite to 65% or 70% of ARV and think they are safe. Here is what they miss. You almost never have an ARV problem. If a borrower executes on a project and does a nice construction job, by the time they list the property you have 25% to 40% equity. You are sitting pretty.
Where you have REAL risk is the day one value. The as-is value. The purchase price leverage. Too many lenders are doing 90%, 95%, even 100% financing based on purchase price. That is where deals blow up.
Think about it. If somebody buys a property for $100,000 and you finance $95,000 of that, what happens if the borrower never starts the project, or walks away from the house or even worse, something happens to them personally? They have almost nothing invested. Walking away costs them a few thousand dollars. Walking away costs you your principal.
Even if they buy under market value with built-in sweat equity, they do not have real incentive to finish if problems arise. The cash they brought to closing is what keeps them in the game. Skin in the deal matters more than anything on paper.
The 20% Rule That Protects Your Capital
At Hard Money Bankers, borrowers bring a minimum of 20% down based on purchase price. Minimum. Most deals require more than that. But 20% is the floor, not the ceiling.
In a perfect world, you would have a 35% equity cushion throughout the entire process. 35% day one. 35% during construction. 35% based on ARV. That would be great. And I know that is hard to achieve consistently.
But here is what I will not do. I will not give someone super high leverage just because the competition will, or because they are a nice person or the ARV looks strong. The deals that have caused us real problems are the ones where we let day one leverage creep too high.
When underwriting, I look at ARV of course. The math has to work. But my primary focus is making sure the borrower has real cash invested. Because an incomplete property with high leverage is where lenders get destroyed.
Case Study: The Light Default That Paid Off
Let me walk you through a recent deal that represents a common type of default we handle.
Borrower bought a property for $320,000. Estimated $45,000 in construction. We valued it at about $425,000 ARV. They obviously thought it was worth more, otherwise why do the deal? We lent $260,000 with $45,000 held back for construction draws. That was $215,000 towards purchase price (67% LTV day 1). That means they brought roughly $130,000 to the table. Real money.
The borrower had 650 credit. Not perfect. Contractor type who probably went over budget on the rehab. What happens in these situations is predictable. They used their available cash to pay for construction instead of making monthly payments. The job got done but payments fell behind.
We extended the loan. Charged them an extension fee. They missed several months of payments while trying to sell. The property eventually sold for $425,000. Our payoff was $279,000 on a $260,000 loan. Several months of accrued interest plus extension fees.
Here is what we did NOT do. We did not hit them with our 24% default rate. This was a tweener situation. They were a couple months behind but communicating. Making an effort. The broker who referred them sends us a ton of business. So we let it accrue at the note rate and waited for the exit.
Why did this work? Because they brought $130,000 to closing. They were incentivized to finish and sell even though they barely broke even. Maybe lost money. But they could not walk away from that much invested capital. That 20%+ down payment protected our principal.
Case Study: The Two-Year Nightmare
Now let me show you a deal that has been a headache for almost two years and counting.
Borrower bought a property at $334,000 with a $699,000 ARV. Legitimately bought under market. That is not common. Real investors in that neighborhood were paying more. They brought about $86,000 to the table on a $320,000 loan amount. Rehab costs were $50,000. So $270k loan day 1 (80% LTV). Looking back, that was higher than we should have done with not enough cash to close. We were nervous about their execution going in.
That nervousness was justified. They ran over budget. Did not complete the job. Started missing payments. We began foreclosure in Maryland, which takes about 6-8 months to reach auction, assuming everything goes smoothly.
Then they filed Chapter 13 bankruptcy to stop the process. 9 out of 10 times filing a BK in these situations is a stall tactic. They rarely are actually bankrupt or plan to go through a bankruptcy trustees 5 year plan. It just buys time.
I gave them the best practical advice I could. Sell the property as-is. Work out a number with us. Get what you can and move on. Time is working against you. They ignored that advice. Tried to find a refinance. Tried to finish the job that had been stalled for a year. Neither happened.
The incomplete renovation means they cannot sell to a retail buyer. No conventional or FHA financing available. Investor-only sale at a discount. We referred an investor who made an offer at $450,000. They were giving them the number they wanted. And the borrower defaulted on signing the agreement since they thought they could sell for more.
Then they filed Chapter 13 again to postpone an auction sale that I had already postponed as a courtesy. Two years of this. Our full payoff at default rate is now massive. Obviously we are not collecting that. But even at a regular note rate with two years of interest, the attorneys get paid, and we get out whole.
The lesson? Even with lighter equity than I prefer, conservative underwriting based on as-is value saved us. If we had lent aggressively on that $699,000 ARV, we would be sweating right now. All that built-in sweat equity from their good purchase price would be meaningless. Remember: the after repaired value only exists if the property actually gets renovated.
