A private mortgage is a legal agreement between two parties that aren't financial institutions in which one party agrees to lend the other one money in return for repayment, interest, and the borrower's real estate if he or she doesn't pay back the loan. The parties involved could be a business and a person or two people, like friends or family members. There are pros and cons to this type of arrangement for both lenders and borrowers, but many of the potential disadvantages can be avoided by careful, clear planning and documentation. Some companies also offer private mortgages as investments, most of which are aimed at medium-level, multi-year investors.
Pros and Cons for Borrowers
The main benefits of private mortgages for buyers are that they can get one from anyone, including a family member, they don't have to meet requirements that banks have to qualify for a traditional mortgage, and the terms of the agreement can be very flexible. People who lend to family members often prefer this type of arrangement because it allows them to keep all of the money involved within the family. Additionally, getting a private loan means that a borrower may not need to provide collateral, and it allows borrowers with a bad credit rating a way to improve it — as long as they make the payments — as well as gain an asset.
Despite this, there is always the risk of not being able to pay back the loan, which can lead both to financial problems and to a bad relationship between the lender and borrower. This can be especially painful for people who borrow from their friends or family members. The borrower will also likely be unable to get tax benefits, such as interest deductions, like he or she would with a traditional loan.
Pros and Cons for Lenders
If structured and documented correctly and legally, a lender can receive many benefits from a private mortgage, including a high rate of return and a steady income from repayments. This type of loan is usually secure, since it's backed by property, and it is a way to move money around fairly quickly, since most agreements last between a few months and a few years.
Additionally, these agreements are often popular among people who have a hard time selling their homes because private mortgage loans are attractive to buyers. In some cases, the seller may choose to offer a private mortgage as a wraparound loan, in which a buyer takes over payments on a current home mortgage. The seller then offers private financing for the difference between the outstanding mortgage and the sales price.
The main risks for lenders are the potential for the borrowers to damage the property or to default on their payments. Since many of the people who take private mortgages can't qualify for traditional financing, they may be unwilling or unable to make regular payments. The lender may also not have any options if the borrower dies or disappears if he or she doesn't specify any terms about passing the debt on. Additionally, there are often limits on how much interest a lender can charge, though this varies by region.
Avoiding Problems
The best way to avoid problems for both lenders and borrowers is to research local laws before agreeing to anything and to understand the risks that come with this type of arrangement. It's extremely important for both parties to secure the loan properly, agree on what's going to happen if the borrower can't make the payments, and keep copies of all documentation related to the agreement. People lending money within a family should also discuss how the new financial setup will affect their relationship and what will happen in the family if something goes wrong.
As an Investment
Some third-party private investors offer seller-financed mortgages as an investment vehicle. Investors can then buy and sell them through a financial exchange. For example, the investor can sell the instrument at a later date for a discounted price and give the seller a single lump-sum payment instead of the normal monthly payments. Another benefit of this type of investment is the inclusion of a balloon clause, which requires the buyer to either pay off the loan or convert it to a conventional mortgage. Despite this, it may not lead to as good returns as stocks or bonds, and it may take several years to make a profit, depending on the setup.