With a private mortgage, you don’t borrow from a bank. Instead, you borrow from another person or business. Whether it’s your only option, or one of many, it's worth learning how private mortgages work and finding out what to watch out for.
As you evaluate where and how to borrow (or lend, if you're the person with cash), keep the big picture in mind: typically the goal is to create a win-win solution where everybody gains financially without taking too much risk.
Understand the Risks of a Private Mortgage
Life is full of surprises, and any private mortgage can go bad. Of course everybody has good intentions, and these deals often seem like a great idea when they first come to mind. But pause long enough to consider the following questions before you get too deep into something that will be difficult to unwind:
- How will the personal relationship between borrower and lender change?
- Will the lender’s financial security (prospects for retirement, risk of bankruptcy, etc) be affected - especially if "something happens"?
- Who else may suffer if the loan is not repaid?
- Is the property in good condition?
- Will the property be adequately insured and cared for?
- Is there any other liens, mortgages, or interests conflicting with the private mortgage lender’s interest? In other words, who gets paid first?
Private Mortgage Agreements
Any private mortgage should be well documented. A loan agreement can take care of this for you, as you'll have everything in writing. When you use a written agreement, everybody’s expectations are laid out so there are few surprises. After several years, you (or the other person) may forget what you discussed and what you had in mind, but a document has a much better memory.
Documentation not only keeps your relationship intact - it protects each party to a private mortgage. Again, you don't know what you don't know about the future, and it's best to avoid any legal loose ends from the get-go. Finally, a written agreement might make the deal work better from a tax perspective.
As you review your agreement, make sure every conceivable detail is spelled out, starting with:
- When are payments due?
- What if payments aren’t received?
- How/where should payments be made?
- Can the borrower prepay?
- Is the loan secured with any collateral?
Securing the Loan
It’s a good idea to secure the lender’s interest - even if you do a private mortgage among close friends or family members. That way, the lender can take the property and get some money back in a worst-case-scenario.
For example, a borrower (who has the ability and every intention to repay) may die or get sued unexpectedly. If the property is held in the borrower’s name only - without a properly filed lien - creditors can go after their home or pressure the borrower to use the home’s value to satisfy a debt. A secured private mortgage helps protect the lender’s interest, assuming everything is documented correctly. In fact, the term "mortgage" technically means "security" - not "loan."
Securing a loan with property may also help you save on taxes. Talk with a tax preparer or CPA for more details.
How to do a Private Mortgage Correctly
You have to think about unpleasant possibilities when considering a private mortgage. Imagine what could go wrong and how it would affect you.
For documentation, work with qualified experts. Talk to local attorneys, your tax preparer, and others who can help guide you through the process. If you're talking about large sums of money, this isn't a DIY project. Some online services provide private mortgage agreements, loan servicing, and they might even file official documents for you - ask to make sure. LoanKin is one example of a loan servicer who can even report payments to credit bureaus (which helps borrowers build credit).Think through everything before you move forward with a private mortgage. The following pages may provide food for thought: