How to Use a Private Mortgage
A private mortgage is a loan made by an individual or a business that is not a traditional mortgage lender. If you’re thinking of borrowing for a home, or considering lending money, private loans can be beneficial for everybody if they’re executed correctly. However, things can also go badly—for your relationship and your finances.
As you evaluate the decision to use (or offer) a private mortgage, keep the big picture in mind. Typically, the goal is to create a win-win solution where everybody gains financially without taking too much risk.
Private Mortgage or Hard Money?
This article focuses on mortgage loans with somebody you know. If you're looking to borrow from private lenders (that you don't know personally), read about hard money loans. Hard money lenders are useful for investors and others who have a hard time getting approved by traditional lenders. They are often more expensive than other mortgages and require low LTV ratios.
Why Go Private?
Qualifying: For starters, borrowers might not be able to qualify for a loan from a traditional lender. Banks require a lot of documentation, and sometimes your finances won't look the way the bank wants. Even if you're more than able to repay the loan, mainstream lenders are required to verify that you have the ability to repay, and they have specific criteria to complete that verification. For example, self-employed individuals don't always have the W2 forms and steady work history that lenders require, and young adults might not have good credit scores (yet).
Keep it in the family: A loan among family members can make good financial sense.
- Borrowers can save money by paying a relatively low interest rate to family members (instead of paying bank interest rates). Just be sure to follow IRS rules if you plan to keep rates low.
- Lenders with extra cash on hand can earn more by lending than they’d get from bank deposits like CDs and savings accounts.
Understand the Risks
Life is full of surprises, and any loan can go bad. Of course, everybody has good intentions, and these deals often seem like a great idea when they first come to mind. But pause long enough to consider the following issues before you get too deep into something that may become difficult to unwind.
Relationships: Existing relationships between the borrower and seller may change, especially if things get difficult for the borrower, who may then feel extra stress and guilt. Lenders also face complications—they may need to decide whether to sternly enforce agreements or take a loss.
Lender risk tolerance: The idea may be to make a loan with the expectation of getting repaid, but surprises happen. Evaluate the lender’s ability to take the risk (becoming unable to retire, risk of bankruptcy, etc.) before moving forward. This is especially important if others are dependent on the lender, such children or spouses, for example.
Property value: Real estate is expensive. Fluctuations in value can amount to tens or hundreds of thousands of dollars. Lenders need to be comfortable with the property condition and location—especially with all of those eggs in one basket.
Maintenance: It takes time, money, and attention to maintain a property. Even with a good inspector, issues come up. Lenders need to be sure that the resident or owner will address problems before they get out of hand and be able to pay for maintenance.
Title issues and order of payments: The lender should insist on securing the loan with a lien (see below). In case the borrower adds any additional mortgages, or somebody puts a lien on the house, you’ll want to be sure that the lender gets paid first. However, you’ll also want to check for any issues before buying the property. Traditional mortgage lenders insist on a title search, and the borrower or lender should ensure that the property has a clear title. Title insurance provides extra protection and would be a wise purchase.
Tax complications: Tax laws are tricky, and moving large sums of money around can create problems. Before you do anything, speak with a local tax advisor so that you’re not caught by surprise.
Private Mortgage Agreements
Any loan should be well-documented. A good loan agreement puts everything in writing so that everybody’s expectations are clear and there are fewer possible surprises. After several years, you or the other party may forget what you discussed and what you had in mind, but a written document has a much better memory.
Documentation does more than just keep your relationship intact—it protects both parties to a private mortgage. Again, you don't know what you don't know about the future, and it's best to avoid any legal loose ends from the get-go. What’s more, a written agreement might make the deal work better from a tax perspective.
As you review your agreement, make sure every conceivable detail is spelled out, starting with:
- When are payments due (monthly, quarterly, on the first of the month, etc.) and is there a grace period?
- How/where should payments be made? Are electronic payments preferred?
- Can the borrower prepay, and is there any penalty for doing so?
- Is the loan secured with any collateral?
- What can the lender do if the borrower misses payments? Can the lender charge fees, report to credit reporting agencies, or foreclose on the home?
Secure the Loan
It’s wise to secure the lender’s interest—even if the lender and borrower are close friends or family members. A secured loan allows the lender to take the property (through foreclosure) and get their money back in a worst-case scenario. Is that really necessary? Again, you don't know what you don't know about the future.
A borrower may die or get sued unexpectedly. If the property is held in the borrower’s name only—without a properly filed lien—creditors can go after their home or pressure the borrower to use the home’s value to satisfy a debt. A secured mortgage helps protect the lender’s interest, assuming everything is structured correctly. In fact, the term "mortgage" technically means "security"—not "loan."
Securing a loan with property may also help with taxes. For example, the borrower might be able to deduct interest costs on the loan, but only if the loan is properly secured. Talk with a local tax preparer or CPA for more details and ideas.
How to Execute a Private Mortgage Correctly
If you’re considering a private mortgage, think like a “traditional” lender. Imagine what could go wrong, and structure the deal so that you are not dependent on good luck, good memories, or good intentions.
For documentation, work with qualified experts. Talk to local attorneys, your tax preparer, and others who can help guide you through the process. If you're working with large sums of money, this isn't a DIY project. Several online services can handle everything for you, and local service providers can also do the job. Ask exactly which services are provided, including:
- Will you get written mortgage agreements?
- Can payments be handled by somebody else (and automated)?
- Will documents be filed with local governments (to secure the loan, for example)?
- Will payments be reported to credit bureaus (which helps borrowers build credit)?