Private mortgage lenders can be private individuals, trusts, partnerships, real estate investment groups or retirement funds, who issue private mortgage loans (also known as hard money loans or private mortgage money).
A private mortgage lender is not a traditional bank or lending institution, and therefore private mortgage lending differs in many respects from the traditional mortgage lending process.
One the best benefits of private mortgage loans is the fast speed at which they can be accomplished, especially for borrowers who find themselves in distressing circumstances. Since these are asset-based loans, they can be completed with a minimum of credit checks, paperwork, and hassles. The private mortgage lending industry provides a valuable source of money for anyone having trouble obtaining a loan through more traditional channels.
The Four “C’s”
Private mortgage lenders will examine four critical factors before granting a mortgage loan. These criteria are frequently referred to as the “Four C’s”:
Collateral — Credit — Commitment — Capacity
Collateral
Collateral refers to the marketability, condition, and value of the property that secures the private mortgage loan. Of the four “C’s”, collateral is usually the most important criterion used to determine if the lender will approve the loan or not. The lender is seeking to ensure enough collateral so that the loan could be repaid from the proceeds of a forced sale, in case of foreclosure.
The value of the collateral is determined by the overall loan-to-value (LTV) ratio. For example, if the property’s market value is $400,000 and you are seeking a first mortgage of $300,000, then the LTV ratio would be 75%. Private mortgage financing usually requires a loan-to-value ratio anywhere from 75% to 50%.
Whereas traditional mortgage lenders will calculate loan-to-value based on the lesser of the appraised value or the purchase price, private mortgage lenders will usually make a loan based on the appraised value. This distinction is very important if you are purchasing a property for price substantially below the appraised value.
Credit
Oftentimes a borrower is turned down by traditional mortgage lenders because of a bad credit history. If by some chance you are able to obtain a traditional bad credit mortgage, you would still be classified as a non-prime borrower and would be assessed a risk premium in the form of higher interest rates and more stringent loan terms.
Private mortgage lenders for bad credit are accustomed to dealing with borrowers with damaged credit. They realize that unforeseen circumstances, such as medical conditions, divorce, failed businesses, deaths, and so on, can result in a ruined credit rating through no fault of the borrower. So although they still examine the borrower’s credit history, it does not form the primary basis of their loan decision.
A private mortgage lender will compensate for damaged credit in two ways:
- Charging a higher interest rate
- Requiring a lower LTV ratio
Both of these methods compensate for the higher risk incurred by making a loan to a borrower with bad credit. Private mortgage notes are not cheap mortgages — they will almost always carry a higher rate of interest than traditional mortgages. The higher interest rate is similar to the risk premium charged by other lenders, whereas the lower LTV ratio provides an extra margin of safety in case of default.
Capacity
Capacity refers to your ability to meet your monthly payment obligations in a timely manner. Private lenders for mortgages will examine your current level of debt obligations and how they relate to the additional debt incurred by the new loan. They will then look at your current level of income, the income generated by the property (if any),and your employment history and consistency in order to determine if you are likely to meet your monthly payments on time. There are two ratios used by the lender to make this determination:
- Front end ratio is the percentage of your income to your proposed mortgage payment, which includes an allowance for principal, interest, taxes and insurance.
- Back end ratio includes all of your monthly debt obligations, including the new mortgage payment as described above.
Commitment
Commitment refers to the equity stake that a borrower leaves in the property. In other words, it means how much of your own money are you reading in the deal. It is not necessarily the same thing as a down payment deposit, but it it is often related. Private mortgage investors like to see a borrower leave a large chunk of equity in the property because it increases the investor’s security.
Private mortgage lenders believe that if the borrower has a large equity stake in the property, usually more than 25%, then he or she will do everything possible to make the monthly payments in order to protect the substantial equity. On the other hand, if the borrower has little equity in property, the odds of a default are increased greatly because the borrower has less to lose by simply walking away.
Commitment is demonstrated by either putting down a large down payment deposit on a new purchase transaction, or else leaving considerable equity in the property with transactions such as refinances, remortgages, or second mortgages. In any case, the lower the LTV ratio, the better the chances of obtaining a private mortgage note.
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