Lending Guide: Risks

Private Lenders Have Risk, Too

2018-09-28T18:50:35+00:00 Risks|

There can be good reasons why a traditional bank will not touch a deal that lands in a private lender’s lap. Understanding what a private lender risks will help you to better understand why they approach deals the way they do.

There’s not always enough time to complete due diligence.

Real estate investors often require a fast closing – sometimes in as little as seven days. If you need to close a deal quickly but don’t have an existing relationship with a private lender, you may find that many lenders pass on your deal. That’s because the lender who chooses to take you on is also taking on a higher risk, with less time to carefully vet all the moving parts.

Even when there is a previous good relationship, the collateral itself will be new. There’s not always enough time to research each factor in a borrower’s ability to repay a loan. This can include the:

  • Property’s current condition.
  • Local comps.
  • Market trends and movement.
  • Liens or other encumbrances against the property’s title.
  • Borrower’s plans and how that will influence their ability to pay.
  • Changes to a borrower’s circumstances (if they have a previous relationship).

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There aren’t legal protections beyond the contract.

Many private money loans are financed by a private investor or pool of private investors. These are individual people looking for a passive return on their capital. This contrasts with banks and even smaller credit unions that use their account holders’ money. If the bank becomes insolvent, their individual account holders have FDIC insurance that will pay out. Banks are also able to offer riskier loans to borrowers because the loan is subsidized or insured by a government entity.

No such protections exist in private lending; their money is locked up in your property just as yours is but without the direct influence you exert. The only recourse they have if you don’t make good on your debt is foreclosure. Private lender risks here are that they are unable to ensure a complete return of their investment.

Foreclosures are rarely a real “win” for honest private lenders.

Most private lenders do not want to deal with foreclosures. There are many rules and regulations involved with foreclosing and possibly evicting tenants. The lender must also make a lot of decisions when the lender or private investor moves from servicing a loan to owning real property. Foreclosure may mean:

  • Dealing with an unsellable property due to the property’s condition, location or tenancy.
  • Costs to upkeep and maintain or repair the property to make it sale-ready.
  • Resale costs, including escrow fees and other wire/courier/cert costs
  • Potential attorney fees if the foreclosure is difficult or non-standard.
  • Potential low current market value.
  • Liens, including federal tax (IRS), state and mechanic (contractor) liens
  • Delinquent property taxes, which are senior to recorded mortgages.
  • The delinquent borrower creating delays by declaring bankruptcy, creating last-minute additional liens on the property, transferring deed ownership and more.

While it may be hard to feel bad for banks in these situations, private lenders and their investors are not impersonal, distant or uncaring people. Most are operating small businesses and can become insolvent with just a few deals that go south.

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