Private Lending Is Great…Until It Isn’t Things That Can Go Wrong When Private Lending
MOST private lending transactions are a win-win for borrower and lender. The investor-private borrower consummates profitable real estate investments and the private lender enjoys a return with a high interest rate.
SOME private lending transactions go bad and when they do, the lenders can lose big time. I personally know dozens of private lenders who lost money by private lending and nearly a dozen people who lost all their savings or almost all their savings. Some lost their retirement funds, while in retirement. Money. Dignity. Hardship.
Each case of private lending gone bad is different. In almost all cases, there was a problem with the private borrower. In one case, I had to foreclose on a property that secured a private loan I made to a 35 year old rehabber who died suddenly and didn't have a will. I did get my money back because my loan was in first position at 50% LTV (loan to value) and I had a mortgage recorded immediately after the loan was closed at a formal settlement in an attorney’s office. If you are a private lender, now would be a good time to dig out and review your note and recorded mortgage and make sure they are written well enough to go through the foreclosure process on an estate without a will.
If you are a private lender, did you seriously consider the possibility that your reliable private borrower might die suddenly as realistic before you loaned $100,000 to your private borrower.
This is just one of 19 things I have seen go wrong in private lending. If you want to learn about the 19 things that I have seen go wrong when private lending and best practices to avoid them, watch my training video “Private Lending Is Great…Until It Isn’t: 19 Things That Can Go Wrong When Private Lending.” This article will describe 8 of the 19 things that can go wrong.
If you are a private lender, did you give the money directly to the private borrower or did you close the loan at a formal and documented closing at a title company or attorney? Lending banks insist that borrowers close the loan at a title company or attorney. You can probably make a long list of reasons why they engage in that best practice.
Did you insist that a title search be run on the collateral and the borrower? If you didn’t, Why? Lending banks do that. If they didn't, how would they know that there are no outstanding liens in a senior position? How would they know if the collateral was not already over-encumbered? When you lend, do you know in which position is your lien? If you do know, is it because the private borrower told you or do you have competent third party verification?
Do you know for sure that your mortgage is or will be recorded? Many private lenders rely on the private borrower to record the mortgage, then never follow up! I personally know too many private lenders who lost ALL the money they loaned to private borrowers without being able to place a lien on the property used as collateral for the private loan, because they relied on the private borrower to record the mortgage, who never got around to doing that (either inadvertently or on purpose).
I ALWAYS had a recorded mortgage when I loaned to private borrowers (except in one hardship case of friends and family...a mistake I made under pressure).
Here is one you probably never thought of...in two cases, I, the private lender, was named as a defendant on lawsuits brought against the private borrower because the private borrower never recorded the notarized mortgage discharge I gave her to record. When she stopped paying the first position lender several years after my loan was paid back, there was no record that my recorded mortgage was discharged. So, I was sued for any "interest, lien or claim" I may have in the collateral due to my private loan. I then recorded the discharge of mortgage and provided to the foreclosing attorneys copies of the original dated and notarized mortgage discharges in addition to copies of the newly recorded mortgage discharges. I was then dismissed as a defendant.
If the collateral burns down and you made a loan using that property as collateral, are you named in a mortgagee clause on the insurance? Do you even have proof that the borrower maintained proper insurance on the property (vacant dwelling, landlord, etc.)?
Even if you, the private lender, close the loan with a title company or attorney, get a full free and clear title report and get a recorded mortgage, the private borrower can still "sell" the property out from under you by recording a quitclaim deed from the private borrower to another entity. This happened to me and I discovered it because I would look at property ownership on public tax records from time to time. I confronted the private borrower when I discovered this and demanded full payment which I received.
TRUST BUT VERIFY is an old Reagan saying (actually an old Russian saying that Reagan translated) that certainly applies to private lending.
Most private lending is driven by sophisticated private borrowers who cannot or choose not to get conventional financing for any number of reasons including possible over-leverage, possible credit problems, possible lack of resources to put skin in the game and other reasons. Sometimes, the reasons are good ones such as a private loan can be made very quickly…so quickly that the private borrower can take advantage of an opportunity that requires very fast closing.
