Ron Kuhlman's friend was in trouble. After he lost his job and fell behind on his mortgage, the bank foreclosed, though it hadn't yet evicted him, his wife, and three children from their home in Horton, Mich. Enter Kuhlman, a Brooklyn (Mich.) franchise consultant, who paid off the $150,000 loan balance to the bank and effectively made a new loan to his friend by leasing him the house.
The friend's monthly obligation was based on a 12% interest rate, but Kuhlman structured the payments so they were lower than those on the original mortgage, allowing the friend time to get back on his feet. The man now has a new job and is seeking a mortgage to reclaim the house from Kuhlman. "By the end of the year he should be able to buy the house back," says Kuhlman, who will have earned a handsome return while helping a friend.
On paper these private loans look like a win-win situation. Borrowers get their rescue money, and lenders earn more than they would in most fixed-income investments, their risk mitigated by real property that serves as collateral. Structured properly, the loans can even be held in individual retirement accounts, with the proceeds sheltered from taxes.
But think about it: Even with real estate pros to help you set up and monitor the loans, they can be complicated. What's more, you have to ask yourself whether you're prepared to throw a family out of its home if the loan goes bad. "We see a lot of deals like this occurring between friends," says Hugh Bromma, CEO of Entrust Group, a Reno (Nev.) firm that acts as custodian and administrator for private mortgage loans held in IRAs. "The advantage as a lender is that you know the person. The disadvantage is that you could lose your money and your friend."
Private mortgages, which are often called trust deeds or "hard money" loans, are as legally binding as a mortgage issued by a bank. To be sure of proper execution, you should hire a real estate lawyer to draw up the agreement. You will also need to do a credit check of the borrower and an up-to-date appraisal of the property's value.
Lending and foreclosure laws vary by state, and you need to be cognizant of them as well. Lenders often avoid states such as Pennsylvania and Ohio, which have fairly onerous foreclosure laws, preferring what is known as "trust deed" states, such as California, Nevada, and Virginia, which let you foreclose on a property without going to court. In these states, once the loan-servicing agency sends the borrower a notice of default and a few months' grace period passes, the trustee or administrator can put the property up for auction.
Whether the loan is between friends or strangers, private lenders say returns after expenses have historically been in the low double digits, with very low default rates. "I've been doing this for 18 years, and I've only seen a few deals collapse and go through the foreclosure process," says Tom Anderson, CEO of Pensco Trust, a Portsmouth (N.H.) firm that administers these loans in IRAs. "Only in one or two instances when a property went into foreclosure have I seen a lender lose money, and never did they lose their entire investment."
Part of the reason for the low default rate is that most of the deals are structured as "first lien" loans that are collateralized against the value of the house, just as a bank would do. In the case of a default, the lender can claim the property or be repaid from the proceeds of the foreclosure auction. Savvy lenders also take extra precautions. "No investor generally wants to lend more than 70% of the appraised value of the property," says Brian Brady, a managing director at World Wide Credit, a San Diego broker that helps set up private mortgages. That way, unless the property value falls by more than 30%, you'll get your money back. Besides, a borrower with 30% equity is far less likely to walk away than a subprime borrower with no equity.
It's not easy to arrange a private mortgage deal unless you've already found a suitable borrower. If you're not in the real estate business, you should seek a professional "hard-money" lender—a real estate broker who specializes in financing private loans. Some brokers lend directly to distressed borrowers, but others lend primarily to investors who use the money to acquire foreclosed properties from banks, fix them up, and resell them. You can often meet hard-money lenders and potential borrowers at local real estate clubs, which are networking groups for people involved with property. To find a club in your area, go to nationalreia.com, the Web site of the National Association of Real Estate Investors. A few states also have private lender groups, the best known of which is the California Mortgage Assn., at californiamortgageassociation.com.
If you hire a pro to assist you, that person will get a cut of the loan. Paul Williamson, a licensed hard-money lender in Maitland, Fla. (not all states require licenses), typically arranges loans with durations of six months to three years at 12% to 15% interest. He appraises the property, assesses the borrower's credit quality, and handles the paperwork. In exchange, he pays the private lender 10% interest and keeps the difference. "In the past two years I've only had two foreclosures out of 200 deals, and one of those, after going through the foreclosure process, got all the money back plus interest," he says.
The ability to shelter private mortgage loans in IRAs makes them especially attractive for many investors. To do that you need to set up what is known as a self-directed IRA. Entrust, Pensco, and Guidant Financial Group specialize in these accounts. Bear in mind that by federal law, IRA loans must be established solely as investments. So if you lend money to a friend and he doesn't pay up, you'll have to evict him or face stiff IRS penalties for giving preferential treatment.
Guidant helped Kuhlman set up a limited liability company for the deal with his friend, then wrapped the LLC in an IRA. "We both realized we were putting our friendship at risk," Kuhlman says. "But given the alternative, we thought the risk was worth taking." Luckily, in this case, the friendship survived.
By Lewis Braham