Investors in private mortgage lending used to consist of families and friends helping each other with house payments. But the profit potential in private mortgages for the lender—and the clear benefits to the borrower—helped this investment strategy gain notoriety in the investing community.
Private mortgage lending involves an individual investor—usually a home seller—taking on the risks and rewards typically held by mortgage lending institutions. This type of lending can offer good returns and low risk if structured properly, because it is secured against the actual property.
Private mortgages have several benefits to borrowers and investors. They allow borrowers who don’t qualify at traditional lending institutions to get mortgages elsewhere. Investors holding private mortgages can receive interest rates significantly higher than standard rates offered by banks.
“In most respects, the private lender should look at himself [or] herself as a mortgage company, and should demand everything that a good mortgage company would require when deciding whether someone qualifies for a mortgage,” Jay Kivitz, an attorney specializing in private mortgages, said in an e-mail interview. “They should also get an interest rate that makes the risk worthwhile. While it cannot be usurious, it should be at least [50 to 100 percent] higher than a bank rate.”
The mortgages are usually structured like hard money loans: short-term—from six months to three years—and typically based on the property’s equity value. In general, private mortgages hover between 50 and 70 percent loan-to-value (LTV), according to Don Konipol, general partner of the Managed Mortgage Investment Fund LP.
The lender should be sure the LTV is not less than 70/30 so there is an equity cushion if the mortgagor defaults, Kivitz said, and lenders should perform due diligence on the borrower.
“If these are small, residential mortgages, that would normally be given by one person to another, they have to get as much financial [and] employment information as possible from the mortgagor for at least two…years, as well as a credit report and a judgment search of the person, to see if they have current or past collection issues,” Kivitz said.
A private mortgage can take on different structures, depending on what the parties are willing to agree to. While most private mortgages take on terms similar to hard money loans, it is possible for the lender and borrower to come up with a completely different structure.
Different property types are generally covered by different LTV ratios. For instance, private lenders will often look for a 50 percent LTV on raw or undeveloped land, 65 percent on commercial property and 70 percent on multifamily properties, according to Konipol. Theoretically, a lower LTV on a property correlates with lower risk.
Buyers who take on a private mortgage can also build equity, if they pay on time, assuming the loan is fully amortized and not an interest-only loan. Borrowers may eventually be able to refinance the mortgage at a lower interest rate through a conventional lending institution.
If investors need to get their money out before the loan matures or is paid off, there is the potential to sell the private mortgage to a number of companies that buy them. Buyers of private mortgage notes include companies such as A.B. Merrill and Northeastern Capital Resources.
To resell a private mortgage note, the investor would need to present a copy of the promissory note to the loan sale business, according to Valerie Halaby, president of A.B. Merrill. The business would then review the note’s terms, including its length and type. This information is important to calculate the return on investment, Halaby said.
A.B. Merrill uses a time value of money formula, but a huge part of their calculations are current market conditions, according to Halaby.
These companies will typically purchase the mortgages at a discount, but if the investor urgently needs the funds for something else, it may be worth considering. However, investors should consider what kinds of investment properties would be most worthwhile to a private mortgage company.
“Residential properties are losing value and in many areas of the country we are finding that properties are selling for less than the mortgage balances owed,” Halaby said in an e-mail interview. “Commercial properties…are holding steady for now, but the threat of a declining commercial real estate market is also beginning to loom.”
Many investors may be looking at private mortgages on multi-family buildings, which Halaby said is most attractive to the market right now.
“Multi-family complexes…are commanding the strongest pricing in the loan sale market, but are still trading lower, in perhaps the last decade,” Halaby said.
As always, investors should conduct due diligence procedures before pursuing this investment strategy.
Investors should not jump into private mortgage investing without doing research beforehand, Halaby said. “This takes real estate experience and knowledge, as does any viable business. There are risks associated with any investment, and investing in mortgages should be carefully considered just as you would carefully analyze an investment in stock or any other investment vehicle.”
Unlike banks, an individual who offers a private mortgage loan is subject to state and federal usury laws capping the amount of interest on a loan. Additionally, some states’ laws limit the number of private money loans an individual may offer without licensing. Information on state usury laws can be found on most state government websites; investors may also want to consult an experienced attorney regarding these matters.
Congress does not regulate interest rates on private transactions, but it has defined money lent at an interest rate more than two times the local state usury rate as an “unlawful debt” under the Racketeer Influenced and Corruption Organizations (RICO) Act. The act of lending and trying to collect unlawful debt is a federal felony.
Although private mortgages can be structured to minimize risk, they are generally risky investments. Often, borrowers seek private mortgages because they are unable to obtain a traditional loan from a legitimate lender, or they don’t have enough cash for a qualifying down payment, Kivitz said. Conversely, sellers who elect to offer private mortgage loans are usually in a position to make a sale quickly.
The bottom line? “Don’t do it unless you can afford it,” Kivitz said.