Occasionally, it will make sense for a borrower to look outside of conventional mortgage options, utilizing a private mortgage to buy a home or investment property.
A private mortgage, which is a mortgage loan created by a private individual, can be beneficial to both the borrower and private lender -- bypassing a lot of the hurdles and red tape that can be associated with getting a loan from traditional mortgage lenders while providing a return and form of passive income to the private lender.
If you're considering using a private mortgage, here's what you need to know about private real estate loans, both as a lender and a borrower, how a private mortgage can be beneficial for both parties, the risks involved, and things to consider when using a private loan.
What is a private mortgage?
A private mortgage is a loan created between private individuals for the purchase of real estate. The lender, who could be a friend, family member, colleague, or investment firm, will loan the money to the borrower just as a bank would, securing themselves with a mortgage note or comparable contract. The loan is then paid back over time through monthly principal and interest (P&I) payments, earning the lender interest on the original principal balance.
Typically a private mortgage is created for one of three reasons:
- As a favor to a family member, friend, or loved one.
- As an investment.
- As a combination of the two.
The terms of a private mortgage, including the length of the loan, down payment amount, interest rate, and type of loan, are negotiated between the private individuals. There are certain laws in place that limit the type of loan or the maximum allowable interest rate that can be charged, depending on the purpose or use of the property, as well as the location, but it's up to the lender and borrower to come to agreeable terms for the loan privately.
The benefits of a private mortgage
Private mortgage lending has been around for decades as an alternative to conventional loans, and it has benefits for both parties involved.
Benefits for the lender
While not always the case, it's fairly typical for private mortgage lenders to charge a higher interest rate than traditional lenders may be charging at that given time. This can be because of the risk they are carrying by lending to the individual, to compensate for a lower down payment or poor credit score, or simply as part of their business model. But it's common to see interest rates 3 to 5 points higher than the current mortgage rates.
Since the lenders are secured by real property, private lending can be a lucrative way to earn a higher return than they may be able to receive elsewhere while earning cash flow from the monthly mortgage payment.
Benefits for the borrower
One of the most obvious advantages of a private mortgage for a borrower is the fact that there is far less paperwork, underwriting criteria, and borrower qualifications. Banks have strict underwriting criteria, requiring a minimum credit score in addition to verifying income and down payment source, analyzing your debt-to-income ratio, and inspecting the property to ensure it meets their required loan-to-value ratio for that type of loan.
A private lender can establish their own lending criteria and qualification requirements, meaning, in most cases, that the application and approval process is much quicker and easier than it would be with a traditional lender.
What fees are charged as a part of the loan is established as a part of the loan terms, which can be lender paid or fees passed on to the borrower as closing costs. But usually there are fewer fees involved with creating a private mortgage.
Additionally, a private loan can be created in a matter of days if needed, which allows investors, in particular, to be able to close on properties with cash quickly.
The last major borrower benefit of using a private mortgage is not having to pay private mortgage insurance (PMI). PMI is a form of private insurance that protects lenders in the event a borrower defaults and is a requirement for most borrowers who put less than 20% down, although there are a few exceptions to this rule. Once 20% of equity is established in the property, they can request to cancel PMI, but for many borrowers, the cost of PMI is unnecessary while providing no personal benefits.