A private mortgage, which is a mortgage loan created by a private individual, can be beneficial to both the borrower and private lender -- bypassing a lot of the hurdles and red tape that can be associated with getting a loan from traditional mortgage lenders while providing a return and form of passive income to the private lender.
If you're considering using a private mortgage, here's what you need to know about private real estate loans, both as a lender and a borrower, how a private mortgage can be beneficial for both parties, the risks involved, and things to consider when using a private loan.
What is a private mortgage?
A private mortgage is a loan created between private individuals for the purchase of real estate. The lender, who could be a friend, family member, colleague, or investment firm, will loan the money to the borrower just as a bank would, securing themselves with a mortgage note or comparable contract. The loan is then paid back over time through monthly principal and interest (P&I) payments, earning the lender interest on the original principal balance.
Typically a private mortgage is created for one of three reasons:
- As a favor to a family member, friend, or loved one.
- As an investment.
- As a combination of the two.
The terms of a private mortgage, including the length of the loan, down payment amount, interest rate, and type of loan, are negotiated between the private individuals. There are certain laws in place that limit the type of loan or the maximum allowable interest rate that can be charged, depending on the purpose or use of the property, as well as the location, but it's up to the lender and borrower to come to agreeable terms for the loan privately.
The benefits of a private mortgage
Private mortgage lending has been around for decades as an alternative to conventional loans, and it has benefits for both parties involved.
Benefits for the lender
While not always the case, it's fairly typical for private mortgage lenders to charge a higher interest rate than traditional lenders may be charging at that given time. This can be because of the risk they are carrying by lending to the individual, to compensate for a lower down payment or poor credit score, or simply as part of their business model. But it's common to see interest rates 3 to 5 points higher than the current mortgage rates.
Since the lenders are secured by real property, private lending can be a lucrative way to earn a higher return than they may be able to receive elsewhere while earning cash flow from the monthly mortgage payment.
Benefits for the borrower
One of the most obvious advantages of a private mortgage for a borrower is the fact that there is far less paperwork, underwriting criteria, and borrower qualifications. Banks have strict underwriting criteria, requiring a minimum credit score in addition to verifying income and down payment source, analyzing your debt-to-income ratio, and inspecting the property to ensure it meets their required loan-to-value ratio for that type of loan.
A private lender can establish their own lending criteria and qualification requirements, meaning, in most cases, that the application and approval process is much quicker and easier than it would be with a traditional lender.
What fees are charged as a part of the loan is established as a part of the loan terms, which can be lender paid or fees passed on to the borrower as closing costs. But usually there are fewer fees involved with creating a private mortgage.
Additionally, a private loan can be created in a matter of days if needed, which allows investors, in particular, to be able to close on properties with cash quickly.
The last major borrower benefit of using a private mortgage is not having to pay private mortgage insurance (PMI). PMI is a form of private insurance that protects lenders in the event a borrower defaults and is a requirement for most borrowers who put less than 20% down, although there are a few exceptions to this rule. Once 20% of equity is established in the property, they can request to cancel PMI, but for many borrowers, the cost of PMI is unnecessary while providing no personal benefits.
The drawbacks of a private mortgage
Drawbacks for the lender
The biggest disadvantage of creating a private loan is that the borrower could default at any time. The lender then has to pursue foreclosure or legal action to try and recoup their original investment, which can be both time consuming and expensive.
The other drawback is that the lender's money is tied up until the borrower sells the home, refinances, or pays the loan in full as outlined in the mortgage. If the lender has a sudden need for a lump sum of money, they could sell the mortgage to another investor, but it will almost always be at a discount.
Drawbacks for the borrower
The biggest drawback as a borrower is that you may have to pay less favorable terms for the loan, such as a higher interest rate, an interest-only loan, or possibly a balloon payment.
|Party||Pros of a Private Mortgage||Cons of a Private Mortgage|
• Less underwriting criteria, making it easier to get a loan.
• Fewer fees, which means lower closing costs.
• Can be done quickly, which is great for investors who need to close for cash fast.
• Eliminates paying mortgage insurance (PMI).
• May have less favorable terms than a traditional loan.
• Earn interest on their original loan amount.
• Can charge higher rates.
• Earn cash flow by collecting monthly payments.
• Secured by real property.
• Risk the borrower stops paying.
• Money is tied up until the loan is paid in full or matures.
Things to consider when creating a private mortgage
Both parties should be well versed in the terms and options available when creating a private mortgage. Lenders should establish their own lending criteria beforehand and understand how to properly underwrite a loan according to the current laws and regulations. The Dodd-Frank Act put several restrictions into place for a residential mortgage that define the number of loans a private lender can create in a given year based on the use of the property as well as the terms of the loan, depending on whether it's an investment property or a primary residence.
For this reason, it's always a good idea to consult a real estate attorney to help draft any mortgage loans. This will help you include the required statutes by law for your state while following the state and national guidelines for private mortgages.
Most loans require the borrower to obtain and pay for homeowners insurance, property taxes, and the cost of maintaining the property. For any policy the homeowner gets, the lender should be named as an additional insured on the insurance policy. This means if the property burned down or was destroyed in a storm, the lender would have a financial interest in the property.
The lender can add a layer of protection by having the insurance premiums and annual taxes be added to the monthly payment amount and placed into escrow. However, unless the loan is being serviced by a professional servicing company, it's not common practice to include escrow.
It's also important for both parties to consider the loan and the impact it could have on the relationship if it were to go south. When a loan is created, no one expects the borrower to stop paying, but that is always a risk. Both parties should be comfortable with the responsibility and consequences and aware of the impact it could have on the relationship if things don't work out as planned.
Using a private mortgage in summary
Private mortgages can be helpful for certain situations and can be a creative solution for borrowers who may have difficulty borrowing or simply need the flexibility private lending offers. Weigh the risks to rewards before entering into a private agreement, and seek professional help for guidance as needed.
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