Being a private lender presents a unique dilemma. Every time you lend your money to someone, you worry about getting it back, but the second you get it back you start worrying about the fact that it’s not earning any interest until you find a new borrower. In fact, believe it or not, the biggest challenge to being a private mortgage lender is not lending your money out safely – it’s keeping it lent out for as many days as possible throughout a calendar year. The longer your money sits idle earning nothing, the lower your actual annual return on investment falls.
With that in mind, you’d think every private lender would want to offer a fully open mortgage since it creates a win-win for both sides. Borrowers don’t want to be in a private mortgage any longer than they have to since there’s no such thing as a cheap private mortgage, and investors want to attract responsible borrowers who need their funds today but are highly motivated to pay their debts as quickly as possible. The problem is, most private lenders don’t realize that closed ended private mortgages create barriers to optimizing their return on investment, and they don’t make their investment any more secure.
The reason why most private lenders don’t offer open mortgages is two-fold. First, investors don’t want to go through all the hassle of underwriting an application, preparing documentation, getting conditions fulfilled and formalizing any more often than once a year. Second, once they lock a borrower in to a 12-month term, they want to be paid interest for all 12 months or be paid 1-3 months interest if the Borrower pays out early, so they have time to find another Borrower to lend to without hurting their expected annual return. It’s that simple. But it’s short-sighted.
Each Borrower’s circumstances are different, so choice is the key to creating win-win private mortgage solutions. When a lender underwrites a private mortgage application, their primary focus should be on the collateral. If the collateral is strong enough that it can be sold in a reasonable amount of time for enough to pay the lender back his/her principal investment plus interest, the risk involved shifts to the Borrower. From there, the terms and conditions of the loan have to work for the Borrower or else the lender will invest a lot of time underwriting loans but not fund very many. As a result, the lender’s money will spend more time earning nothing which will damage their long-term annual ROI more than anything else.
Borrowers should be able to choose between open and closed mortgage products with every loan because effectively they’re gambling on themselves. The private mortgage allows them to either acquire a property they wouldn’t otherwise be able to or keep a property they would otherwise have to sell because of their current financial circumstances. The goal for a private mortgage borrower will always be the same – to replace the private mortgage with cheaper financing or retire it using their own resources as quickly as possible. Choosing between an open or closed mortgage term forces the Borrower to make an educated guess about how long they believe it will take to achieve this goal.
If the Borrower thinks they can replace or retire the private mortgage (relatively) quickly, they should have the option to choose an open mortgage. Open mortgages should be priced slightly higher than closed ended mortgages because the Borrower makes no commitment to a set number of months paying interest. The only guarantee to the Lender is the upfront Lender fee and one month’s interest. At Switch, for example, an open, first position mortgage is priced at 0.75% per month. That’s 9% per year if the Borrower ends up not paying out early. By contrast, if the Borrower were to choose a closed mortgage, the rate would be 6-8% for a 1st mortgage but they must commit to a 12-month term or agree to pay a 3-month interest penalty for early repayment. The lender fee should be the same in both cases. It’s a trade off that makes perfect sense for both sides.
With both options to choose from, the Borrower controls the most important part of the equation – the cost.If they believe they can pay the mortgage off in less than 12 months, they can go month to month with an open mortgage and the sooner they pay out the more money they save. In exchange for the privilege, they agree to pay a small premium to the Lender by way of a slightly higher rate. If its unrealistic to assume they’ll be able to pay the mortgage off early, then they choose the closed ended mortgage, commit to 12 monthly interest payments and in exchange they get a better rate.
Private mortgage Lenders and Borrowers are both real estate investors. Getting together on a loan is a business transaction that should serve both sides so that in the long run both parties can make money. The Lender makes money by helping the Borrower acquire or keep a real estate asset today and by keeping the asset the Borrower stands to make money through appreciation tomorrow.
That’s how we see things here at Switch. We’re different, we know.
