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   ARTICLE   |   From Scotsman Guide Residential Edition   |   February 2007

5 Mistakes to Avoid

Help your private-investor partners avoid making critical investment mistakes

Some mortgage brokers work with private-mortgage investors to fund their clients’ deals. Private mortgage investors often are private individuals who lend their own money to others and who secure that loan with a real estate mortgage. They also can be private trusts that are managed by a trustee and set up for a private individual or group of individuals.

Private mortgage investors also are known as private mortgage lenders. This is in contrast to institutional lenders, which generally are large corporations.

There are many mistakes that mortgage brokers and their private-mortgage-investor partners should avoid. The following five critical mistakes are the most-common mistakes mortgage brokers make.

1. Not inspecting the property

The first critical mistake is when the mortgage broker and investor do not inspect the property.

Consider this scenario: Your investor must foreclose on a mortgage that you recommended. Neither of you inspected the house before closing, but you relied on a drive-by appraisal.

During the foreclosure process, you go to the property together, and you find that the house is not what either of you thought it was. You could tell from the pictures that it was a wood-frame home, but you did not know that your foot would break through the wood on the front-porch stairs. Also, the house has termites.

Your investor panics, thinking it was a mistake to invest in this property. Then, your investor remembers that the mortgage loan was only 40-percent loan to value (LTV). The investor thinks that the investment will even out if the house is bulldozed and the land is sold.

You both then look across the street and see an abandoned gas station with a hazardous-waste sign posted by the Environmental Protection Agency. There’s underground contamination, which not only means the house can’t be sold but also that the property may cost thousands of dollars to clean up.

To reduce this kind of risk, have the mortgage investor inspect the property with you before the mortgage closes. Having your investors see the property for themselves also reduces the chances of a good relationship going bad.

2. Not requiring a flood check

There are many private companies that will do a flood-zone check. You also can have your surveyor put the flood-zone information on the survey if one is being completed.

Although the appraisal includes a place to note the flood-zone status, it is not as accurate as a survey or a flood-zone check. Sometimes, the property is at the edge of a flood zone, and only a survey can determine its exact status.

If a property is in a federal flood zone, make sure the borrowers have federal flood insurance in place or are getting it. They often can get it through their own insurance agent. This protects the borrowers and the investors who own the mortgage.

3. Investing in second mortgages

Brokers should encourage their private investors to stick with first mortgages only.

Successful private-mortgage investing depends on a number of factors. One factor is the LTV. A $100,000 first-mortgage loan against a $200,000 property, for example, has a 50-percent LTV. A 50-percent LTV is typical for a private-mortgage investment.

The LTV is not the only risk factor in private-mortgage investing, however. Consider a borrower who owes $40,000 on a $200,000 house and who wants to borrow $60,000 as an interest-only second mortgage from a private investor.

Although the LTV ratio would also be 50 percent in this scenario, the risk for the second-mortgage-holder is greater than that for the first-mortgage-holder who is owed $100,000 against a $200,000 house.

The problems begin for the second-mortgage-holder if the first mortgage goes into foreclosure. The first problem is that the borrowers now owe $71,000 on the first mortgage and are more than 30 months behind; this can sometimes happen if the first mortgage is a private mortgage. The interest, late fees and advances  add up.

The second problem for the second-mortgage-holder occurs when the borrowers countersue the first-mortgage-holder because they think the original first mortgage was not disclosed properly. Now things drag out for another two years, and the borrowers owe more than $100,000 on the first mortgage with back interest, late charges and attorney fees.

The borrowers eventually lose the case but decide to appeal. They lose the appeal and owe $115,000 on the first mortgage.

Now, the $60,000 second mortgage has an 87-percent LTV.

If the mortgage investor wants to protect the $60,000 interest in the property, the $115,000 mortgage must be satisfied first. Need I say more?

As a good mortgage broker, in a case like the one above, you want to protect all parties involved. As such, you should simply tell borrowers that your mortgage investor will only do a first mortgage.

