Private lending on deeds of trust is both an art and a science. There is a formula as well as a philosophy designed to originate well underwritten and well secured non-bankable loans of institutional quality. The philosophy when evaluating and underwriting a potential loan opportunity is based on what is commonly referred to as The Three C’s: 1) Capacity, “Can they pay?” 2) Character, “Will they pay?” 3) Collateral, “If they don’t pay, where do we stand?”

1) Capacity, “Can they pay?”
This seems like a no-brainer. Verifying whether the borrower has the ability to pay goes way beyond what they state on their application. Even for the ‘stated income’ loans, a borrower must have a verifiable position that merits the stated income (for example, a gas station attendant that makes $10K a month does not make sense) and provide bank statements or assets that support that income. It is unethical and in violation of the law to lend money to borrowers who knowingly can not make the payments as stated. Making sure the borrower understands the terms of the loan, the repayment plan (most loans are not longer than a 6 year term, with the average being 3-5 years for non-residential loans), and the consequences of non-payment are critical to the success of any given deed of trust.

2) Character, “Will they pay?”
Sometimes borrowers show they have the capacity to pay, that doesn’t always mean they will pay. The borrowers’ character and desire to pay are based on their past performance in handling credit. A three bureau merge credit report provides payment history on existing loans, including the number of late payments, any open or outstanding liens for taxes, and credit references to verify the borrowers’ character and desire to pay. Lending on private money trust deeds is typically not a stellar credit proposition. Most borrowers who are looking to private money lenders as a source of funds do not have perfect credit. Reliance on the credit report as the last word on a lending decision is not prudent, but it is potentially a good indicator of future behavior. A letter of explanation regarding the issues highlighted by the credit report is a helpful tool in assessing creditworthiness of a borrower but is by no means the final word.

3) Collateral, “If they don’t pay, where do we stand?”
Worst Case Scenario – the borrower can’t or won’t pay…now what? The collateral is the backbone and security of all our loans. All private money lending is equity based. As such, the market value of the property is critical in the decision making process. Prudent private lenders stick to 65% Loan-To-Value (LTV), requiring at least 35% protective equity in the property. The protective equity is the difference between the market value of the property and the indebtedness secured by the property. The lower the LTV and the greater the equity, the more incentive for the borrowers to protect the equity in the property and protect the investment of the lender. Verification of the market value of a property requires an appraisal, preferably completed by an independent appraiser. Many investors prefer to lend only on properties located in their “back yard,” allowing them to visit each property and personally meet each borrower.

The goal of any investor or pool is to build a loan servicing portfolio comprised of well underwritten and well secured real estate loans. As a lender, you don’t want to become a collector of property. Collections of interest and fees are the best way to make money lending money. Looking to achieve maximum security through increased levels of protective equity is a sound lending strategy.

Laura Riffel
President