Using Your Default Rate as a Tool
Talk to the attorney who does your loan documents. Based on your lending states, see what default rate is allowable and enforceable in court for these investment/business use commercial transactions. For many states we lend in its been as high as 18%- 24%.
Will you necessarily collect 24% through a full foreclosure? Maybe yes, maybe no depending on the state. But you should have that tool available. Here is how I think about it.
The default rate creates urgency. When someone gets behind and stops communicating, a letter from our attorney with 24% gets their attention fast. They come out from hiding. Suddenly they want to talk about their exit plan.
But I do not automatically deploy it. We have deals with rolling 30-day or 60-day lates where we have not sent a default letter because the borrower is communicating and working toward resolution. The default rate is leverage. Sometimes you use leverage. Sometimes you hold it in reserve.
One borrower right now is three months behind on a property where we are sitting at 50% LTV. Great position for us. I called him and said we need to get current. He sent a wire for one payment. Went from four months back to three months back. Progress, but not enough.
Could I default him? Put him at 24% rate and just let the attorneys handle everything? Sure. But I want to work with him. He is actively trying to sell and pay off the loan. That is a good sign. Defaulting him would poison the relationship and might push him into bankruptcy or some other stall tactic that costs everyone more time and money.
Why Communication Beats Aggression
The institutional lenders might not have the flexibility like private lenders do. I was talking to an attorney recently whose client defaulted on five projects at once with a non-private lender. The borrower’s attorney couldn’t even get anyone on the phone at the firm to try to remedy the default. The borrower even had some options to sell properties and pay off the money. Maybe not full payoff at default rate. Maybe note rate. Maybe somewhere in between. But they cannot even have that conversation. Nobody at a shop like that might even have authority to negotiate a workout.
This is where private lenders stand out. I control my own money. I control my own servicing software. If someone gets sideways, I can say give me a call and we will work something out. Real time, I can adjust terms, fees etc. to see what payoff number works based on their exit strategy.
Coincidentally earlier today, I was working on a defaulted loan in Washington, DC where the borrower might be able to refinance. Based on the loan amount she can qualify for, I played with the rate and landed at 18%. Sent a payoff statement at that number. Cannot get full payoff? Fine. Take a negotiated exit, get the money, get your loan paid off, and move on.
Taking the Negotiated Exit
There is an old saying. Pigs get fat. Hogs get slaughtered. Private lending offers plenty of opportunities to be a hog. Resist them.
If you go hardline across the board trying to collect 24% default interest on every deal, you will do yourself more harm than good. Some borrowers will file bankruptcy. Some will just stop communicating entirely. Some will sell to a buyer who cannot cover your full payoff, and you will end up owning a half-renovated property you never wanted.
Discipline matters more than maximum extraction. Take the negotiated exit. Get your principal back. Get a reasonable return. Move on to the next deal.
One more thing about monthly payments versus interest reserves. Some lenders build interest reserves into loans so borrowers make no payments for several months. I prefer monthly payments for a simple reason. It keeps me connected to the borrower.
If someone has 12 months of prepaid interest, I have not communicated with that borrower in a year by the time the loan matures. I have no idea what is happening. With monthly payments, I know within 30 days if something is wrong. We do default meetings every month for anyone behind. That is how we catch problems early before they become disasters.
The Bottom Line
Protecting your principal in private lending comes down to a few core disciplines.
First, underwrite to as-is value, not just ARV. The day one numbers protect you when borrowers fail to execute. Second, require real equity from borrowers. 20% minimum. That cash keeps them in the game when things get hard.
Third, use your default rate as a tool, not a weapon. Create urgency without destroying the relationship. Fourth, communicate constantly. Work with borrowers toward exits instead of just letting attorneys run the show.
Finally, take the negotiated exit. Pigs get fat. You do not need to squeeze every dollar out of a default to run a profitable lending operation. Get your principal back, earn a reasonable return, and live to lend another day.
These principles have guided us through 4,000+ loans since 2007. They work in up markets and down markets. They work with experienced flippers and first-time investors. Build your lending business on this foundation and you will sleep better at night.
Ready to build a private lending business with systems that protect your capital? The Hard Money Mastermind gives you access to 2,600+ lenders sharing deals, strategies, and hard-won lessons. Monthly live coaching with Chris and me. The complete Hard Money Masterclass. And a network of professionals who have been where you are going. Learn more at hardmoneymastermind.com
DISCLAIMER: The information provided here is for educational purposes only and does not constitute financial or investment advice. Always perform your own due diligence and consult with qualified professionals before making investment decisions.
