How to Lend Money as a Profitable Business or Investment

Lending money and profiting by charging interest and fees is an age-old business. A powerful passive income investment, it was mostly reserved for large banks until the dawn of the 21st century. Around 2005, peer-to-peer loan platforms opened the market to individual participants. Investors can also buy into vehicles like mortgage investment corporations and credit funds. However, some prefer to avoid a middle-man and lend money directly as an investment, or even a full-time business. In this article, I’ll show you how you can issue loans and earn income from fees and interest payments.

For the purposes of this post, I will assume that you have already found a borrower and assessed her creditworthiness. You’ve decided that you want to lend to her – it’s now just a matter of doing it.

How do loans work?

In general, the lender loans money to the borrower and profits by charging interest until it is repaid. The interest is usually an annualized rate (e.g., 10% per year), but is payable each month. It’s also common to charge administration and late fees.

If the borrower breaks the agreement, called a “default,” then the lender may demand immediate repayment or sue to recoup her funds. The most obvious default is the failure to make payments.

Some loans are secured with collateral, often real estate. Uncollateralized loans are called “unsecured loans.”

How to lend money as a business or investment

Lending money as an investment or a business is a serious undertaking. Done incorrectly, there’s a good chance that you will lose your capital. The following should be in place before you issue a loan to anyone.

Have a contract

A loan is best evidenced by a written agreement that is signed by the borrower and the lender. It should also be witnessed by a third party. Each person should retain a copy of the contract. You can refer to it if there’s ever a dispute. More importantly, you will need it if you have to go to court.

You should require specific details about the borrower, including her address and a copy of a valid driver’s license. This will be useful if you need to file a lawsuit.

The most common loan contract is a Loan Agreement, which is signed by both parties. However, Promissory Notes are also used, which are signed only by the borrower.

I have used various loan contracts over the years. I’ve had the best experience with shorter contracts (under five pages) that are written in language that’s easily understood. Some lawyers write agreements that are unnecessarily complex and hardly qualify as modern English. But incomprehensible contracts can be risky because one party may argue that they did not know what they were signing. As such, I want them to be clear and succinct.

Note: use a lawyer if possible. You can require the borrower to pay for your legal fees. For example, you might stipulate that you must be reimbursed for your costs before any payments are applied to the principal.

Understand the borrower’s repayment plan

You should have a thorough grasp of how the borrower intends to repay you. This should extend beyond “I just need my business to turn the corner.” Rather, understand what the loan will be used for and how it will help the borrower build wealth. You might even require a written statement. You can use this information to help define your interest rate, fees and maturity date.

Know the usury rate

Most jurisdictions have a maximum amount of interest that can be charged on a loan, called the usury rate. It’s usually a criminal offense to surpass it. Be sure that the interest and fees that you charge do not approach the usury rate. You should calculate it with the assumption that the borrower will incur the maximum number of fees (e.g. the borrower is late with her payment every month).

Charge an interest rate that reflects your risk

The interest rate you charge to the borrower should reflect the risk and effort involved. For example, if you believe there’s a good chance of having to remind the borrower to make interest payments, you should be compensated for your actions. This should be a passive investment.

While it may be tempting to charge a high interest rate, going overboard might hurt the borrower’s ability to repay you. You should not issue a loan if the borrower can’t afford the rate that compensates you for the risk you’ll take.

Most private lenders define a specific interest rate. However, if you are concerned about inflation or changes in prevailing rates, you might decide to peg what you charge to an index. For example, you might say that the interest rate on your loan will be the maximum US Federal Funds Rate + 7%

Define the payment frequency

How often is the borrower required to make payments? Most lenders choose monthly. You should define the specific day (e.g. the 15th of each month). You cannot require the borrower to pay you more than once a month. If you make the loan on the 3rd day of a month, then interest payments should be made on the 3rd. You might even choose the 4th, just to be safe.

Define the minimum payment

Is the borrower required to make interest-only payments? Or should she be regularly paying off the balance of the loan? Interest-only is easier to calculate, but it also might impede the borrower’s ability to repay the debt on time.

Include late fees

Late payment penalties are a good way to encourage the borrower to abide by the contract and make timely payments. I usually set them as 1% of the outstanding balance. Working with percentages, rather than fixed dollar amounts, ensures that I never cross the usury line. That’s a risk if you’re charging flat fees on a mostly-repaid loan as though it was newly issued.