Private borrowers are willing to pay interest rates and sometimes points that are well above what they would pay if they could get conventional bank financing.
In other words, many private lenders are getting higher interest rates to compensate them for higher risk. Many private lenders understand this. Many do not. Private borrowers understand this.
If you are a private lender and you combine the higher risk with relying on the relationship and trust to record the mortgage while not running title or credit on the borrower and the collateral, not insisting on dwelling insurance, title insurance and other protections, your money might be safe, but it might not.
If you are a private lender, look at what commercial banks do when they lend money to lower risk borrowers. If you are not getting at least those same protections with higher risk borrowers, you need to ask yourself if the risk is worth it.
Is 8% return on $100,000 worth it? 10%? 12%? I concluded that 15% was NOT worth it for me and I closed all my private loans in 2011 and stopped making new loans after 2009.
I am a part-time real estate investor and I consistently get returns that are higher or much higher than 15% on my money, including my retirement money. I control my investments.
In the past few years, I have preferred that my money sit at near 0% rather than private lend the money to people who have the same investing skills as I do and for some reason cannot or will not get conventional financing for their investments.
I'm not saying that you shouldn't private lend. After all, you may not have the skills or time to make higher returns than by private lending. What I AM asking you to do is to treat your private loans with a similar (though not identical) level of prudence and due diligence as institutional lenders. Lending banks have best practices for a reason.
Do not choose to ignore all the best practices of lending banks. If you do, you may be putting your principal at undue risk, whether you are aware if it or not.
Noted above were 8 of 19 things I have personally seen go wrong with private loans I made or made by people I know in my sphere of influence. None of these things are a problem for the private lender if the private borrower pays as agreed, the loan is properly satisfied and the mortgage is properly discharged. ANY of these are a problem if the private borrower does NOT pay as agreed.
If you want to hear the 19 things that I have seen go wrong when private lending, attend my presentation next week on June 7, 2017 in Cherry Hill, NJ entitled “Private Lending Is Great…Until It Isn’t: 19 Things That Can Go Wrong When Private Lending.”
Let’s put private lending back in perspective. Do most private loans work out well for private lender and private borrower? Yes. If your private loan will work out well, then both you (the private lender) and the private borrower should have no problem going through the proper procedures and paperwork. Do you think that the extra paperwork is too much of a hassle or too costly when you lend someone $100,000? If the private borrower thinks it's too much of a hassle or too costly to pay for title for example or are concerned about running their credit, do you really feel comfortable lending that $100,000 to that person/entity?
I know of a private borrower who will actually show you his bank statements! He is so transparent and ethical with outstanding best practices, that he instills great confidence in his private lenders. There are MANY highly responsible private borrowers. Find them, use the proper paperwork and always implement best practices.
In order to maximize your protection of your private loans, there is no substitute for going to a local attorney in your state who has significant personal experience and expertise in private lending. Pay that private lending specialist attorney for his/her documents. Different states have different laws about how many loans can be made without a license, what are the maximum interest rates allowable and much more. Do NOT use the private lending documents provided by the private borrower. YOUR money is in their hands. You want YOUR attorney to prepare the documents. You want to close the loan with an attorney or title company that knows the in’s and out’s of private lending and foreclosing on private loans in case of non-payment for whatever reason. Again, examine what conventional lenders and bankers require when making conventional loans. If you are doing less due diligence and less best practices than conventional lenders are doing, you need to know that and assess the risk of doing less.
Maria Bartaromo used to open her CNBC show when the stock market closed at 4:00 pm on Wall Street with the words "Do you know where your money is?" If you're a private lender right now, ask yourself that question right now. Do you feel comfortable or are you uneasy?
Biography: Marc Halpern is a successful part-time investor who has achieved financial freedom in terms of passive income and net worth mostly through rentals and flips using “regular” money and self-directed 401(k) funds.
E-mail Marc Halpern directly if you want to improve your profits through coaching by a local expert in South Jersey/Philadelphia with track record.
Do not take any action or make any decisions based in whole or in part on the content of this article. ALWAYS consult with licensed professionals in YOUR state before making any investment.