One of the most important documents you will ever sign with a private lender is the actual Note that creates the loan obligation. In a typical private lender transaction, you, the real estate investor (borrower), borrow money from a private individual (private lender) and that transaction is documented by a Note and Mortgage.
The Note lays out the terms and conditions under which the private lender is willing to lend you money and under which you are willing to borrow money. The Mortgage is the security document for the borrower's performance under the Note and usually is secured by a piece of real estate you own or are about to purchase.
The Note is where you want to control the private lending process in your favor and give you the control and flexibility you may need in the future. If the Note does not contain the right clauses, you are potentially giving away tremendous control to your private lender and, ultimately tying your hands.
When dealing with private lenders, it is critically important that you remain in control of your future options.
If you were to go to your local office supply store and buy a template note form, you are potentially leaving your future control over to your private lender without even knowing what is happening.
We recommend the following two clauses in any Note with a private lender:
Prepayment Penalty Clause
"The Borrower reserves the right to prepay this Note (in whole or in part) prior to the due date with no prepayment penalty"
The prepayment penalty clause allows you, the right to pay off a Note prior to maturity without a prepayment penalty. Without this clause, you may not be able to pay off a Note early, or worse, you may have to pay a large penalty for the right to prepay the Note.
For example, if you have a three year Note secured by a piece of real estate you own and you get a great offer to sell the property, you may see a big pay day in your future; But, without the prepayment penalty clause, you may have to pay the lender's full three year interest for the right to pay off early or the lender may require a penalty of several percentage points to allow you out of the Note.
With the prepayment penalty clause, you have the full right to pay the Note off early with no prepayment or interest penalty. The benefits of this clause can be very powerful and beneficial to you down the road.
Substitution of Collateral Clause
"The Borrower has the right to substitute like collateral of equal or greater value"
The substitution of collateral clause allows you to sell the underlying real estate without paying off the private lender Note by substituting the collateral with a different piece of real estate of equal or greater value.
With this clause, you can flip a property without having to pay off your private lender every time you sell a property. Imagine the work and inconvenience to you and your lender if every couple months you sell a property and have to pay off the previous loan and draw up a new Note. This can be real burden on both you and the lender alike, and eventually the private lenders grow tired of the process.
A much better solution is to use the substitution and collateral clause so that every time you want to flip a property, you have the right to transfer the Note to another property of equal or greater value without paying off the private lender. The private lender is much happier because his money is always working without any inconvenience of new documents every couple months.
By using the prepayment penalty and substitution and collateral clauses, you are more likely to have a big payday coming because you will have the flexibility and ability to realize that payday.
I recommend that you ALWAYS seek the advice of a professional Attorney and/or professional financial services prior to taking action.
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