Friends and Family Loans for Real Estate Investing: A Guide

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Real estate investors are in constant need of additional funds, and in today’s market there are more sources than ever, between crowdfunding websites, hard money lenders, conventional mortgages, personal loans, even credit cards. But what about the original “crowdfunding” source: your own friends and family? How viable is it to borrow money from them to invest in your next rental property or flip?

Here are five points to consider, before deciding whether to make the plunge with your loved ones’ money.

1. Never Use Friends & Family Money to Fund Your First Deal

Inexperienced real estate investors make too many mistakes for them to be a good bet for investors. Cut your teeth on a few deals with more experienced partners, and learn how they normally fund their real estate deals. When the inevitable hiccups come, you can learn your lessons and then move on, without risking your father-in-law’s wrath.

2. Only Use Friends & Family Money for Short Term Loans

So you have 4-5 property investments behind you, and you’re feeling more confident, but want to avoid the expense and hassle of taking out a mortgage, hard money or otherwise. If buying a property and renovating it, what is your plan for recovering your investment? If selling the property, fine, but if you intend to hold the property as a rental unit, what is your plan for paying back your family members? Taking out a permanent mortgage once the renovations are finished is a viable option, but whatever your plan, make sure you have an exit strategy for paying back your friends and family.

For long term financing, it’s easier (and usually cheaper) to take out a mortgage.

3. Plan for the Worst Case Scenario

Before making the leap and accepting your friends’ and family’s money for your next purchase, consider all of the things that could go wrong with the deal, and account for them. What if the renovation goes over budget? What if it takes three months longer than the contractor projected? What if the property does not rent for what you expected? What if it does not sell for what you expected? What if the contractor takes your deposit money and runs to Mexico?

You should think through these and other potential risks, and account for them both with proper planning and adequate capitalization.

4. Be Prepared to Pay People Back Even if You Lose Money

The worst case scenario happened, and you’ve lost money (perhaps even a lot of money) on the deal. You have a choice: you can ask your friends and family to eat the loss, or you can pay them back all of their principal, or you can pay them back their principal plus the interest you promised them. Whatever you decide to do, be completely open and honest with them, and explain what happened. Most of us are willing to do whatever it takes to make our friends and family whole on the deal, even if that means that the interest you pay them comes in the form of helping them paint their house for the next three weekends.

5. Remember Other Forms of Funding

Assume a common pitfall occurs: the renovation goes over budget and takes several months longer than expected. You run out of money, and don’t want to lose your creditors’ faith by going back to them and asking for more money. There are plenty of places where you can raise extra funds, albeit at a cost. The cheapest of these is likely borrowing funds from your 401(k) or IRA, which can be effectively free, especially if paid back quickly.

You can borrow cash from your credit card (but it will generally cost 4 points and 18-24% interest)… or you could just put every expense possible on your credit card for the next two months while you finish renovations and execute your exit strategy for paying back your friends and family creditors.

Mortgages are an option, and hard money lenders can often close in 10 days. Similarly, personal loans or lines of credit may be practical, and if you have plenty of equity in your home, perhaps a HELOC.

Even the shadow banking industry, payday- and tax return lenders, are an option, if a generally bad one. The point is that there are always places to turn, if your best laid plans fall short and you need a temporary source of funds.

There are tangible benefits of borrowing from friends and family, which include lower costs and faster availability, which are valuable and shouldn’t be ignored. And while there are legitimate emotional reasons why investors are reluctant to borrow from their friends and family, remember that even if you have to pay them back late, they will still love you, and will respect you all the more for going through difficulty in order to honor your debt to them.

For all that, you may well pay them back in full, on time, with generous interest, because the deal was successful and earned a profit. You might just find yourself flooded with offers to invest with you, if your deals continue to earn a profitable return.

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