Private Mortgage Loan Investments

It used to be that private mortgage loan investments primarily consisted of family or friends helping out one another when in a time in need to help make mortgage payments. Since the mortgage crash of 2008 in the United States; however, the potential profit in private mortgages for the lender while providing significant benefit to the borrower have significantly increased. As a result, private mortgage loan investments have become more popular across the investment community as an investment vehicle.

How Does Private Mortgage Lending Work?

Conceptually, a private mortgage loan involves an investor who is normally selling a home that chooses to take on the risk (and potential profit) normally realized by traditional mortgage lending companies. If structured properly to be secured against the property being sold, this type of private loan can offer good returns and less risk than other investment options. Today, the private mortgage industry has expanded to include companies or organizations that provide private loans to individuals who might not otherwise be able to obtain a home loan. In order to provide loans to the largest potential customer-base, most private loans will require private mortgage insurance (PMI) to be paid if the mortgagor does not have at least 20% equity in the home at the time of purchase.

What are the Benefits of Private Mortgages?

A private mortgage provides a number of advantages for investors as well as mortgagors or borrowers. The most significant benefit for those shopping for a new home is the ability to qualify for a mortgage when public institutions may not be apt to provide a loan. For lenders (aka investors), private mortgages commonly see interest rates that are measurably higher than those offered by publicly backed banks. In most cases, a private lender can consider themselves to be acting as a mortgage company. Private lenders do not have to accept anyone who applies; just have an idea of what level of risk he or she is willing to accept. Additionally, private lenders should also see an interest rate that is a minimum of 50 to 100 percent higher than the going public mortgage rate of return.

How are Private Mortgages Normally Structured?

Private mortgages are typically structured similar to a hard money loan. The term is normally short; ranging from six months to three years in length and is based on the home or property’s overall equity value. The majority of private mortgages closed on the market today will typically be based on a 50 to 70 percent LTV (loan-to-value) ratio. In these cases, PMI or LPMI (lender-paid mortgage insurance) is not required. There are a number of investment agencies; however, that will offer private mortgages to mortgagors who don’t have sufficient equity in the home or available to put into a down payment.

How Does PMI Work?

Private mortgage insurance is a mortgagor paid insurance on a home mortgage. The insurance is used to provide protection to the lender against the loan going into default or being foreclosed upon. PMI is typically required on properties that the consumer does not have at least 20% equity  (or an equivalent amount of money to put down on the loan). Once PMI is incorporated into the loan, it is seen as an additional payment to the mortgagor each month. Once the borrower is able to obtain 22% equity in the property, PMI will normally be automatically eliminated unless otherwise written into the terms of the mortgage to remain in place for the life of the loan.

How Does LTV Impact Private Mortgages?

The primary reason that private mortgage lenders worry about LTV when considering investing in a home loan is to ensure there is a suitable equity cushion available with the loan in the event a mortgagor defaults on the note. If the lender does not have the ability to require PMI (private mortgage insurance) be paid by the mortgagor, then the common convention is to require a 70-30 LTV from the mortgagor. This is to account for the likely loss assumed when selling a home in foreclosure (home buyers typically assume that foreclosed properties will sell for a discount and may have damage). If the mortgagor does not have any equity in a home, then the lender may take a harder look at their credit history from the past two years to see if they are at risk of going into collection during the term of the private home loan.

Private Mortgage Investment in Commercial Property

Despite rumors to the contrary, private mortgages can be used for commercial properties or buildings in the United States. Depending on what each party is willing to agree to, the private loan take on a variety of structures. Although the majority of private mortgage lenders will use terms similar to a hard money loan, there are a variety of structures used between lenders and borrowers in the marketplace.

Typically, private lenders will use different LTV (loan-to-value) ratios for different property types. For example, many lenders will require a 50 percent LTV on undeveloped or raw land, 65 percent on property zoned commercial or to be used for commercial purposes, and 70 to 80 percent on single to multi-family homes. In theory, the lower the LTV on an investment equates to lower risk for the lender.

Do Private Mortgagors Build Equity?

Unlike ARM, or “interest-only” home loans, most private mortgage terms will allow mortgagors to develop equity by making on-time payments on the note.  There are some variants of private mortgage that do adopt the “interest-only” model, so the due diligence of both the mortgagor and lender is a must. When the loan is fully amortized; however, borrowers not only build principal, but also may be able to refinance the note through a conventional lending institution at a later date for a lower interest rate.

Selling Private Mortgages for Profit

In an investor in a private mortgage needs to “cash in” or pull their money out of the loan prior to the term being up (or it being paid off), it is possible to sell the loan to companies specializing in buying private loans such as A.B. Merrill. In order to resell the private mortgage, the investor will have to first provide a copy of the loan’s promissory note to the business looking to possibly buy the loan. The business would then take some time to review the mortgage’s terms to include type and length of note. The information will be used to calculate the potential return on investment for the company as compared to the risk associated with the loan.

Some companies such as A.B. Merrill use a more classic time value of money formula with proprietary calculations used to take current market conditions into account. Many times; however, companies specializing in buying private mortgages will do so at a discount. Although investors may lose money in the long term choosing this option, there is a market for this type of loan sale for those who require ready capitol in a relatively quick timeframe.

Similarly, some investors will buy private loans with the sole intention to ultimately resell them to businesses that acquire this type of mortgage. As a result, the savvy investor will take some time to research the types of property that are being purchased on the private loan market to make investments in like-properties.

For example, over the past five years residential properties have seen a greater loss in value in many locations throughout the country. At the same time, commercial loans have remained steady in value while multi-family homes have seen some increases in value over the past several years. What’s “en vogue” for the given year will likely continue to evolve based on market conditions, so it will continue to pay dividends to research real estate market trends.

Properly Researching Private Mortgage Investments

Similar to other financial investments, one should not enter into a private mortgage loan investment without conducting research into all aspects of the investment strategy. Similar to any viable business, there are a number of risks associated with putting significant money into private loans as an investment vehicle and should be analyzed as thoroughly as any stock, bond, or mutual fund.

For example, individuals who offer private mortgage loan services are subject to both federal and state usury laws. In plain language, this translates to effectively placing a cap on the total amount of interest that can be charged on a private home loan. In some states, the total number of private money loans that can be offered by an individual is capped without paying for a license. The majority of state usury laws are available on the applicable state government website, but it is also recommended that first time investors seek the advice of an experienced attorney before moving forward on a new loan investment.

At the time of this writing, there is not a congressionally mandated cap on interest rates for private transactions; however, the federal government does define money lent at a rate of more than two times the local state usury rate as an unlawful debt. The Federal law governing this de facto cap on interest rates on private transactions is governed under the C (Racketeer Influenced and Corruption Organizations) Act. Both the acts of lending and attempting to collect “unlawful debts” is considered to be a felony.

Are Private Mortgage Loan Investments Risky?

Even the most structured private mortgage investment is generally considered risky. This primarily comes from the fact that the majority of borrowers who seek out a private note are not able to get a traditional home loan from a publicly backed home loan provider. Another reason that consumers seek out a private home loan is that they do not have enough cash to put down for a qualifying mortgage.

Although private mortgages can be structured to minimize risk, they are generally risky investments. At the same time, a seller who chooses to make a private mortgage loan is normally able to make a sale fairly quickly on the property. At the end of the day, a similar thought process on acceptable risk must be taken into account before making the decision to invest in a private mortgage loan.