What to consider before becoming a private lender
CBC's On the Coast personal finance columnist breaks down private-lending precautions
Tracy, a 61-year-old pensioner, recently sold her townhouse to help fund her retirement. Knowing that she needed an investment that produced a stable and predictable income source, a friend of hers suggested she try private lending.
This friend knows a homeowner whose home is worth $3.2-million with a $1-million mortgage and who is looking to borrow $200,000. This homeowner is willing to pay 7 per cent per year for a term of three years.
Tracy is considering the deal because 7 per-cent-interest is four times what her is bank is offering on their term deposits. She feels there would be some protection because a lien would be registered against the borrower's home, thus eliminating the risk of the property being sold or re-financed.
Before agreeing to these terms, Tracy wrote to me for my opinion.
Cash flow and rates
To make this decision, Tracy requires a lot more information. She should take the same precautions that a bank would and collect personal and financial information on the borrowers.
My main concern would be their cash flow as they have an existing $1-million mortgage. I would want to verify their employment, salaries, credit scores and their plan with respect to paying back the loan.
I also need to know how the funds are going to be used. If the money is being borrowed to service existing debt, that's a concern as it likely means there is a cash-flow issue.
Another concern is that the 7 per-cent interest rate seems low. Rates charged are risk-based, and private loans are often risky. Any borrower dealing with a private lender is usually doing so because they have exhausted all other options.
Their parents, banks, credit unions and secondary or alternative lenders have likely turned them down or were willing to lend money, but at a much higher rate than 7 per cent.
Often, borrowers are turned down for good reason, likely because they can't afford or shouldn't be borrowing more money. Due to the increased risk, most private-lending deals pay 10-20 per-cent interest.
I also think the term is too long. I wouldn't be comfortable with a three-year deal.
I would only consider a one-year deal, which could be renewed but at the discretion of the lender.
Know the reasons
For me to consider lending, I would need to know the reason their bank turned them down. Maybe it was simply due to a small technicality, which had nothing to do with their credit worthiness or ability to service or pay back the loan.
I may consider lending the funds in this case, or if, for example, they are borrowing the funds to simply fix up their home before selling it. Or maybe they just need a year to sort out their financial affairs before being able to qualify for a loan with a traditional lender.
What a private lender wants to avoid is a situation where the borrower can no longer make payments or pay out the loan by the end of the term. If that were to happen, then the lender would have to force the sale of the property, which is expensive and time consuming.
In the end, Tracy decided against private lending. She wasn't comfortable lending $200,000 as it made up 40 per cent of the proceeds of the sale of her townhouse. She didn't want to risk having that much of her retirement tied up in one investment.
My recommendation was that she lend no more than 10 per cent of the sale proceeds.
Tracy instead decided to invest in a mortgage fund where professional underwriters complete the due diligence on the borrowers, something Tracy wasn't willing or able to do herself.
The rate of return is approximately the same and the fund doesn't tie up her money for three years.