Pros and Cons of Private Mortgage Lenders
How This Alternative Home-Buying Process Works
A private mortgage is a home loan financed through a private source of funds, such as friends, family, or a business, rather than through a traditional mortgage lender. It can come in handy for people who struggle to get a mortgage the typical way.
This kind of mortgage can benefit everyone involved if it's executed correctly. However, without precautions, things can also go badly—for your relationship as well as your finances.
As you evaluate the decision to borrow or lend through a private mortgage, keep the big picture in mind: creating a win-win solution where everybody gains financially without taking on too much risk.
Benefits of Using a Private Mortgage
Ease of Qualifying
For starters, some borrowers might not be able to qualify for a loan from a traditional lender. Banks require a lot of documentation, and sometimes a borrower's finances won't appear to be sound enough for the bank's preference. Even if you're more than able to repay the loan, mainstream lenders are required to verify that you can repay, and they have specific criteria to complete that verification. For example, self-employed people don't always have the W2 forms and steady work history that lenders require, and young adults might not have good credit scores because their credit history is short.
A loan between family members can also make good financial sense.
Borrowers can save money by paying a lower interest rate to family members than they'd be able to get through traditional means. Just be sure to follow IRS rules if you plan to keep rates low; if your loan doesn't meet the Applicable Federal Rate (AFR), there could be tax implications.
Similarly, people with extra cash on hand can earn more by lending privately than they’d get from bank deposits such as CDs and savings accounts.
Understanding the Risks
Life is full of surprises, and any loan can go bad. You may agree to a personal mortgage with good intentions, but there are risks you should consider beforehand.
Relationships May Change
Introducing debt into a relationship can be tricky. If money gets tight for the borrower, he may feel extra stress and guilt if he's unable to make payments. The lender, on the other hand, is put into the predicament of either sternly enforcing a payment schedule or taking a loss.
Circumstances May Change
Just as the borrower's financial situation may change, so can the lender's. Evaluate the lender’s ability to take on the risk of a large loan before moving forward. This is especially important if others are dependent on the lender, such as children or spouses. Consider whether making the loan may affect the lender's ability to retire, care for dependents, or make other important financial moves.
Property Value May Fluctuate
Real estate is expensive, and the value of a property can vary greatly over time. Lenders need to be comfortable with the condition and location of the property and confident that the home's value will not decrease.
Maintenance Can Be Expensive
It takes time, money, and attention to maintain a property. Even with a satisfactory home inspection, issues can come up. Lenders need to be sure that the resident or owner will be able to pay for maintenance and address any problems before they get out of hand.
The Title May Not Be Clear
The lender should insist on securing the loan with a lien. If the borrower adds any additional mortgages, or somebody puts a lien on the house, this ensures the lender gets paid first. However, you’ll also want to check for any issues before the sale. Traditional mortgage lenders insist on a title search, and the borrower or lender should ensure that the property has a clear title. Consider title insurance, which provides extra protection.
Your Taxes May Be Affected
Tax laws are tricky, and moving large sums of money around can create problems. Before you do anything, speak with a local tax adviser so that you’re not caught by surprise.
How to Structure Your Private Mortgage
Any loan should be well-documented. A good loan agreement puts everything in writing so that everyone's expectations are clear and there are fewer possible surprises. Years down the road, you or the other party may forget what you discussed, but a written document will spell out the details.
Documentation does more than just keep your relationship intact—it protects both parties of a private mortgage. 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) and is there a grace period?
- How and 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?
Also, it’s wise for the lender to secure their interest—even if the lender and borrower are close friends or family members. A secured loan allows the lender to take back the property through foreclosure and get their money back in a worst-case scenario.
If the property is held in the borrower’s name only—without a properly filed lien—creditors can go after the home or pressure the borrower to use the home’s value to satisfy a debt.
Enlist Professional Help
For documentation, work with qualified experts. Talk to local attorneys, your tax preparer, and others who can help guide you through the process. You're working with large sums of money; this isn't a DIY project. When hiring a professional, you may want to consider:
- 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)?
Professional help at the outset will ensure that your private mortgage arrangement continues to benefit both parties for the life of the loan.