A combination of the 2008 financial crisis and the expansion of Fintech has caused large swaths of retail investors to dabble in the mortgage lending markets. While banks scaled back their debt portfolios after the Great Recession, other financing businesses quickly occupied the newly-vacant space. In this article, I will highlight three points of due diligence for investors who are interested in mortgage lending to consider.
Table of Contents
#1: What rank is the mortgage?
A mortgage is a legal tool that is used to secure a debt against real estate. Ultimately, it stops the debtor from selling a property until secured lenders are repaid in full.
A piece of real estate can have multiple mortgages registered against it. This is a concept known as “lien priority” or “rank.” For instance, let’s assume that Joe purchased a house in 2010. He paid $500,000 for it, which included borrowing $400,000 from the bank. The bank placed a mortgage on his home. It will be lifted once Joe’s debt to the bank is paid off.
In 2012, Joe borrowed $50,000 from you. Since you wanted collateral for the loan, you required him to allow you to register a second mortgage on his residence.
Now, let’s say that Joe wants to sell his house in 2019. After listing it on the market for two months, he is able to earn $600,000 from it. Before he can retain any of the proceeds, he must first repay the bank. Then, he has to pay you back. After both secured creditors recoup their funds, Joe can keep what remains.
Rank is important because it is directly correlated to risk. The earliest lenders get their money back first. The deeper down the ladder one goes, the greater the chance of not being repaid if the borrower defaults.
#2: What is the loan-to-value ratio of the property?
Assessing the mortgage rank is important, but it’s not enough for complete due diligence. The lender must also know how much debt there is on a property when compared to its worth. This is a concept known as the loan-to-value ratio or LTV.
In the prior example, we saw that Joe’s house was purchased for $500,000. It had two mortgages on it: the first for $400,000 and the second for $50,000. As such, it had a cumulative debt of $450,000, which is 90% of $500,000. As such, the LTV was 90%.
However, Joe’s property price increased over the years. By the time 2019 came around, the house was worth $600,000. Thus, the LTV ratio was reduced to 75%. In fact, he was likely making principal payments to both you and the bank, so the LTV would have dipped even further.
LTV matters because it helps the lender understand how much room there is for the real estate’s price to decline. If it falls below the value of the mortgage, then there is a high risk of the lender losing money if the borrower defaults. This is called being “underwater.” Sadly, it was all too common during the 2008 economic collapse.
As an example, let’s say that the economy slows down. People now have less disposable cash, so they’re unable to purchase homes as frequently. This places downward pressure on all houses, causing the price of Joe’s to plummet to $420,000. Six months later, he loses his job and can’t meet his obligations on either of his mortgage loans.
After repeated warnings, the bank loses patience with Joe. It files a lawsuit against him and moves to foreclose on his property. The court approves a sale of the home at market price, $420,000. As such, the bank recoups its money and can move on.
After paying back the bank, there is only $20,000 left. All of that goes to you. But you loaned $50,000, so you’re still out $30,000. You’ll now have try to collect the balance from Joe’s remaining assets, which can be substantially more difficult.
We can therefore see that lending at a 90% LTV was a costly decision. So, what is a good loan-to-value ratio? 30%? 50%? 80%? There is not a perfect answer to this question. However, many in the industry consider 75% to be comfortable. That number provides for a property devaluation of 25%.
It is critical to note that our discussion of LTV thus far was a bit simplistic. Oftentimes, the court will approve a sale of the property at below market value. That can skew the picture. Further, the lender will probably incur legal fees during the foreclosure process. These are usually tacked onto the balance of the borrower’s debt. But they should be accounted for, or at least considered, in the LTV equation.
For instance, in Joe’s case, the bank may have spent $10,000 on attorney fees to foreclose on the home. Thus, his debt to the bank would have increased to $410,000. That eliminates another tranche of capital that could have otherwise gone to you.
#3: What is the borrower’s exit strategy?
The lender should know how the borrower intends to repay the debt. It might be through a property sale, from a refinance or via generating capital in another way. But regardless, it is risky to give a loan without knowing how it will be paid back. It could result in the borrower’s inability to repay the loan by the agreed-upon maturity date.
Conclusion
Mortgage lending can be a good investment. Among other things, it can provide for security in real estate and consistent interest payments. However, it can be risky if done incorrectly. The foregoing three points are just the tip of the iceberg. Thorough due diligence will call for a comprehensive review of the borrower, the asset, the local market and the economy in general.
Further, some jurisdictions require a license to be a lender. Before embarking your journey as a private debt financier, it may be worthwhile to consult with an attorney. That person could be useful to you later on, as well. You will likely need help with legal documentation, such as promissory notes and mortgage agreements.
Author Bio
Alexis Assadi is an investor, writer and entrepreneur. He operates various financing companies, including Pacific Income Capital Corporation and Assadi Capital Corporation. Alexis lives in Vancouver, Canada with his family.
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