Avoid Risky Private Loans

Private mortgage lending or investing in “hard money” mortgage Notes or a Deed of Trust is something that is becoming more popular with investors. I used to work in the lending business and am strongly opposed to individual retail investors buying or funding a loan.

The baking industry is very competitive. They already have corneded the market in terms of acquiring the best borrowers, so the only ones left for small investors would be high risk borrowers that banks won’t accept. Banks are the professionals: they know what is a loan that is a reasonable risk, they know how to generate the proper legal documents that protect their rights during a foreclosure, they know how to handle defaulted debt in a way that is more professional and cost effective than single retail individual could do.

The problem with affluent individuals loaning money to needy, shaky poor quality borrowers is that there is a huge gap in attitude between the two parties. The investor is so affluent he can’t imagine how ruthless or desperate a borrower can be or will become so the investor is taking on hidden risk of default and foreclosure that he is not emotionally prepared to deal with.

The Problem With Lending Money

The risks of private lending to poor quality borrowers include: risk of failure underestimated, risk of failure to diversify, risk of becoming an involuntary owner of a property through foreclosure (for example imagine owning through foreclosure a tainted property that requires a huge expenditure to remove toxic waste), risk of a lawsuit over alleged failure to properly disclose loan terms, risk of improperly executed paperwork either at the start or during foreclosure, risk of taking a lot of time off work to meet attorney and go to court over a loan that has a value roughly equal to the attorney’s fee, risk that “junk bond” quality loans could suffer an 80% loss in bankruptcy plus a loss of interest for several years (during bankruptcy no interest accrues).

To be a successful private investor in Notes it would be best to have a large diversified portfolio of them, have a full time loan expert on retainer who is legally obligated to be exclusively your agent and not the borrower’s agent.

The crucial missing item in loans not accepted by banks is not the lack of good credit but rather it is the lack of income as defined by the bank. So the private party lender gets stuck with lending to someone who has shaky income which is the worst type of lending mistake. Poor quality or inadequate income is what destroyed the Tech stock bubble of 2000, the real estate and mortgage bubble that crashed in 2007-08, and it is the factor that destroys “asset based” lending. It is what fools uninformed retail Note investors. It is hard to judge the “quality” of income unless someone is a fulltime loan underwriter. It is the lack of this critical skill that causes investors to be exploited by “B” paper borrowers.

The misunderstanding that retail Note investors have is that they assume that a mortgaged asset will never drop in value, never become old, worn down, unpopular, will require no marketing expertise to sell, will be perfectly maintained by a poor borrower with a reckless behavior pattern that resulted in poor credit. They assume the borrower will quickly and meekly cooperate to complete the foreclosure and that there will be delays in the court system, etc., etc. The reality is that private non-institutional lending only works if the borrower magically is fated to never default. If the borrower defaults then the structural nature of high foreclosure costs eat up the profits and cause losses.

So leave lending to the pros and if you want to invest in high risk high yield debt then settle for publicly traded junk bond, preferably by buying shares in a mutual fund that specializes in that. There mutual funds that invest in bank loans, junk bonds, Emerging Market debt, etc. where you don’t have to hire an attorney, a loan document drawing expert, a loan disclosure expert, a foreclosure expert. You simply click on a Broker’s website and buy the mutual fund after carefully shopping for the right funds. Of course, junk bonds are risky too. I would prefer that people avoid junk credit regardless of how it is made available to them.

About the author

Don Martin, CFP®

2 Comments

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  • Last year I made a private mortgage loan to my son and his wife with National Family Mortgage. I was earning nothing with my CDs and after reading about the intra-family mortgage loan concept in the NYT it seemed like a great, relatively low-risk investment vehicle. I’m now earning 3.50% on my $150K investment, and I have a nice monthly income stream. My son has a low rate and we’re keeping money in the family. We’re using the company’s loan servicing platform to keep a buffer between us, to collect payments, and issue year-end tax forms. It’s a legitimate, tax-deductible mortgage, and I’m happy to have invest my money this way. My son and his wife have great careers and a stable marriage — it’s a great wealth transfer tool. There are some fair points in this post, but I’m proff that not all private lending is a bad idea.

  • This article makes some valid points, but they don’t all apply to every private lending model out there. This type of lending should absolutely be left “to the pros”, though there are many well-managed mortgage pools available to investors with pros making the decisions and managing the processes. The bottom line is that every investor should do their own due diligence if they are interested in finding a high quality lending fund managed by true professionals.

    Chuck Tralka
    GCA Equity Partners, LLC

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