When you hear the word mortgage, most of us think of a 30 year term, a low fixed interest rate, or perhaps even our home that is secured as collateral for repaying of the loan. The modern day concept of a mortgage loan is, historically speaking, a relatively new idea dating back to the 1930’s. Originally, the idea was forged not by banks, but by insurance companies who provided the debt instruments not looking to collect interest on their money, but instead in the hopes that the borrower defaulted on the loan so they could then subsequently own the real estate at a reduced price. While this would be deemed an abusive practice for a residential owner occupied mortgage, their thought process illustrates an important aspect of the investment. This scenario presents real estate investment loans in similar terms of a pawn or personal property loan with collateral securing the debt.
If there’s more than enough equity to safeguard and preserve the principal loan balance and whatever interest amount they may receive, then it should be a no brainer right? Investing in private mortgage loans isn’t rocket science, however, you should rely on someone experienced in reviewing and analyzing these types of alternative investments. Here are a few items to keep in mind when considering investing in private mortgage loans:
Collateral- We all enjoy purchasing items for a lower cost than average, especially big ticket items right? With a private mortgage loan investment, it is no different. If you lend 50% of the value of an investment property – with the intention of collecting a passive fixed income from the mortgage interest – even if the borrower were to default on the loan, you have inadvertently acquired the real estate asset half off through claiming the real estate title via foreclosure. Depending upon the property, you may be able to rent out the unit and potentially gain a 50%-100% higher annual return than what you were making on passive mortgage interest income. If of course, you wanted to recoup your principal invested and additional profit you could simply resell the property.
Repayment Ability- While how much equity or collateral the real estate contains most often comes to mind when discussing private mortgage loans, the repayment ability of the borrower is a crucial part of determining whether or not to make an investment. The issue of repayment ability addresses the level of certainty as to whether or not a borrower will make the regularly scheduled payments versus defaulting on the loan. If the rental income more than covers the mortgage payment and monthly property expenses, then there’s a higher likelihood of repayment. For a borrower purchasing and renovating a property to resell, if they’ve recently completed and resold previous projects similar to the subject property, then the new loan is being secured should present a higher likelihood of repayment. Requiring the borrower have a certain amount of their own cash into the property also lowers the default risk. Ultimately, most investors desire a passive fixed income investment and generally have an aversion to foreclosing on any property.
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Exit Strategy (Loan Repayment) – In this day and age where banks aren’t even lending to well qualified buyers, knowing how your principal investment will be returned is crucial. For example, if you provide a two year interest only balloon loan on a rental property with the strategy for the borrower to refinance or resell, a few factors should be considered. What’s the borrower current credit history? Are there additional free and clear properties or other assets that could repay your loan via selling those assets? Do they have a history of repaying short term loans on other properties that can evidence they’d pay this new one off? What if the real estate market declines and they can’t obtain the resale price they want for the property?
No single answer to the questions listed above will provide a concrete or definitive conclusion, however, the overall experience level of the borrower should be weighed more heavily upon for balloon payments. Each private mortgage investor should be thoroughly aware of how the borrower is going to pay back the loan when it comes due. There are numerous examples of private lenders being forced to extend loan terms on ballooning loans because there’s no way to refinance the property. This can be problematic, especially if the mortgage holder needs to receive their principal investment back at a specific time or deadline. One way to overcome the obstacles present with a balloon mortgage, is to offer a fully amortizing loan on existing rental properties where the rental income can more than sufficiently repay the mortgage and property expenses. Not only are you being repaid your principal invested, but there is less debt owed on the property over time, ultimately reducing your exposure to a loan default because so much equity is built up in the property.
Experience level- Lending to a borrower with a track record of successful real estate investing is always preferable for private mortgage investors that are seeking a passive fixed income. While you could loan to a first time investor with perhaps a larger down payment, a first time borrower without real estate experience often is required to put additional cash into an investment real estate transaction to compensate for this increased risk.
Credit and Character- Life happens and often bad things happen to good people. Some real estate investors who have owned properties and personally signed for loans have experienced foreclosures or loan modifications on properties they owned over the past few years. This does not in and of itself rule out making a private mortgage loan, however, often times a large cash down payment is required and/or a reduction of the loan to value is required to reduce the loan default risk.
In an age of global financial markets being so interdependent, hard earned dollars are put into investments with the risk of loss often obscured. Why not invest in what everyone on earth needs to live; a place called “home”. When facilitated in a thorough and conservative manner, private mortgage loans are a great source of passive income with the ability to preserve your principal investment even in the event of a loan default.