Retirees are often not exposed to private mortgage investments because your stockbroker won't tell you about them, your insurance agent won't tell you about them and your investment adviser won't tell you about them. Since none of these professionals earn money (and in fact lose money) when you divert money from their offerings into private mortgages, they never mention the opportunity. Not only can these opportunities increase your income, they can also reduce your risk. I know you have been taught that a higher yield means higher risk but that notion is generally espoused by people who don’t know any better (people not in the 1%).
What is a Private Mortgage?
Let's first explain how private mortgage opportunities come about. Suppose you have a neighbor who lives two blocks away. He attempts to borrow money on his house so that he can expand his business. However, during the economy his business struggled and he was late on payments and his FICO score is now below 600. So when he applies to the bank, he can't get a loan. However, the market value of his house is $800,000 and he only owes $300,000 on this first mortgage. He needs to borrow $200,000. After he completes the loan, he will owe a total of $500,000 on his $800,000 house, a loan-to-equity ratio of 63% ($500,000/$800,000). If the bank would lend him money and at some point your neighbor failed to pay, the bank could foreclose on his home and they have $300,000 cushion of equity securing their loan.
But the bank won't lend the money because they have all kinds of rules that are not designed to optimize their profits. Even though your neighbor has plenty of equity in his house, he won't qualify because of his low credit score. Your neighbor's businesses is now doing very well and he is more than happy to pay 8% interest to borrow the $200,000 he needs for business expansion. Of course, this $200,000 will be secured by the equity in his house. Since you have $200,000 in the bank earning 1%, why not withdraw it and lend him the money and make 8%? In this example, you would actually be increasing your risk because your money in the bank is federally insured and the money secured by his house, while safe, is not guaranteed.
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Higher Return, Lower Risk is Possible
But let's consider a slightly different scenario. Let's assume your house is worth $800,000 and is free and clear. You are at risk for the entire value of your house that is uninsured. I will bet your house is uninsured for flood, earthquake, other assorted perils and acts of God. You have likely never read your home insurance policy but in fact you are uninsured for several potential calamities. An uninsured disaster could cost you the entire $800,000 if your home were decimated.
What if you borrowed $200,000 against your home which you could do at 4% interest-only because you have a high credit score? You then lend that money to your neighbor and earn 8%. You have just reduced your risk because now you have $600,000 of equity in your home that you could potentially lose to an uninsured risk and you have diversified your portfolio by having equity in his home. Your money is now diversified across two pieces of real estate rather than concentrated in one. Additionally, you are earning 4% on the loan against your home–$8,000 annually simply by being smart.
How safe are private mortgages?
You should know that people have been making private mortgage loans for decades and trillions of dollars of such loans have been made. So just because you may not of heard of this before doesn't mean it's new or risky.
In the worst-case, the borrower fails to make payments and you are able to take over ownership of the house. That almost never happens because the borrower has equity in the house that he doesn't want to lose. So the practical worst-case is that the house is sold and you get paid off. However, there could be a period of time which could last several months or even up to a couple years when you don't get payments such as in the case when the borrower files for bankruptcy. You will get your principal and your interest payments eventually, assuming you have made a loan against the home with sufficient equity, but you may have to wait.
I have made 20 or so such loans in the last three decades. In the worst case, one loan went about six months without payments and the home was eventually refinanced and I and the other two lenders were paid off – our principal and all the accrued interest. Every other loan was boring – I received my interest monthly and my principal at maturity.
If the borrower defaults on payments, how do you actually get your money? That depends on the state in which you live. I live in California which is a non-judicial foreclosure state. That means that my state already has a process that allows me to foreclose and take ownership of the house in a 120-day process without involving attorneys, courts or significant expense. Any expense I do incur in the foreclosure process, I get repaid out of the sale proceeds of the property. As mentioned above, very few homes go to foreclosure because the owner wants to save his equity and will either sell the house on his own or refinance and pay you off.
Where can you find such lending opportunities?
In your town, there are likely several hard money brokers (licensed by the Department of Real Estate in your state). These brokers match borrowers who won't qualify for loan at the bank and investors, such as you. You as the investor receive an appraisal, so you know the property value, title insurance to ensure that there are no liens or clouds on the property and the transaction is handled through a third-party escrow company (all expenses paid by the borrower). It is recommended that you go visit the property and if there is any doubt, even pay for a home inspection to make sure that the foundation and the structure is sound. If you're investing $200,000, paying $300 for such an inspection can be a wise investment.
If that sounds like too much of a bother, you can invest in a private mortgage fund. Similar to a mutual fund, the fund manager does all the work and due diligence on each loan. You are a passive investor. The fund manager gets compensated usually by taking points on each loan (from the borrower) and 1% annually from the fund. While I usually invest in individual notes (much like the investor who buys individual stocks), I just made a an investment in a fund that yields just over 10%. The fund holds 65 notes diversified across several states.
Since this is a blog post and not a book, the explanation of private mortgages here is simplified. You can learn more by talking to some hard money brokers in your town, reading about private mortgages (sometimes called trust deed investments) on the Internet or reading books such as:
The author is an Amazon affiliate.
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The person who puts the two together is called the trust deed broker.
I have always experienced the risky phase of private mortgage.