By David Franklin
Private mortgage lenders look at mortgage lending somewhat differently than banks and other regulated mortgage lenders. Here are the essential differences in outlook.
The financial institutions look at the creditworthiness of the borrower in addition to the security based on the value of the property. Banks especially give weight to the credit worthiness of the borrower, even more so than other lenders such as trust companies, who are more inclined to consider self-employed borrower’s income in considering the credit worthiness of the borrower. The private lender looks more to the value of the property as he considers that should the borrower default; the only security is that of the mortgaged property. Default could occur, for example, if the borrower was to lose his job. The private lender still wants to have satisfactory documentation as to the borrower’s income and net worth in making his decision, but relies more on being satisfied as to the value of the mortgaged property. Experienced private mortgage lenders know how to determine the value of the property based on market comparables. These comparables can indicate what the property will sell for if there is a need to enforce mortgage security. The experienced lender will require that his approved appraiser provide the appraisal and that the value of the property be based on the property being sold within three months on an all-cash basis. This appraisal valuation could indicate a lower value for the property as the normal appraisal is based on the value a willing buyer would pay in an open market and there is no timeframe set out.
The private lender knows that he is being approached for private mortgage financing for some or all of the following reasons:
1) the borrower needs to close quickly and that the financial institutions cannot act quickly enough;
2) the borrower has been turned down by the financial institutions; or
3) the borrower knows that he will not be approved by the financial institutions.
The experienced lender knows that since the borrower cannot access lending from the financial institutions, he can charge a higher interest rate. In today’s marketplace the interest rates that private lenders can earn on residential first mortgage loans are 6% to 8%, and higher, depending on the income, net worth, creditworthiness of the borrower and loan to value.
In determining the loan to value, the experienced lender, since he does not want to lose money, uses as a rule of thumb of not lending over 80% of the value he determines. The reason for this limit is based on the lender having to take legal action to enforce his security. As a result the lender deducts 5% for real estate commission, 5% reduction in price because market conditions can change, and the property might need some repairs. Added to these deductions are the interest owed on the mortgage, realty taxes, insurance, appraisal for resale and legal fees. If the interest rate on the mortgage is 8% and if it takes one year to sell the property, the interest owed is 6.4% of the value of the property. For illustration purposes, assume the value of the property is $100,000 and the mortgage was $80,000, 80% of the lender’s value, and the interest rate was 8%, one year’s interest, without compounding is ($80,000 X 8%) 6.4%. The deductions from value then are 16.4%, leaving 3.6%, or $3,600, to cover the other expenses. If property taxes are 1% of value, that leaves 2.6% or $2,600 for the balance. The 5% allowance for change in market conditions also allows for any costs that are not covered in the 2.6% balance.
As you can see from these calculations, there may not even be enough from these deductions to prevent a loss as the appraisal alone could cost $500 or more and the legal fees could be substantially more than allowed for. Prior to April 2007, the loan to value for financial institutions was 75% so that there was more leeway. and mostMost private lenders used that as their maximum loan to value as it allowed an additional 5% to cover any deficiencies. The reason the loan to value was increased to 80% was because of the financial problems that resulted from the US mortgage meltdown that occurred because of improper mortgage lending. and theThe Canadian government needed to stimulate the Canadian economy. In addition to increasing the loan to value, CMHC was allowed to insure zero down first mortgages and mortgage amortization was increased to 40 years to help people qualify for mortgages. This was changed in subsequent years with CMHC requiring down payments and mortgage amortization was reduced but the loan to value was not decreased back to 75%.
The large private lenders lend primarily in markets with large populations because they need the liquidity that these markets offer to be able to sell the property if they are required to realize upon their security in the event of default. They normally will not lend in markets with small populations and, if they do, they lend at a lower loan to value.
The term most experienced lenders use is one year, and the reasoning behind this is that you usually forecast how the economy will be for one year and what interest rates will be and, if you are wrong and the economy looks like it could slow down or interest rates could increase, then you can get your money back at the end of the term. If the borrower has made his payments and nothing much has happened to impact the economy or interest rates, then you can negotiate the extension of the term of the mortgage for a further year and the interest rate and lender fee, if any, for the renewal.
If the economy has turned negative and you do not want to renew, then, because of the loan to value being a maximum of 80%, the borrower should be able to find another lender to pay you out. If you loaned above the 80% it may be difficult, if the economy has turned or interest rates have increased, for the borrower to find another lender.
To find these types of mortgages you have to find mortgage brokers who are knowledgeable in this lending area to provide you with deals to look at. If you not have large amounts of money to invest in first mortgages, then you need to find mortgage brokers who syndicate mortgage loans and the minimum amount of money they will accept. You will have to rely upon them for doing all the due diligence set out above so you have to do your due diligence on them.
You can also lend on second mortgages which usually are at higher rates, but now that you have read this article this far, you probably have decided that these loans may not be worth the risk unless they are at much higher rates. Rates for second mortgages are 10% plus, and are once again based on who the borrower is and the loan to value. These types of loans may require smaller amounts of capital. If you lend to 85% of value, then based on the above information, you can see that you could lose some or all of your capital in addition to not receiving your interest. There are mortgage brokers who specialize in these types of loans.
If the first mortgage has a lower loan to value and is with a financial institution so the interest rate is low, then a second mortgage may not carry a lot more risk than a first mortgage and the rate could start at 8%. The reason for this is that, based on a one year timeframe for being repaid, the mortgage was, say, $60,000 on a property worth $100,000, then at, say, 4%, the interest would be $2,400, and when you add the interest at 10% on the second mortgage of $20,000 to bring the loan to value to 80%, the interest for one year would be $2,000 for a total of $4,200, as compared to the above example of it being $6,400, or 8% for one year on $80,000, a difference of $2,000 or 2%. So in a sense there is less risk. However, you must take into account in being a second mortgage, that if the first mortgage also goes into default, the first mortgagee has priority over you as a second mortgagee, and unless you keep the first mortgage current by making the mortgage payments, which payments are added to your mortgage and bear interest at your mortgage rate, they can act to sell the property, and since they have a lower loan to value, they are not as concerned about what the sale price is, although by law they must obtain fair market value. If they act by way of foreclosure then unless you pay them, your interest can be foreclosed along with that of the owner.
By way of comparison to residential loans, on commercial loans, the private lenders may only loan to 65% of value and on raw land loans 50%. The rates on commercial loans are 8%-12% and on land loans, since there are very few lenders, 10%-15%. There are construction lenders as well who are usually very sophisticated, and they lend up to about 70% at 8% plus. If the property is owned by a company, then the lenders normally require personal guarantees of the parties that are involved with the company.
The large private lenders, in addition to receiving their interest, charge a lender’s fee of 1%-2%, which fee is in addition to the mortgage brokerage fee. The mortgage broker fees for these types of loans range from 2% to 5%.
The good news for those with RRSPs and tax free savings accounts (TFSA) is that mortgages are eligible investments and the interest income is taxed as regular income. In comparison, when as compared to investing in the stock market where the returns are derived from capital gains, which if owned personally, are taxed at 50% of the gain and dividends which, if held personally, entitle the investor to a dividend tax credit. So from a tax point of view you are receiving the full benefit taxwisetax wise.
David Franklin, B.Comm, JD, has been practicing law in Ontario for over three decades, specializing in securities, mortgages, tax and real estate, and overseeing and transacting millions of dollars of transactions. Contact David at email@example.com.