May 302012
 

I know, if you’re anything like me, you were sick of hearing about passive income about 4 months ago. Did you know building a blog is a good way to create passive income? THIS IS THE FIRST I’M HEARING ABOUT IT TOO. (Aside: except it isn’t) Online income is popular with young people because seemingly anyone can do it, they understand the medium, and the big one – they have very little capital. Because blogging is dominated by people born before 1978, hardly anybody who blogs often has a whole lot of capital.

Anyway, you’re here because you want something different. You have capital (or are on your way to accumulate some) and you’re looking for places to put it to work. Sure, you could look at some of the usual suspects, but they’re not really looking very exciting. Investors are starved for yield, which has pushed up shares of all sorts of companies with large dividends. Real estate in most major cities in Canada is almost in bubble territory. Low interest rates are good for companies trying to raise money, but aren’t good for bond investors. What’s an investor to do, besides throwing up their hands and screaming like some sort of sissy girl?

How about investing in somebody’s mortgage?

Getting Started

In theory, all you need to get started in some money and some sucker who needs a mortgage. In reality, things aren’t so simple.

The first thing you need to know is that you won’t be dealing with the best borrowers. They will have already gone to their bank to try to convince them to hand out money. And they will have been rejected worse than that time I went to prom. Banks look at two things when they give out loans – your credit history and your ability to repay. You’re trying to find people with bad credit who still have the ability to pay.

The most effective way to find these people is to get friendly with a mortgage broker. The borrower goes to the bank and gets rejected, so the banker sends them to a mortgage broker. The mortgage broker does her best to match the borrower with a lender who’s comfortable with the borrower’s checkered past.

Before we get any further, one warning. Unless you’re sitting on a decent pile of money, most mortgage brokers will laugh you out of their office. Also, major private lenders exist in most major cities. Like in any business, competition is fierce. The process may take a while for the first one, but becomes easier with each investment you make.

Making The Investment

Once your new broker friend has found somebody needing money, they’re going to approach you. The broker only gets paid on completed deals, so you’ll need to scrutinize the application carefully.

You’re first going to look at the borrower’s ability to repay the loan. Chances are they’ll be applying for a second mortgage, so you’ll need to factor in their first mortgage payments, as well as payments on all their other debts. The industry standard is 40% of the borrower’s gross income can go towards their debt payments plus their property taxes comfortably. If you stuck to the 40% number, you’d probably never invest a dime. Remember, these are high risk borrowers. All you’re looking for is a number relatively close to 40%.

Next, take a look at their employment history. Do they have stable jobs? Have they spent a bunch of time with one employer? Do they have marketable skills that are in demand? The last thing you want is somebody losing their job shortly after accepting thousands of dollars of your money.

How do you protect yourself? It’s simple, but effective. You look for properties that are worth much more than what’s owing on them. If a borrower owes $150,000 on a $300,000 house, this means they have 50% equity. (As in, they own half the house and the bank owns the other half) Most private lenders will only go up to 75% equity, since that 25% cushion is plenty of motivation for the borrower not to trash the house and walk away.

Once you and your new friend finalize the arrangements of your new agreement, it’s off to the lawyer to make things official. The lawyer will write up the actual mortgage contract (for a small fee of course) and do all the work of registering the mortgage on the title of the house. Once the mortgage is officially on title, you’ve secured your collateral and you’re officially a lender.

How Much Money Will You Make?

OMG, I almost forgot the most important part.

These days, private second mortgages usually yield the investor 8-18%, with the rate going up as the deal gets more risky. If somebody’s paying 18% on a second mortgage, chances are they only have a job or a pulse, not both. The better deals are in the 8-10% range. You’re probably going to want to stick to those.

Lender fees are also common on private loans. A typical lender’s fee is a few thousand bucks, which covers the mortgage broker’s commission, as well as legal fees and a little extra for your time as well. There is no chance a borrower will be able to come up with several thousand dollars for the fee, so you just roll it into the mortgage. You get a little extra compounding action, which is probably the least sexy action ever.

That’s It Kids

This is, admittedly, a pretty basic look at private lending. There are all sorts of things about the business I neglected to mention, possibly because of laziness, or maybe ineptitude. If you have questions, leave them in the comments. I might actually get around to answering them.

 

Tell everyone, yo!

  7 Responses to “Passive Income Sources You Haven’t Thought Of: Private Mortgages”

  1. […] checkered past. Before we get any further, one warning. Unless you're … … Link: Passive Income Sources You Haven't Thought Of: Private Mortgages … ← Mortgage Loans for People With Bad Credit Have Higher Approval … Q&A: Home […]

  2. There’s also the option of investing in REITs. To do so, you won’t need as big of a stack of money as you would to lend the big lump sum for the mortgage. Now, whether or not REITs are a good investment is worth some more discussion (which I will not provide as this is merely a comment). I suppose I should disclose that I do own shares of MFA; I’ll leave it to Nelson to laugh me around the block.

    • I haven’t been impressed with REIT performance, personally.

      But let’s look at the differences: Nelson is suggesting investing in the portion of the market that the REITs ignore. There is a potential there, but you need to be careful.

  3. […] believe me? A few months ago, I wrote a post outlining the basic steps to becoming a private mortgage lender. It got one comment, which basically said that you shouldn’t bother and just invest in REITs […]

  4. How do you find a broker?

  5. […] little hard in the pants when I think of the succulent returns I’ve gotten over the years by lending money privately. I’ll admit it’s tough to get started, but maybe you should […]

  6. […] credit end up paying more to finance most anything, like a car or a house? There are all sorts of subprime lenders specializing in lending to both kinds of […]

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