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An Inside Look At Private Mortgage Lending

I’ve always been a bit of an odd guy.

While the rest of my friends were off having fun immediately after high school and going off to higher education, I intentionally took a job working overnights at a local grocery store because it would kill my social life. If I didn’t have distractions then I could save more money, which was 18-year-old Nelson’s ultimate goal. I also lived in my parents’ basement much further into adulthood than any person should admit.

Surprisingly, this was not a hit with the ladies.

My weirdness also spread over to my investments. When I got serious about the stock market back in 2004 or 2005, I embraced a deep value contrarian approach, buying stakes in the cheapest stocks I could find. Sometimes it worked, and I had some huge winners. But it often didn’t, and some of those winners were negated by serious losses. Fortunately I saw the light and now embrace a portfolio stuffed with solid blue chips, real estate, and owning the mortgages on close to a dozen local homes.

Okay, maybe I haven’t eschewed the odd investing choices completely. But unlike my deep value portfolio, being a private mortgage lender has been a lucrative investment choice since I started in 2005.

Let me run you though the process of what I look for in a loan, red flags to avoid, and what kinds of returns a private lender can expect in today’s market.

The process

I first entered the private mortgage sector with my dad and another business partner back in 2005, which was a fantastic time to get into the business. We were the only lenders offering that type of financing in our small town (population: 8,000 people), which made it pretty easy to get business.

We started working exclusively with the local mortgage broker, who had become the go-to person for folks with home ownership dreams and credit issues. Most of the deals we did then (and now, actually) follow a similar pattern:

  • Borrower buys a house and gets a conventional mortgage
  • Borrower then runs into money problems and starts to rely on high-interest, unsecured credit
  • The proverbial light bulb goes off when that unsecured credit starts to impact their ability to pay the mortgage
  • Traditional financiers reject a new, larger mortgage
  • Borrower then seeks out alternate financing (e.g. us)

When we first started in the business, getting 18% on a second mortgage was common. You can see why I was attracted to this.

Unfortunately, not every borrower is created equal. So one of the first things we did was create underwriting standards. But since our market was much different than a bank’s, our rules came out a whole lot different. We looked for the following:

  • Someone with a large amount of equity in the property. Our maximum loan-to-value ratio was 75% with that ratio ideally closer to 50%
  • Borrowers with a long history in our community. We wanted “local yokels” as my dad puts it, folks who are less likely to leave town
  • An ability to afford both the first and second mortgage, but we weren’t as strict with income verification as the banks
  • A fair credit report. Being behind on payments is fine, but we don’t like to see accounts the lender has written off or forwarded to collections

The good news about doing this in a small town is between the three of us we were familiar with 80% of our borrowers before they came through the door. This helped the underwriting process greatly.

A typical private mortgage deal

Let me walk you through a common private mortgage deal these days. I also did this on my blog a few years ago, in greater detail.

We no longer work with a mortgage broker. In fact, we don’t even advertise. These people find us, not the other way around.

Take, for instance, the local business owner who needed capital to do some improvements to his building. He was looking for $30,000. Since it was a business loan, the banks wanted a huge amount of paperwork before they’d even consider the deal. He wasn’t willing to go through the process, so he came to us.

For collateral we were offered a building worth approximately $150,000 with $60,000 owing on it. After our second mortgage was applied we’d have a property with a loan-to-value ratio of 60%, well within our parameters. A quick look at the business’s books made it obvious the payments wouldn’t be that big of a deal, either. We charged him 8%, which is on the low end of our rates these days. We’re usually somewhere in the 8-10% range, sometimes higher.

Once the deal is agreed to, the file goes off to the lawyer. They prepare the official legal documents for the client to sign and assist us in putting our interest on the title of the property. We pay for these legal expenses but charge the client a fee to enter the loan. We just slap that fee onto the mortgage balance and let the customer pay it off over time.

Many private lenders make their borrowers re-qualify on an annual basis, collecting a fee each time. We don’t. We’re happy to make a long-term investment in these folks. A typical loan these days comes with an 8-10% annual interest rate with a generous payout provision. Our borrowers can make extra payments or even pay the whole loan off whenever they want, without penalty. We want to reward good financial behavior.

Most folks don’t bother. They pay their minimum payment and that’s it.

What about losses?

We’ve been lucky. In close to 15 years as private lenders, our total loss on principal has been $0. Yes, that’s right. Our private mortgage portfolio hasn’t suffered a nickel in capital losses.

We do, at times, discount interest rates for folks who are struggling. It becomes more important to get the principal back than maximizing our return on investment. We’ll also waive late fees and other extra charges built into the mortgage contract. See? I’m not totally heartless.

We’ve never had to foreclose on anyone, but we have had borrowers who have walked away from their property. We lend in Alberta, which means there’s no recourse except to sell the property.

This is when having a low loan-to-value ratio comes in handy. Both times this happened we were able to sell the property and get all of our money back with accrued interest, along with enough to pay the Realtor a generous commission to sell the place.

