We talk a lot in other Lending Guide articles about due diligence as it pertains to evaluating a loan. This is where we get into detail about exactly what that looks like and the factors involved, including how private lenders evaluate deals and the time value of money.
You’ve probably already got a solid handle on how to decide if a real estate deal is right for you. (If you’re new to investing, head over to our friends at Think Realty for some free advice). But how about how private lenders evaluate deals?
You’ll save yourself a lot of time and headache if you know what a lender cares about and how they arrive at decisions.
When it comes to how private money lenders evaluate deals, they care about:
- Whether it’s worth it to loan you money.
- That you will repay their money.
- What they get if don’t repay their money.
Whether it’s worth it: the time value of money
Time value of money is why investors invest. Time value of money is also a core principal of finance that, due to its obviousness, is easy to overthink. It’s the idea that people, being reasonably assured that they will receive the same amount of money either way, will always choose to receive it now rather than later. Money you have now has potential earning capacity between now and later. (Bird in the hand anyone? Anyone?)
The private money lenders in Washington DC will use a time value of money calculation to decide between competing loans. They will also use it to figure their opportunity cost to waiting for a better deal. This calculation considers:
- The lender’s average rate of return (their opportunity cost) over a given time
- Their anticipated cash flow
- The cash flow’s timing
Time value of money formulas can vary from lender to lender, so we won’t get into them here. Rather, take this example to illustrate why time value of money matters to lenders:
John has $10,000. He sticks it under a mattress today and forgets about it. Meanwhile, Jane has $10,000. She invests it at a 10% interest rate.
Jane has additional risk (well, unless John’s house burns down). But a year from now the investment comes through and she has $11,000. Jane made the better decision; John now has $1,000 less than Jane. Add in inflation in our not-quite-real-world example, and John has lost money – his buying power is now less.
Moreover, let’s say all John really wanted was to have $10,000 in a year. A year ago, he could have invested $9,090.91 at a 10% interest rate to come out at that same $10,000 while also keeping $909.09 in fun money. John, why did you put $10,000 under a mattress?!