Also, help your investors read their title commitment closely. Be sure that when they close, their position will be a first mortgage and that the title insurance is for that purpose. Make sure all liens shown on the title commitment are required to be paid. Also ensure these liens are paid, either before closing or with the loan proceeds that come at closing.

4. Not verifying legal description

Failing to verify the property’s legal description may be the result of an innocent mistake made by the property-owner. When borrowers apply for a mortgage, they generally are asked to bring in a copy of the warranty deed or property-tax statement so a legal description of the property can be obtained. This legal description is then used to conduct a title search on that property.

What can go wrong? Consider this example: Borrowers want to use their home as security for a mortgage loan. They bring a copy of the warranty deed to the mortgage broker. The deed looks to be in order.

When a copy of the deed is given to the title company to search the title, however, the legal description is of the lot next door to the house. It turns out that the borrowers own two separate lots next to each other, and they innocently brought the wrong deed.

There are a number of ways to ensure you have the proper legal description before the transaction closes. The best way is with a survey, which should show the address of the property along with its proper legal description. It also will show the house within the boundaries of the lot. It is not always possible to close the mortgage transaction with a survey, so brokers and investors must do a little extra homework.

The broker or the investor should go to the county records office and look at the plat map, property-tax map or subdivision map to examine what lot numbers match up to the location of the subject property. These records also may be online.

By comparing the lot on the plat map to the physical inspection of the property, any necessary questions can be raised.

Make sure the legal description matches the subject property before your investors close any mortgage transaction, whether they are funding a new mortgage or purchasing one. In the above example, the mortgage investor may want to be sure both legal descriptions are on the mortgage for additional security.

5. Not understanding Section 32

The fifth critical mistake occurs when brokers and investors do not know about Section 32 mortgages.

When private investors originate a mortgage or purchase an existing mortgage, they must know if it is subject to the federal law known as Section 32 (part of Regulation Z of the federal Truth in Lending Act).

Section 32 mortgages are regarded as “high-rate, high-cost” mortgages. High-rate, high-cost mortgages are defined by the Home Ownership and Equity Protection Act of 1994 (HOEPA).

You also should know whether the mortgage is subject to your state’s high-cost mortgage laws. When the mortgage transaction falls under these laws, investors must ensure it complies with the rules and regulations of these laws.

Too many mortgage brokers do not know about these laws, however. There are serious consequences for the original lender and buyer of these mortgages if the mortgage transaction does not comply with these laws.

The original private lender must make the proper disclosures at the proper time, and the mortgage must have the proper clauses and restrictions these laws require. Brokers usually provide these disclosures to borrowers as a courtesy for the lender, although it is the lender’s legal responsibility to ensure it is done.

Violations of these laws can subject the lender (or purchaser of one of these mortgages) to liability to borrowers. Borrowers have three years from closing to challenge the transaction. Private lenders could lose all their finance charges.

For a mortgage to potentially be a Section 32 loan, it has to be against the borrower’s residence at the time of closing. Home-purchase mortgages, commercial mortgages and investment-property mortgages are not subject to Section 32 guidelines.

Current federal law has two trigger points to determine if a loan against the borrower’s residence is a Section 32 mortgage. One is a rate trigger point and one is a cost trigger point. If these trigger points are exceeded, you have a Section 32 mortgage. These triggers are subject to change after regulator and industry review.

Making a Section 32 mortgage typically is no problem as long as the lender complies with all the disclosure requirements and restrictions that come with making the loan.

Before you have your private-mortgage lenders buy any mortgage, determine if it is a Section 32 loan. If it is, help your investor determine if it was disclosed and closed in compliance with all the restrictions of a Section 32 mortgage and applicable state laws.

•  •  •

By understanding the various aspects of private-mortgage investing and working closely with your investors, you can avoid making these critical mistakes. A smooth transaction is beneficial to all parties — you, the investor and the borrower. 


 
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