10 Questions You Should Ask Before You Consider Private Mortgage Lending
Updated: Feb 26, 2019
Are you looking for an alternative investment strategy that has the ability to bring in 2-3x the returns your traditional investments can?
Well if that is the case... Private Mortgage Lending may be just for you.
Sadly, one of the main reasons that many investors are unaware of this strategy is because their investment advisors typically do not reap any benefits of pointing their clients this direction. This means that there is nothing in it for the middleman.
As an investor myself, I am looking for a place to put my money with limited downside, high returns, and control over my investment.
When you invest your money through traditional mediums, such as:
You can be exposed to volatile markets and risk if there is a downturn. The worst part is you do not have much control or most times the knowledge to make an educated decision on when to become liquid in the market. To me, this is a very poor way to invest your money.
In real estate and specifically Private Money Lending, you will be exposed to risk but you will always be secure by the real estate and have collateral based on the property's value, if your borrower failed to make payments.
There are many alternative forms of investing, such as:
Real Estate (own)
Foreign Currency Trading
Private Mortgage Lending
All of these strategies have their pro's & con's but for today's discussion, we are going to focus on PRIVATE MORTGAGE LENDING. In our opinion one of the best ways to diversify your money and benefit from .
With any investment, you should have a great understanding of how this vehicle works, concepts you should understand and key terms needed to make wise investments.
Let's get going and learn some of the question's you should be asking yourself before taking the leap into private mortgage lending.
1) What Exactly Is Private Mortgage Lending?
In the eyes of "Webster Dictionary" “Private Mortgage Lending is the lending of a "private" individual’s money to a borrower(s) who pledge(s) real estate for the loan by way of a publicly recorded mortgage. The publicly recorded mortgage secures the loan that is evidenced by an original promissory note. The recorded mortgage secures the promissory note in the event of a default by the borrower.”
So in basic English terms, what does this mean?
You, the lender decide to loan money to Dan, the buyer who issues you a promissory note (promising to pay back the debt on the terms associated with the loan) and he grants you security on the loan in form of collateral on the home (or a lien against the property).
The lien on the property is known as the mortgage.
In simple terms, you will take the place of a bank but you will garnish 2-4x the return that a bank would receive on their loans.
The two most important documents for you as the lender are:
The Promissory Note - Evidence of the debt
The Recorded Mortgage - Security for for your funds
We will touch on these 2 documents in more detail later on in this post.
2) How To Become A Private Mortgage Lender
There are no business regulations, guidelines or requirements that you need to work off of in order to lend on real estate.
These mortgages that you are going to lend on are going to be with real estate investors.
Buy & Hold Investors
You will have to find real estate investors in your area (successful real estate investors) who are purchasing properties at a discount and are looking for money to help scale their operation.
If you want to fund a new (original) mortgage, let's remember a couple things.
A) You set the rates & terms of the loan
B) The rates & terms that are set will determine your return for the subject mortgage
C) You are in control as to when the mortgage is due
D) You determine the LTV (Loan to Value) that you are comfortable lending up to.
However, as an independent private mortgage lender, you will need to structure your deals around the exit strategy your borrower is using. If you are dealing with buy and hold investors, then the loan terms will be different than if you are dealing with a house flipper.
3) Why Would Someone Borrow Money From A "Private Mortgage Lender"
I am sure you are wondering why a real estate investor doesn't just go through a traditional bank to get financing for the property and rightfully so!
The answer is that in most cases, the borrower must turn to a "Private Mortgage Lender" for several reasons:
A) Typically the real estate investor needs the money fast to close and since these are cash funds, closing can happen very fast
B) The borrower may have been turned down by the traditional bank (for several reasons)
C) The real estate (property) being lent on does not meet the bank's requirements (banks will not lend on a property that is not in livable condition)
There is a lot of red tape when it comes to traditional mortgages and getting approval on real estate investments. The process can take a tremendous amount of time and as a real estate investor, time is of the essence. This is why private mortgage lenders get such great rates on their money.
For a real estate investor, having the ability to build relationships with "Private Mortgage Lenders" gives them the ability to improve and scale the business. Allowing them to do more deals, make more money for the lenders and their business. If these deals are structured properly, a win - win situation should be created for everyone involved.
4) Why Would An Individual Choose to Invest Their Money in Private Mortgages?
If you have not already seen the great benefits of becoming a "Private Mortgage Lender", we are going to give you some more reasons why this is a great alternative investment vehicle.
