What you need to know about Private Lenders

 
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First you should know that all lenders are regulated either federally or provincially. Do not do business with an unregistered lender. Ever.

What is a private lender?

In the residential lending space, private lenders provide what industry professionals would call “bridge” financing or a temporary solution while you get your affairs in order and move your business to an “A” or “B” lender. In business and construction finance, private lenders are critical because they can provide creative solutions, but you need to keep in mind that a construction loan is increasing the value of a property so this can justify the higher costs. Using a private lender to finance a primary residence rarely makes sense.

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“A” lenders, is a term that refers to the quality of the loan from the perspective of an investor. “A” mortgages have much more supporting documentation so the lender is very safe in assessing the likelihood of repayment and the loss to the lender if the borrower can’t repay the mortgage. Since they are lower risk, they offer the lowest mortgage interest rates.

“B” lenders look at both the likelihood or repayment, and the loss to the lender if the borrower can’t repay the mortgage but they are less particular about documentation. They will accept more creative forms of income proof but because they are accepting some more risk, they will charge you a higher mortgage interest rate.

Private lenders tend to be companies and individuals who are less concerned with your ability to repay and more concerned with their ability to recover their money if you are unable to repay the mortgage. They will still want to hear your story and feel confident you have the capacity to make the monthly payments but that is a lesser concern. They often manage their loans on a spreadsheet so don’t expect standard forms.

Benefits of a private lender

They are flexible. With private lenders you are dealing with business people and not bank employees. Banks are constrained by many rules and guidelines, they have several levels of review and approval,  and they have to get an approval any exception or modification to an approved offer. Private lenders don’t have 2 kg manuals but instead they look at the business case. If the deal makes good business sense, they’ll do it.

That doesn’t mean they’ll do anything. They will still want you to have some skin in the game so don’t expect them to loan you 100% of the purchase price of a home!

As well, private lenders tend to be more comfortable lending in major urban centres because properties hold their values better in more active markets.

From a borrower’s perspective, here are some typical scenarios when using a private lender makes sense:

  • You bought a condo pre-sale and now that it is time to take possession you find you don’t qualify for a mortgage under the new stress tests. You plan to complete the sale and sell the condo with a year.

  • You have some urgent major repairs to do on your home and but are between jobs. You know that once you find a new job, you can refinance the mortgage at a more reasonable rate.

  • You have an opportunity to buy the perfect home but the buyer wants to be paid within a week. You know that a regular lender may not be able to get an approval, appraisal, and other due diligence completed in time so you turn to a private lender.

Key Differences with Private Lenders

Mortgage Rate

Depending on how much you want to borrow and how creditworthy you are, private lender rates can range from 6% to over 10%. This may sound high, but in the early 2000s a mortgage rate of 7% was considered good. 6.5% was the bank staff rate. As “A” lenders raise their rates, expect private lenders will raise their rates too.
For a second mortgage behind an “A” or “B” lender, the rate would be 10-15%.
Usually the rate is committed for 1 year, and then they will renew the contract. When the contract expires they will have a clause that bumps up the rate significantly unless you renew or pay-off the loan.

Fees

Expect to pay a fee of 1% to 3% of the amount of the loan. The lender will use part of the fee to pay the mortgage broker and the rest is intended to make sure they make money even if you pay off the mortgage early.
Repayment

Prime “A” Lenders want you to pay down your loan over 25 to 30 years, whereas Private Lenders are fine with you paying interest only on your loan. It’s easier for them to track in their spreadsheet and if you don’t pay down the loan then they earn more interest.

Holdbacks

Sometimes lenders keep a holdback. It’s like the 1 month rent that your landlord keeps as a security deposit. Lenders call the security deposit a holdback. If they don’t want to worry about collecting monthly payments from you, they hold back a cash amount equivalent to some or all of your payments for the year. The safest, but more expensive, option is to have a lawyer keep the holdback money in a trust account.

Legal Costs

You need 2 lawyers to close a private mortgage. One represents the lender and the other represents the borrower. The borrower pays for both lawyers.
Since private lenders don’t have standard documents, the lawyer will have to write the mortgage documents billing at their hourly rate. Both lawyers together could cost $4,500 or more. Make sure you get a quote on the estimated cost from the lawyers before you sign the commitment letter from the lender.

An Example

Jim, made a no subject offer on a condo for $500,000 but the appraisal came back at $450,000 and the bank will only lend him 80% of the appraised value. He only has $100,000 for the down payment and was expecting a loan of $400,000, so the deal will fall through unless he can find another option.

The private lender will loan him $405,000 or 90% of the appraised value. Here is what the deal looks like:

 

Mortgage Amount:

$405,000

Holdback 2 month’s payments (held by lawyer in trust)

$4,725

Funds paid to Jim

$400,275

1-Year Fixed Mortgage Rate:

7%

Monthly Interest Payment:

$2,362.50

Lender/Broker Fees of 2%

$8,100

Appraisal

$360

Borrower’s Lawyer

$1,500

Lender’s Lawyer

$3,000

Interest paid by the end of the year: $28,350

Appraisal, fees, and legal costs: $12,960

The fees and costs can be paid from the proceeds of the mortgage loan so you can defer the cost of paying them.

As you can see, private lenders aren’t for penny pinchers. Don’t let anyone tell you private lending is the same as prime lending but with fewer rules. The all in annual cost of financing (including fees and costs) is 10%.

Caution

As mentioned earlier, a private lender can make a lot of sense in the short run but there is a risk you may never qualify with an “A” lender. For example, if the property value drops then you may not have enough equity in the property to qualify with an “A” lender. Then you will be trapped with high rates or may be forced to sell the property.

 

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