Private money foreclosures are likely the last thing you want to think about when obtaining a new hard money loan. (But you wouldn’t be reading this guide if you were willing to walk into a private money deal with your eyes closed.) There are two kinds of foreclosures: judicial foreclosure and non-judicial foreclosure.
An important reminder is that private lenders are not in the business of foreclosures. They are in the business of originating loans to earn monthly payments, fees, etc. from you. Foreclosures are generally a last resort, as they cost a great deal of unexpected time and money.
What to consider
Review the risks associated with private money lending. These include:
- Your ability to pay
- Loan terms that are not the same as traditional banking
- The different rights and protections available to you as a borrower
Private money lenders are not after your property. Most investors make a hard money loan for the fees and interest. They want to service it for that fee income for as long as they can. But the private money lenders do have a fiduciary duty to protect their private investors’ collateral. They are obligated to act, and act quickly, if you are in breach of your loan agreement.
When reviewing the terms that can lead to foreclosure, remember that everything is negotiable in private money transactions. These terms vary from lender to lender, and can change depending on your history and relationship with the lender.
Reasons private money lenders foreclose
Below are a few examples of the circumstances that may cause foreclosure. There may be others depending on the loan terms in your contract. You should always review contracts carefully and consult with a real estate attorney.
- Delinquent payment: The most common reason is a default in the agreed upon payment as detailed in the promissory note. This can include the common balloon payment. Some short-term loans will not require you to pay monthly, and will instead have the entire loan due and payable on the loan’s maturity date.
- Unmaintained covenants: Some loan provisions give the lender the ability to review the financial condition of the borrower. These are generally based on a variety of non-monetary covenants included in the loan documents. If these covenants fall below the agreed-upon threshold, the lender may “call the loan due.” If you can’t pay, the property goes into foreclosure.
- Illegal transfer: If you deed the property to another entity without the consent of the lender, you have completed an illegal transfer. The lender may call the loan due regardless of the maturity date. This is also know as a “due-on-sale” clause. Lenders view the transfer of the property as a “sale” whether you received monetary consideration or not.
- Illegal junior liens: Many private lenders require you to obtain permission before adding junior financing (also called junior liens or a second mortgage). Junior financing dilutes the borrower’s ability to pay the senior lien in the event their financial situation changes.
What happens during private money foreclosures
How a private lender forecloses on your property can vary greatly depending on the loan terms and applicable regulations. Regulations can vary from state to state and are dependent on the location of the property, not the private lender or borrower. Know your rights and the available protections prior to entering a private money loan. Also read up on trustee sale guarantees and personal guarantees.
Beyond that excellent advice, foreclosure proceedings depend on whether a mortgage or trust deed secures your debt. Your state may allow both types of documents, allowing the lender to choose which kind to offer. Trust deeds generally have fewer regulations surrounding foreclosure and are therefore more common in private lending.
Mortgages and judicial foreclosures
The court supervises a mortgage foreclosure in a process called judicial foreclosure. This includes the lender filing suite against the borrower.
This suite can be time consuming and expensive for the lender, but has the added benefit of allowing for a deficiency judgement. This judgment says that if the lender doesn’t get enough money from the foreclosure auction to pay off the note, they can sue the borrower(s) for the remaining balance.
A judicial foreclosure also has additional protections for the borrower, allowing for a “right of redemption” to the borrower even after the property is sold at auction. Within a certain time frame after the foreclosure sale (which varies by state), the borrower can repay the lender and reacquire title to the property.
In some states, even if a trust deed was used as the security instrument, lenders can elect to do a judicial foreclosure to preserve the option of a deficiency judgment. Despite this, hard money lenders prefer the less-expensive non-judicial process. This is another reason you will find more lenders in trust deed states.
Trust deeds and non-judicial foreclosures
Trust deeds allow the lender to bypass the court system. To do so, they must follow applicable state law and the procedures outlined in the trust deed. This process is called a non-judicial foreclosure. Typically, non-judicial foreclosure includes issuing certain notices, after which if the borrower doesn’t bring the loan current, the property goes to a trustee’s sale.
Upon sale, the property’s title is conveyed from the trustee to the new owner via a document called a Trustee’s Deed. The borrower has no right of redemption after the property is sold.