A member of Networth IQ asks:
I’m debating on loaning a friend around 30k that I will dervire from a HELOC on my primary residence. I will recieve a flat 16% interest over the 6 months of the loan, and an extra 3% per month for every month if it’s not paid within 6 months. This moeny will be used for remodeling expenses on his investment property. We are in the process of creating a promisory Note and mortgage note for the loan.
Now, I know this is risky for a few different reasons but I don’t know how else I could generate $4,800 over 6 months for an investment of 30k.
Is there any glaring reason not to move forward with this loan?
Don’t go into business with relatives or friends … and, don’t lend money to them – which is pretty much the same thing, anyway …
… unless they are collateral damage and you are prepared to foreclose on them or sue them at the drop of a hat.
But, for the sake of this post, let’s put aside the “friends” issue and focus on the underlying ‘investment opportunity’ laid out in the question:
This goes to a debate that I was having on another topic about Trust Deeds …
[AJC: worth reading just for the entertainment value … you get to see how closed minded and rude some people can be when encountering contrarian thinking] just scroll back to see it)
… my contention is – all other things being equal – is that if you are going to take the risk, why not take the upside as well?
We don’t know the outcome of the remodelling of the investment property. For example, is this ‘friend’ going going to remodel then flip? Or hold?
Let’s take these two scenarios one by one:
You have to ask yourself what the chance of success is in the current market?
Because, if you lend the money and the flip is not successful, how do you get paid back without suing/foreclosing? And, you presumably stand behind the bank, so what chance do you have of getting your money back, if you do foreclose?
If you are going to take this risk, you may as well be in the full-hog and hold equity in the deal to get the full upside, as well.
On the other hand, if the flip is successful, you have taken a major risk for limited upside: if the property can be sold to (a) pay you back your principle, and (b) pay you the interest owed to you, and (c) give the ‘friend’ their required profit, why don’t you just take a split of equity in the deal instead of (as well as?) the interest.
In fact, I would be asking for a split of the profit or equity in a rehab/flip deal, with a minimum payout of the interest component that I would have expected … a kind of cake-and-eat-it approach. Friend or no friend … take it or leave it offer.
There are only two ways that I see this as a likely scenario:
1. The Rehab/Flip scenario didn’t work, so the investor/friend team are forced to hold on to the property (foreclosure being the ugly alternative, as discussed above), or
2. The friend intends to approach the bank (or another one) to refinance on the new post-rehab, presumably improved, valuation and use some of the proceeds to pay out investor out … in the current market, a lot of if’s and but’s in there!
The safest approach for both parties in this scenario is to borrow the unimproved value from the bank, add in the $30k from the HELOC as ‘equity’ and hold the property together under some agreed equity split. Paying HELOC interest the whole time doesn’t make sense, so the partnership agreement should spell out the requirement to at least try and refinance every so often.
The advantage: the property increases in value over a sufficiently long hold period (in the current market, who knows how long ‘sufficient’ will be … which is why buy/hold, at least as a backup option to flipping, is so attractive) and you get the negotiated % of the upside.
So, in both cases, by lending the money, you take on significant risks associated with the underlying investment, without access to the underlying capital returns. Why do it?
One final note: by using a HELOC to invest in this new property you are gearing to the max.
This, of course, is a good thing ifyou are (a) certain to flip at a profit, or (b) able to hold and cover the costs of the HELOC long term (or refinance out of it) … pretty big if’s, if you ask me 😛