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.