Private Mortgage Lending

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What You Should Know

  • Private mortgage lending is used when conventional mortgages are not obtainable.
  • Private mortgages are usually considered more risky than conventional mortgages, so a borrower is expected to pay a higher interest rate on the loan.
  • Private mortgages tend to have a higher interest rate, a higher LTV ratio and a higher quality of collateral.
  • Private lenders usually look at the quality of collateral pledged rather than the financial position of a borrower.

What Is Private Mortgage Lending

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Private mortgage lending is mortgage lending that is provided through private sources. Usually a bank or a lending institution provides funds for a mortgage, but there is a less conventional way to obtain a mortgage loan. Private lending consists of individuals who provide funding to borrowers. These individuals can be family members, friends or other private individuals who are willing to engage in peer-to-peer lending.

Pros & Cons of Private Mortgage Lending
PartyProsCons
BorrowerLess Requirements For ApprovalHigher Interest Rate
Faster ProcessingLess Favorable Terms
Less Fees And Other Expenses
LenderHigher ReturnHigher Risk of Default
Low LTV RatioFinancial Commitment
Often Income Generating Collateral

To properly execute a private mortgage loan, the parties should outline and agree on certain aspects of the loan:

  • Loan Term (e.g. 5 Years)

    The length of the loan is important to determine the monthly payments required and the estimation of how much the loan will cost to the borrower. Outlining this part is essential to successfully execute the loan.

  • Interest Rate (e.g. 7%)

    Interest rate is another important part of clear loan terms. Even though the loan is private, some laws may regulate the maximum allowable interest rate on a loan.

  • Type of Loan (e.g. Secured and fully amortized)

    The loan may be secured or unsecured. The type of loan will affect the risks a lender takes by providing the loan to a borrower. It is important to outline the type of loan and whether there is collateral provided for the loan.

Private lending is usually used by individuals who cannot obtain a conventional mortgage. Usually, private lending is not as strict as for conventional lending in terms of the factors they look at for approval. They may require a lower credit score or less than ideal credit history. On the other hand, private lenders require a higher return on their investment, so a borrower who chooses to borrow from private lenders should expect higher mortgage payments on their loan.

Depending on who the lender is in private lending, both parties should be aware that their relationship may be at stake when engaging in such type of lending. Usually, private mortgage lending is being done through people who have some kind of relationship. Whether it is a family member, a friend, or an acquaintance, if the lending procedure is not done the right way, the relationship between the parties may take a toll. It is encouraged to outline the details of the loan in a contract and consider the worst-case outcomes that may arise during the loan repayment to avoid unnecessary conflicts.

Why Consider Private Mortgage?

Private loans can be quite expensive for the borrower with interest rates sometimes surpassing 10%. Getting a private mortgage is certainly more expensive than a conventional loan, but multiple advantages sometimes makes a private mortgage more attractive than a conventional mortgage:

  • Closing Time

    A conventional mortgage takes a lot of time to initiate. It takes approximately 40 to 90 days to fund a mortgage request. During that time, an institutional lender needs to conduct an appraisal of collateral, analyze a borrower’s credit history and evaluate the financial situation of the borrower. This is a lengthy and uncertain process at the end of which, the borrower may be declined for a mortgage. On the other hand, private lenders usually do not look at the information thoroughly. It takes about a week for a private lender to decide on a loan request since private lenders usually only consider the value of the collateral. It also takes much less time for a private lender to approve a mortgage because they can decide by themselves while institutional lenders have to request approval from a loan committee.

  • Application Process

    The application process for a conventional loan is much more detailed and formal compared to a private loan. Generally, private lenders make their decision based on the loan-to-value ratio of an asset pledged as collateral. This means that they will not pay attention to the financial status of the borrower as much as a financial lender would. A financial lender may be hesitant to issue a loan to a borrower who does not have their financial position up-to-date, but it will not be a problem for a private lender.

  • Approval Requirements

    There are many reasons why an institutional lender may reject a loan request. The reasons can range from not having a good enough credit history to having too much debt already. The main benefit of private mortgage lending is the fact that private lenders have lower approval requirements. It might come in handy when a borrower needs a mortgage, but cannot obtain it through conventional lending institutions.

If a borrower needs a loan quickly without undergoing a thorough screening process, then private mortgage lending may be an appropriate way for the borrower to obtain funding. It is important to remember that a private mortgage is usually more expensive than a conventional mortgage, so a borrower should weigh all pros and cons before choosing a private mortgage. In some cases, it might be beneficial to wait and obtain institutional lending rather than paying extra for a private mortgage.

Pros & Cons of Private Mortgage Lending

Private mortgage lending may be very beneficial for all parties involved if executed correctly. On the other hand, there are certain risks involved for both parties that are not present in conventional mortgage lending. Before proceeding with private mortgage lending, a lender and a borrower should consider the advantages and potential drawbacks of this type of lending.

