In the mid-to-late 2000s in the United States and in much of the free world, the requirements to obtain a home loan or mortgage had been significantly relaxed. Since the mortgage crash of 2008; however, the rules to obtain a publicly backed mortgage have significantly increased to the point that many consumers find it difficult to obtain a home or property loan. As a result, the private mortgage industry has seen a “mini-boom” in providing home loans to both consumers with strong credit as well as though who may have “less-than-desirable” credit ratings or foreclosures on their record. Although private mortgages service this critical need in industry, there are a number of private mortgage dangers worth looking out for before signing the bottom line on a private note for your own home.
How Does a Private Mortgage Work?
As mentioned, a private mortgage is an alternative to obtaining a traditional home loan. Instead of going to your local bank to finance the mortgage, they are provided by either companies or individuals who lend money to consumers for home purchases as an investment. Many times, a private mortgage firm will do business with a number of mortgage brokers who recommend their services to clientele seeking out both traditional and alternative mortgage options. Once obtained, the private loan is very similar to a traditional note but may have different terms. These include but are not limited to: being required to pay for private mortgage insurance if you don’t have 10 or 20% of the loan value available in capital funds when closing the loan, potentially have to pay a balloon payment during the life of the loan, and other legal differences from publicly backed notes.
Private Mortgage Dangers
#1 – Requiring a “Good Faith” Payment Prior to Closing
A common scam encountered in the private mortgage market is requiring the consumer to make a “good faith” payment before closing on the note. The typical “promise” by many of the scam companies is that they require this payment to do an “underwriting test” on the individual’s credit to see if he or she is worthy of the loan. This is likely a trick or scam to get a large payment from you that may never actually be used towards the property and is just asking for trouble.
#2 – Thinking You Can’t Qualify for a Publicly Backed Mortgage
A number of private mortgage lenders will try to play on consumer’s fear that they can’t qualify for a publicly backed mortgage and try to convince you not to do so. Many times, this fear on the part of the consumer can possibly be unfounded. In reality, many individuals would actually qualify for a publicly backed note now that the market is showing signs of recovery; albeit, it may be at a higher rate than those being advertised. It’s worth checking; however, as the costs associated with a publicly backed loan with a slightly higher rate may be equivalent to those you get back from private mortgage loan quotes.
#3 – Not Knowing what to Expect with a Private Mortgage
A private mortgage isn’t free money. At best, you are going to obtain a home loan that is equivalent to what you were used to qualifying for several years ago. At worst, you are going to run into individuals or a company who just want to make more money off of you than a bank would on the loan! Make sure you know what you are getting into with the loan. The worse your credit score, the higher the interest or fees you should expect to pay. Not that this is a bad thing, but just something to keep in mind when shopping private loans for your own home.
#4 – Not Hiring a Lawyer to Review the Loan
Another common danger with private mortgages is relying on the lending company or individual’s lawyer to prepare and review the loan documents. In most locations in the United States, it should only cost you a few hundred dollars to retain a local real estate attorney to take a look at your private loan paperwork BEFORE YOU SIGN IT! This is a small price to pay compared to the potential of being out thousands of dollars if the loan is a scam, or the potential long-term damage that scammers can do to your credit if you sign up for a less-than-legitimate loan.
#5 – Failing to Research the People Involved with the Loan
Seems like small stuff, but definitely a step many people who have fallen for private mortgage scams in the past have failed to accomplish. For example, if your mortgage is being put in place by a local mortgage broker, they are required to be licensed by both your state and the National Mortgage Licensing System & Registry. You will want to do your due diligence and make sure that they are in good standing. Similarly, if you are obtaining a private loan through a group of investors who have a company or LLC established, you will want to inquire with both the local and national Better Business Bureau to see if they have had any significant complaints lodged in the recent past.
#6 – Providing the Down Payment Directly to the Lender
Private mortgage lenders that are not out to take all of your money will not insist that you make the down payment check out to them or their LLC. The legitimate companies will insist you write the check out to a trust that will not authorize the payment until you approve. The trust is typically maintained by a third-party lawyer who does not have ties to either side in the transaction. This provides a comfort factor to the lender that you have enough money to make the down payment; however, they are still required to uphold the sales end of the bargain before seeing the payment.