Request post-dated cheques

It’s common for borrowers to forget to make payments. The easiest way to avoid that is for them to provide you with post-dated cheques that you can deposit into your account. It will help them avoid late fees and eliminate awkwardness between the parties.

Charge an origination fee

In addition to interest and late fees, you might decide to charge a set-up fee. I usually charge between 1-4% of the loan amount. For example, if I’m lending $10,000, I would charge $100-$400 in origination fees.

Set a maturity date

A maturity date is when the loan must be repaid. This is a necessary component of a loan agreement. In my experience, most borrowers underestimate how long they will need capital for. It’s common for them to tell you, “Lend it to me for one year, but I’ll probably repay you in six months.” That almost never happens.

As well, you should specify whether there will be a penalty for repaying the loan ahead of time. Some lenders will charge additional fees if the loan is returned before a certain date.

Define the application of payments

When your borrower pays you, to what portion of the loan are those payments applied? Interest? Principal? You should address that in your agreement. I usually apply them as follows:

  1. Interest
  2. Reimbursement of my costs
  3. Fees
  4. Principal

For clarity, the first portion of the payment must cover outstanding interest. If there’s anything left over, it would be applied to my reimbursements. After those are all paid, it would cover any fees. Lastly, loan payments would eat into the principal balance.

Define the collateral

You may require the borrower to pledge an asset as collateral for the loan. That should be defined in the loan agreement. If the collateral is real estate, you must involve a lawyer. It will probably not be enforceable, otherwise.

Add other default events

Beyond missing payments, you may want to include other actions that could cause a borrower to default on her loan obligations. These default events could increase your risk of loss. As such, you want the ability to immediately call in the loan if they occur.

Common examples are:

  • Not paying her taxes
  • Borrowing more money from others
  • Being sued by someone else
  • Receiving a civil or criminal judgement

To make it simpler, your loan agreement might stipulate that you have the right to recall the loan at any time and for any reason.

State the relevant jurisdiction

If you are lending to someone in a different city or state, you should define which laws govern the agreement and where legal action should take place. Obviously, it should be where you live or do business. For example, you might say that the agreement is governed by the laws of Massachusetts and any legal action will take place in the city of Boston. This will help you avoid travelling to enforce your contract.

Independent legal advice

The loan agreement should state that each party has had the opportunity to receive independent legal advice. This can help protect against claims that one side didn’t understand what they were signing.

Issue the loan by cheque

When you are ready to make the loan, you should give it by cheque. On the memo line, write “loan.” This will help your case if the borrower tries to allege that you actually gave her a gift. There is plenty of case law that binds to the depositor of the cheque to what was written on the memo line.

If you aren’t able to write a cheque, try to include a message elsewhere. For example, if you are making the loan via email money transfer, include “loan” in the message area. If all else fails, write an email to the borrower before you send the money. A simple “Hey, I’m about to send you the $5,000 loan” can be helpful.

Keep good records

You should track the progress of your loan and include notes about late payments or other important events. A simple spreadsheet will suffice.

Conclusion

Lending money is intrinsic to a functioning economy. Many entrepreneurs and small business owners cannot function without credit. As such, you can profit from helpful loans by charging interest and fees, and turning them into income producing assets. This is one of the main investment vehicles I used to achieve financial freedom.

Before lending money as a business or investment, you should research the applicable laws. Some jurisdictions require lenders to be licensed. Others have specific regulations that govern relationships between borrowers and lenders. Involving a lawyer is highly recommended.

Lastly, always enter the borrower/lender relationship with the assumption that the loan will not be repaid. Taking legal action is an unfortunate, but common, part of the business. You should only participate in it if you are comfortable with that. Some lenders (like me) try to avoid it at all costs and will not lend if there’s a high risk of litigation. Others are more predatory and purposely use the courts to seize assets that are worth more than the entire loan. But like it or not, lending money and filing lawsuits often go hand-in-hand.

As part of my mentorship program, I offer a 30,000+ word course that explores private lending. Learn more here.

About The Author

Alexis Assadi

Alexis Assadi is an investor, entrepreneur and writer, who advocates for making high-performing income investments and the lifelong pursuit of financial intelligence. He is a shareholder and director in three companies that provide funding to small businesses, entrepreneurs and real estate projects. His most recent venture is a firm called Pacific Income LP.

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1 Comment

  • Anonymous

    Reply Reply July 12, 2017

    You are great sir.

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