Lender's Side

Pros
  • Higher Interest Rate

    The lender usually benefits by charging a higher interest rate on the loan amount. They can set a higher interest rate because a private mortgage is usually considered riskier than a conventional mortgage. Since private financing is used mostly when conventional financing is not available, the borrower is likely willing to accept a higher interest rate to obtain financing.

  • Low LTV Ratio

    Usually, private lenders issue mortgages at lower LTV ratios. This means that the collateral used is worth more than the value of the loan. In this case, if a borrower defaults, the lender will be able to recover the full amount of debt outstanding.

  • Income Generating Collateral

    People who seek private mortgages are usually investors who are looking to purchase income-generating properties such as commercial real estate or multi-family residential properties. Even if a borrower defaults and the lender is not able to sell the collateral quickly, the lender still receives income generated by the property.

Cons
  • High Risk of Default

    The risk associated with private lending is much higher than the risk of conventional lending. Even if the loan is secured with a property used as collateral, the lender will have to undergo a time-consuming and expensive process of foreclosure to recover the outstanding balance on the mortgage.

  • Financial Commitment

    Another downside that might affect the financial stability of a lender is the fact that their funds are committed until the loan is repaid. If the lender suddenly requires a large sum of money, it is unlikely that they would be able to get the money loaned out quickly.

Borrower's Side

Pros
  • Lower Approval Requirements

    The biggest advantage of a private lending mortgage for the borrower is the lower requirements for approval. A private lender will likely approve an individual who would not be approved by an institutional lender.

  • Faster Approval

    Institutional lenders have a strict process of issuing loans while private lenders are more flexible. This means that a private lender is likely to issue the mortgage much faster than a conventional lender.

  • Fewer Fees and Other Expenses

    Institutional lenders also collect certain closing costs for initiating a mortgage, but private lenders do not have such a procedure for the most part. Lastly, it is common for an institutional lender to require private mortgage insurance for which the borrower has to pay. Private lenders usually do not require insurance, which means the borrower can save money by avoiding insurance costs.

Cons
  • High Interest Rate

    Borrowing from a private lender may lead to a higher interest rate on the loan because the lender takes on much more risk than an institutional lender. Even though the borrower avoids paying as much in closing costs and private mortgage insurance premiums, getting a mortgage from a private lender will still be more expensive than a mortgage from an institutional lender.

Investment Parameters of Private Lenders

Private lenders are less strict in giving out mortgage loans than institutional lenders. Private lenders do not necessarily look at the ability of a borrower to pay off their mortgage, but instead, they look at whether they can cover the amount outstanding with collateral in the event of default. Because of that, private lenders do not look at the metrics related to the borrower, but instead, they look at the metrics associated with the collateral. There are four main parameters private lenders look at.

  1. Loan-to-Value (LTV) Ratio

    The most important metric private lenders look at is the LTV ratio. Private lenders will calculate the LTV ratio to ensure that they would be able to recover the amount of debt outstanding if the borrower defaults on their debt. They usually lend up to 50% of value for land and undeveloped property, up to 65% for commercial income-producing properties, and up to 70% on multifamily residential properties. The LTV ratio can vary depending on other factors a specific lender looks at.

  2. Ease of Disposal

    Another important factor private lenders look at is how easy they can dispose of the property that is used as collateral. Private lenders, just like institutional lenders, want to recover the amount outstanding as fast as possible. They take into account how easy it will be to dispose of the property to ensure that even if the borrower defaults, they could still get their money rather quickly. Private lenders are willing to accept higher LTV ratios for finished income-producing properties because they are usually easier to dispose of than properties that do not produce any income.

  3. Income Potential

    Income-producing properties are much more favorable than single-family homes. Private lenders might be willing to approve a mortgage for multifamily properties more than for properties that do not produce income. This is because even if the lender is not able to sell the property quickly, they can still earn interest through the income generated by the property. Private lenders are also not restricted in their operations as institutional lenders are. If it makes sense to keep the property given its income potential, the lender may do so. Private lenders may calculate net operating income on the property to determine whether they would like to dispose of the property right away. This makes loans with income-producing properties as collateral a very safe and thus favorable investment for private lenders.

  4. Viable Exit Strategy

    Most of the time, borrowers consider private lending for rather short-term financing. Private lenders understand that, and they want to make sure that the borrower has a viable exit strategy to do so. For example, if they choose to refinance their mortgage in a few years, then they might improve their credit score or reduce the amount of debt they currently have. A private lender will work closely with a borrower to understand how exactly they are planning to repay their mortgage amount. They may also look into the financial position of a borrower to ensure that their strategy is viable.

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