#7 – Not Understanding the Impact of a Balloon Payment
For those who don’t know, a balloon payment, is a lump-sum payment that can run into the tens of thousands of dollars or more that comes due during the life of a mortgage requiring such. The primary purpose of a balloon payment is to keep monthly payments low while preserving cash flow on the part of the mortgagor. Its ok to have this type of payment incorporated into a loan if: 1 – You know it’s coming, and 2 – You’ll either be able to save for the payment or refinance the loan by this point. Some shady lending agencies will include the balloon payment just 6 months or a year down the road as a backdoor way to repossess the homes of people who couldn’t afford a down payment to start with!
What is PMI?
When applying for a private mortgage, the organization providing the loan (lending company, LLC, or private individual) will want to make sure the property has enough equity in it to pay off the amount of money owed in the event it goes into foreclosure. Since many foreclosed homes sell for a steep discount; however, the majority of private lenders will want to have a cushion of 10-20% of the total amount borrowed for the property. This provides a hedge against the person obtaining the loan from going into foreclosure. Many individuals seeking out home loans; however, do not have this much capital available to put down on a new home loan.
Although in some countries this may mean individuals have to wait to get a home loan, in the United States there are a number of private mortgage lenders who will be willing to underwrite loans for individuals that do not have 20% to put down on a property. The cost is having to pay for PMI, or private mortgage insurance if the loan to value percentage is not at or below the 80% mark. PMI helps minimize the risk to the lender by a third party guaranteeing the amount of money that the lending company or individual may be out of pocket if the home is forced to be sold during foreclosure. PMI only pays the lender in these cases if they take a loss on the home due to having the list price fall significantly below the amount lent under the original note.
Unlike other publicly backed mortgage programs which have their own fees to help insure lenders against risk, private mortgage insurance is offered only to private lending companies or organizations. In many states, PMI automatically “expires” when the loan-to-value ratio drops to 78% or less. In a hot real estate market, home appreciation may also drop the LTF; however, it becomes incumbent on the home owner to request PMI be lowered or eliminated in these cases.
Do Private Mortgage Lenders Charge PMI?
The short answer is yes, most private mortgage lenders do charge PMI on mortgages which do not meet the LTV requirements for the lending agency. PMI helps protect the lender against the borrower from defaulting on their loan or against those who may not be assessed as the “Best” clientele to put into a property. Typical PMI requirements are levied against a loan with an 80% or greater LTV ratio.
The primary benefit of PMI within industry is that it provides a significant security blanket for lenders against nefarious borrowers. PMI also allows potential mortgagors to buy a new home with as little as a three to five percent down payment on the home without having to save up funds for years to get together an extremely large down payment.
Homeowners Protection Act (HPA) of 1998
The Homeowners Protection Act (HPA) of 1998 implemented a number of restrictions on the mortgage industry. The Act does require those providing private lending or mortgage services to provide several disclosures regarding PMI for loans they service that were secured after July 29th, 1999. The Act also includes a disclosure provision for mortgage loans, as well as provisions for mortgagor requested cancellation and the automatic termination of PMI.
Why Did PMI Requirements Change?
Over the past decade or two, the majority of home loan lenders would honor your request to drop PMI if the loan balance was paid down to 80% or less of the property’s overall value and they had a good credit history. In this scheme, the consumer was responsible for keeping track of their amount of money owed and payment history. As a result, a number of people failed to request their PMI be eliminated when it was time to do so for their personal loan (s). With the new law being passed, both consumers and lenders have a shared responsibility for ensuring all facts are on the table for home loans. The current law governing private mortgages is The Homeowner’s Protection Act (HPA) of 1998.
The HPA generally applies to all mortgage loans that were finalized on or after July 29th, 1999 and also has some requirements for loans obtained prior to that date. The new law does not cover government-guaranteed loans such as FHA or VA loans. The law also has provisions for classifying loans as high-risk for those mortgages exceeding $252,700 in value (also referred to as “non-conforming” loans).