Real estate is often touted as one of the most effective ways of growing wealth, but the caveat is that it is very capital intensive. If you want to invest in real estate, you can get financing in several ways, aside from using your personal cash. You can get loans from traditional lending institutions (which usually mean banks), credit unions, insurance companies, investment firms, monolines (companies that focus on a single financial product or service), trust companies, hard money lenders, or private lenders.
These days, more people are turning to private lenders. While banks are still the primary institutions investors turn to for funding, the market share of private lenders has doubled since 2015. In 2018, 8% of Canadian mortgages were recorded to be under private lenders, a 37.8% growth from 2017!
One thing that explains this surge is the stress test the OSFI (Office of the Superintendent of Financial Institutions) expanded in 2017 to include all borrowers. Prior to the new impositions, only insured borrowers, those who made down payments of less than 20%, were subject to the test. With the new rules, it became mandatory for banks to conduct a stress test on both insured and uninsured borrowers. Everyone would now have to be able to make payments at a rate 2% higher than the actual contracted rate. The objective was to protect Canadians from being unable to afford their debts due to unforeseen circumstances, like financially crippling diseases, death, or business foreclosures.
The added difficulty of acquiring bank loans drove more people to borrow from private mortgage lenders, who aren’t governed by the OSFI, instead.
This is only one illustration of how private lending is essential to the real estate industry. Without private lenders, a good number of people would not have the opportunity to start investing and leveraging the assets they do have.
While it’s true that private lenders may have higher interest rates, they also have more flexible terms and are willing to take on more risk, especially on individuals who may not otherwise have been able to qualify for a loan at all.
So what is the general profile of these types of borrowers, and how do private lenders save the day?
New to investing
Maybe you’re new to investing and therefore have neither a good portfolio nor a strong reputation yet. Banks might be reluctant to take a chance on you simply because you haven’t had much of an opportunity to prove that you can be successful in your chosen industry.
No matter how viable your investment looks, a bank is likely to place more weight on your background as a borrower, giving you a chicken and egg problem: How can you build a stronger profile if you can’t get your foot in the door? And how can you get your foot in the door if you don’t have a strong profile?
Private lenders, on the other hand, will have the flexibility to approach things differently. The strength of the asset will count more heavily in their decision-making. It will matter less that you’re new to the industry and more that you’ve presented a strong deal that they can get behind.
People with a low credit score
Similarly, certain requirements immediately disqualify some individuals from bank loans, even if they have a strong financial profile overall. A private lender is more flexible and is able to overlook certain stringent criteria upheld by a rigid loan qualification procedure at a traditional bank. Private lenders typically place more emphasis on the underlying asset in question as opposed to the creditworthiness of the individual borrower.
Investors in a hurry
Time is of the essence in the real estate industry. A deal could have a one-week deadline, or even sooner! In this regard, private lenders definitely make more sense than banks, who have much longer processing times.
Lovers of “ugly houses”
Some real estate investors actually specialize in flipping or renting out “fixer-upper” houses. These are properties that need lots of work and renovation. Even if the borrower has a strong reputation as an expert at doing this, banks are more likely to look at the deal unfavourably.
Lovers of deals less than $100,000
A deal that’s too small may not be worth the effort to a bank. It takes them the same amount of man hours and the same number of print-outs to process a $1,000 loan and one that’s worth $100,000. With the number of people coming through their doors, they need to pick and choose their deals quickly and efficiently.
This is unfortunate for some investors who might even prefer smaller deals. They may not always have huge amounts of cash on hand, or they are attracted to the lower level of risk. This is where having access to a private lender comes in handy!
Cash-strapped individuals
Just because somebody isn’t very liquid doesn’t mean they’re financially challenged or irresponsible. They could have other investments or businesses that their money is tied up in. This could be a problem for an investor with several income-generating activities, as they may not be able to make the down payment necessary for a bank loan.
Because they have more flexible terms and the time and resources needed to see the bigger picture, private lenders are a great alternative for borrowers like investors or small business owners who have other places to put their money.
Borrowers with a good relationship with the lender
Loyalty and personal relationships matter more in dealing with a private lender. If you have a great history with your financier, they can really help you in a pinch! You can get quicker turnaround times and better mortgage payment terms because you’ve built enough trust with previous transactions.
This doesn’t mean, however, that paperwork will no longer be necessary; after all, proper documentation protects both lender and borrower.
An investor’s ability to pay back a loan cannot entirely be captured on paper, and this is something that private lenders understand. As more and more people, especially millennials, begin to realize the importance of wealth building and putting their money to work, traditional financial institutions may impose ever stricter restrictions. In this regard, private lenders are an alternative source of funding that may have more tailored programs and terms for different types of borrowers.
The next time you find yourself in a difficult position to invest in something you really believe in, don’t give up just yet! A deal with a private mortgage lender may be right for you.