There are 3 main reasons that an individual would choose to lend their money on real estate backed securities:
A) Secured Investment - collateralized by the subject property
B) High Returns - Private Money Lenders can see 2-4x the traditional returns
C) Liquidity - You determine the liquidity of your investment
A Secured Investment With A Good Return
Every investment does have a degree of inherent risk built into it. Private lending is no different, however, you can minimize your risk drastically by following some of the concepts we talk about in this post.
Since the property is secured by a lien, there are 3 things that can happen
A) The borrower pays as agreed and you see a monthly return and a principal pay off at the life of the loan (or an early payoff)
B) The borrower defaults on the loan, then the "Private Lender" will foreclose on the property and gain ownership to the property for far less than the market value of the property.
The Mortgage Is Now Liquid
Since you are in control of the length of the loan, you control how liquid your investment is. Typical real estate loans can last anywhere from 3 - 36 months (with no prepayment penalty on the loan). So you determine how long your money should be working for you.
5) What Return Should I Expect?
This is probably one of the most asked questions that we receive and we see why. Who doesn't want to know the expected return on their investment? I know i do. The return that you receive will be based on a couple factors.
The length of loan (short term loan or long term loan)
The investor's experience
The relationship or built in trust between investor & lender
The type of property being lent on (SFH, Multi-Unit, Commercial)
Typically "Private Mortgage Lenders" can expect to see anywhere from a 10-14% interest only return for any number of months. The longer the loan, the lower the expected interest rate. If it is a short term fix & flip loan, the lender will receive higher interest rates because the length of the loan is much shorter.
Outside of the traditional monthly interest returns, lenders can also negotiation origination fees or points. Origination fee is 1 % of the total loan amount that is issued. This means that lenders can require 3 points at closing on a $100,000 loan and at closing they would receive $3,000.
This is why this investment strategy is very intriguing. It is very hard to find an investment that has minimal risk but also offers double digit returns.
6) What Does The Process Look Like - From Beginning to End
If you have never lent your money on a real estate back security, you are probably wondering what does the complete process look like. Let's go over a brief activity list of all of the task involved in a deal.
1) Find A Real Estate Investor (Borrowers)
2) Analyzing The Deal
3) Get an Appraisal If Necessary
4) Complete Underwriting Process
5) Setting Up Payment Structure
6) Signing Loan Commitment
7) Signing Promissory Note
8) Issue Renovation Schedule
9) Closing on Deal - Recording Mortgage
10) Receiving Monthly Payments
11) Close Out Loan - Receive Principal Payment
The process is fairly simple, once you have a knowledgeable real estate attorney on your team to process the paperwork and record your documents.
7) What Are The Risks And How Can I Minimize Them?
As we stated previously, with every investment comes risk. The great thing about this investment is if you do your due diligence and understand the concepts you can greatly improve the odds of a successful investment. In our opinion, there is no "true" risk since your money is protected by the subject property, but we want to talk to you about how to ensure everything goes to plan. So, let's go over some of the analysis that will mitigate your risk.
1) Due Diligence - Do your due diligence on the investor that you choose to work with. You want to see a list of the last 5 deals that he has done. You want to ensure that the money was properly returned to the investors. You also want to feel comfortable with this investor (trust, honesty)
2) After Repair Value - You want to have a good understanding of what the property will be worth after the repairs are made. This is going to determine your LTV (loan to value) for your investment
3) Loan to Value - Typically as a rule of thumb, you want to stay under 65%-70% LTV. This means that if the property is worth $100,000, the max you want to lend on the property is $65,000 - $70,000 to protect your investment. This is because if you need to foreclose on the borrower, you will have at least 30% equity in the property.
4) Comparable Market Analysis - When you are lending on a property, you need to know the ARV. The ARV is determined by running a Comparable Market Analysis. This is basically an analysis as to what similar properties in the area are selling for. You can use a local real estate agent or brokerage to help you out with this figure.
5) Appraisal - If you really want to have a good understanding of what that property is worth, you can get a professional appraiser to place a value on the property. Typically this will be a requirement by the "Private Mortgage Lender" and will be paid for by the borrower.
6) Construction Documents - You will need to know exactly what the repair costs will be on the property. In order to do this, you should have your borrower send you a couple documents
Scope of Work
7) Current Income - You should probably ask yourself if the borrower has the ability to service the loan off of his current income. You can do this by requesting that he send bank statements, that have at least 3x the amount of the total due amount for the life of the loan.