How can you get in?

Chances are the typical person reading this resides in a major city. If that’s you, I don’t like your chances of getting into the private mortgage game. There’s just too much competition already. Lots of competition means you’ll be left chasing the worst deals, which is how you lose.

But there are certain things you can do to stand out. Perhaps you join a local house flippers group and create relationships with these folks. Or you just do this type of lending for your group of friends. It’s smart to start small, too, while you get the experience needed.

If you do work with a mortgage broker, like we did, offer a compelling value proposition. We were able to make decisions on loans within an hour, for instance. Most other lenders take 48-72 hours. Our broker partner loved that.

And that’s about it. I’ll hang around in the comment section and answer any questions you might have, including “why are there so many typos in this” and “God, you’re ugly”, even though the latter isn’t really a question.

Nelson Smith normally writes at Financial Uproar, which is mostly a place for him to make 37 bad jokes into a serious point about finance. He lives in rural Alberta with his wife and loud cat. His hobbies include being perpetually disappointed in the Toronto Blue Jays, shaking his head at the antics of young people, and falling asleep on the couch.

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13 Comments

  1. Albert S on June 11, 2019 at 5:51 am

    Thanks for sharing your experience, Nelson. You mentioned increased competition in this space but I’m curious about the impact that the stress test is having on home buyers and whether that’s led to a major increase in demand. Have you noticed this in your area?

    • Nelson on June 11, 2019 at 7:49 am

      In my area, no. The stress test hasn’t impacted things at all. But keep in mind houses don’t get much more than $400,000 here, and the average price is in the $200,000 range. Affordability isn’t really a concern where I live.

  2. Rick Wagner on June 11, 2019 at 8:09 am

    Isn’t there a way to participate in this more passively, i.e. a peer-to-peer lending pool or a mortgage investment corporation? That would seem more diversified than owning a couple of local mortgages, no?

    • Nelson on June 11, 2019 at 9:47 am

      Mortgage investment corporations are definitely an option, and like you said they come with better diversification.

      But I would never invest more than a token amount in one. I’m a big believer in physically underwriting these loans myself. I want to talk to the borrower, see their house, etc. I’m not sure an underwriter working in an office somewhere will take the same care.

  3. Cheryl on June 11, 2019 at 9:11 am

    I worked at the head office for a credit union and the department behind me were part of the RSP investing. One of the things they arranged was this type of mortgage. People who had I guess enough funds in their RSP would lend to another person to get a mortgage. I’m not sure of all the ins and outs but it seems that’s another way to go, either if you’re the lender or the borrower, if your credit union can match you up. I did get the impression the borrowers would have otherwise had difficulty getting a normal mortgage.

    • Nelson on June 11, 2019 at 9:50 am

      I’ve heard of big mortgage brokers doing this but never an actual bank. That’s neat. Good for them for thinking outside of the box.

      I would assume such a product would have some pretty aggressive fees, but I like the concept.

      • David on July 7, 2019 at 8:57 am

        I use Canada Western Trust division of Canada Western Bank to lend RRSP funds for private mortgages. 2 other institutions in Canada also provide the service but none of the big 5 banks anymore.

  4. Don Reese on June 11, 2019 at 10:29 am

    What do you say to a us that has 2.5 million already in GIC’s well spread out for deposit insurance with many financial institutions but is content with the $90,000 a year interest coming in.

    It is simple and straightforward for us to manage our finances and are content with the interest income . We still are able to save after all our expenses, taxes etc. $42,000 a year which we reinvest to get more interest. We are totally debt free, no mortgage, car loans etc. We still own our home worth $576,400 since our last market evaluation. We do still make sure we have some balance in our lives so we have a vacation, us fun fund periodically.

    I think we are in a very good place even as we are not getting the higher interest rates of 8%+ from the past.

    • Nelson on June 11, 2019 at 2:38 pm

      Don – I’d say if you’re content with your returns then don’t change a thing.

  5. Linda Krinos on June 11, 2019 at 10:47 am

    I had no idea that private mortgages could charge 8%-10%. I guess like any other business, it is what people are willing to pay for good service and good communications, information with that company.

    • Nelson on June 11, 2019 at 2:40 pm

      Some charge even more. It’s not entirely uncommon to see 15-18%, especially for higher risk stuff I would never touch.

      • Scott Tomas on June 11, 2019 at 5:11 pm

        In this current interest rate environment I can understand what you mean. Right now, the regular banks, credit unions are charging 3% to 4% mortgage rates are the norm.

        However, if we were to see even mortgage rates back like in 2000, 7% to 8% was the norm back then. Those 15% to 18% rates would probably be less risky due to higher overall mortgage rates in the market.

  6. John on June 26, 2019 at 6:59 pm

    How much coin would I need to start something similar? My approach would be similar to your model conservative with a heart, securing principal is primary. Should I start by finding a lawyer that specializes in this and I would like to know what to pay a mortgage broker for their service. I would be conservative and how do you measure interest rate charged based on risk?

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