A mortgage is defined as: A debt instrument that is secured by the collateral of specified real estate property and that the borrower is obliged to pay back with a predetermined set of payments. Mortgages are used by individuals and businesses to make large purchases of real estate without paying the entire value of the purchase up front. Mortgages are also known as “liens against property” or “claims on property.” (As defined by Investopedia).
What do you think of when you think of a mortgage? Most of us think of 30 year term loan with a fixed interest rate that is secured by real estate as collateral. Now, in the last 10-15 years there have been many variations on terms for a mortgage, but the basic principal has remained the same, banks make money off the interest and fees.
However, when the modern concept of mortgages started back in the 1930’s, it was created by insurance companies not banks. Back then the model was not necessarily to make money off the interest charged on the loan, but instead to make money because of the property’s value. The hope was that the borrower would default on the loan and the insurance company would then take ownership of the real estate. The insurance company would then have ownership of the real estate that was mortgaged at $70,000 but worth $100,000. Hence making a $30,000 profit. While we will all admit this is abusive and was deemed as abusive practice, it makes long term business sense. Banks now work from the prospective of making money off of interest and fees, however private mortgage companies use both models to limit their risk.
A private mortgage is simply when you borrow from someone other than a bank or institution. In other articles I’ve written, we have talked about borrowing from Self Directed IRA’s and in the Professional Real Estate Investor Class we talk about hard money. But Private money is different from all of those. These Private money loans are mostly used by investors. Here are some guidelines.
Collateral – A good rule of thumb is the lender will lend 50-70% of the ARV (after repaired value) of the property. If the borrower were to default on the loan, the lender would then acquire the real estate assets with instant equity, safe guarding their investment and ROR (rate of return). They would obtain the title via foreclosure.
Structure of the loan – Most of the time the loan is written for a short period of time, 1 to 5 years. The intention is to collect passive fixed income from the mortgage interest. The payment is interest only (no principal is paid monthly) with a balloon of the principal due at the end of the loan or sale of the property.
Repayment Ability – Equity in the property is the collateral which allows the lender a reduction of risk but the most important thing is the ability to repay the loan. So even though the investor taking the loan doesn’t go through a traditional application process, their ability (credit report, credit score and assets) will be taken into consideration when the loan is made.
Terms of the Loan – The interest rates are usually higher than traditional mortgages and high fees (called points) are usually required up front.
Exit Strategy – The lender will want to make sure that the exit strategy is sound and that there is a backup plan (what I call plan B).
Experience Level – It is important that the investor have a good track record of successful real estate investing.
Diana D Hill