8) Additional Insurance - As a Private Mortgage Lender you want to ensure that you are also covered through insurance.
Hazard Insurance - You need to require that you are added to the hazard insurance policy to ensure that you are covered in the event of damage during the loan.
9) Loan Servicing - This is simply the plan that you have in place to collect the monthly payment from your borrower. If you choose to collect your principal and interest at the end of the loan, you will not have to worry about loan servicing.
8) What Is The Minimum Investment I Can Make?
The amount that you can invest will depend on the real estate investor that you are dealing with. Typically, all real estate investors will want you to at least cover the purchase price of the property, so that they can give you first lien position on the property and protect your investment. In some cases, borrowers will allow you to lend less than the purchase price of the property, but the security on the property may waiver depending on how many liens will be out on the property.
9) What Are The Specific Terms/ Concepts That I Should Familiarize Myself With Prior To Becoming A Private
PROMISSORY NOTE: As previously stated, this is the evidence of the debt, also known as the IOU on the property. In it, the borrower acknowledges the debt and agrees to repay it under a certain set of terms. These terms include the interest rate, the length of time he has to repay the note, the periodic payment, and whether or not it is fully amortized or paid interest-only. This note is NOT filed as public record – you should view it as a personal “IOU” (unless you’re from the part of the country that says “I.O.Y’all”)
MORTGAGE/DEED OF TRUST: This document is the one that has teeth – it’s the one that gives the lender the right to take back the property should the borrower default. This paper IS notarized and filed as public record. That way, should the property ever sell, you, the lender, get your money first before anyone else! And that’s really important, especially when it’s your money!
AFTER REPAIR VALUE - You want to have a good understanding of what the property will be worth after the repairs are made. This is going to determine your LTV (loan to value) for your investment
LOAN TO VALUE - Typically as a rule of thumb, you want to stay under 65%-70% LTV. This means that if the property is worth $100,000, the max you want to lend on the property is $65,000 - $70,000 to protect your investment. This is because if you need to foreclose on the borrower, you will have at least 30% equity in the property.
COMPARABLE MARKET ANALYSIS - When you are lending on a property, you need to know the ARV. The ARV is determined by running a Comparable Market Analysis. This is basically an analysis as to what similar properties in the area are selling for. You can use a local real estate agent or brokerage to help you out with this figure.
APPRAISAL - If you really want to have a good understanding of what that property is worth, you can get a professional appraiser to place a value on the property. Typically this will be a requirement by the "Private Mortgage Lender" and will be paid for by the borrower
SCOPE OF WORK - The list of all of the repair activities and who those tasks will be performed by
MATERIAL LIST - A list of all of the material that will be purchased for your investment
ESTIMATE/BUDGET - The total cost of the project - both labor and material with a built in contingency for any unknowns.
10) How do I differentiate between the “good guys” and the “bad guys?”
Your property investors should treat you with respect, and…visa versa! Here are, in my opinion, some reasonable things to expect from a long-term, mutually beneficial relationship:
1. They should always take your calls, and visa versa! Even if they’re busy, they shouldn’t hide behind voice mail, faxes or emails. Instead, they should be available to answer Page 165 of 267 your questions and make you feel good about investing with them.
2. Have them send you pictures of their project. I’m sure that you’d love to see both the progress and besides, that way you know that work is progressing!
3. If a deal pays off sooner than expected, make sure that they FIRST send your money plus profit to you, and THEN ask you if you want to reinvest. If they’re unwilling to give you your money at the end of a deal, red flags should be flying all over the place!
4. Expect them to do what they say they’re going to do, and you do the same! If you commit to funding a deal based on due-diligence and if that due-diligence comes through, don’t back out at the last minute. Their livelihood depends on you and just like a bank, if you say that you’re going to fund based on further investigation and that investigation proves positive, you should do so.
5. If you don’t want to do the deal, let them know immediately. Why? Because you want to give them plenty of time to round up another funding source to complete the transaction
Wrapping Up |Private Mortgage Lending
We hope that after that read you have a pretty good understanding of the details of private mortgage lending. At this point, you should have a clear view of the benefits that this alternative investment strategy offers. Our plan was not to try and make this strategy sound complicated but to let you guys in on how profitable this can be for all parties involved.
We currently own and operated a real estate investment firm in the Upstate New York Region. We also do some private lending ourselves and we are always looking to add to our private lender network. If you are interested in learning more about lending your money back by real estate, click the link below.
If you have any questions, comments or concerns let us know in the comment section below.
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