Wanna Lend This Guy $200,000?

A young investment banker I know went bankrupt. He had let his debts get the better of him and had gambled recklessly in the market. But he was of essentially good character and excellent financial prospects, so if only his creditors had borne with him until he got his bonus, everything would have been fine.

“Sure, sure,” said three of his creditors, who had heard it all before. They forced him into bankruptcy over $60,000. Six months later he got a $250,000 bonus and paid off all his creditors. (Except these three. When his rage at them subsides, he may pay them, too. I hope so.)

Now he wants to buy a $300,000 house in Connecticut with $100,000 down. Have you ever tried getting a mortgage after you’ve gone bankrupt? Never mind the circumstances or the size of your down payment: almost no bank will touch it.

But that’s where you or I might come in. You or I might look at this and say, bankruptcy or no, the $300,000 house supports a $200,000 first mortgage. You might not want to lend that kind of money — if you have that kind of money — at 7% for 30 years. I certainly wouldn’t. But how about lending it for two or three years, and at 12% or 14%, say, backed by a first mortgage on the house and by the borrower’s personal guarantee? With the borrower paying all closing costs? And with no prepayment allowed the first year (so you earn your good rate of interest for at least that long)? And with perhaps even a “point” or two thrown in for good measure?

If you have a spare $50,000 or $500,000, that’s the kind of mortgage you might want to make.

Such deals are widely available. There are borrowers who can offer good security but who, for whatever reason, can’t get, or don’t want to try to get, a conventional loan. Or can’t get it as fast as they need it.

To find them, start by contacting mortgage brokers in your area and letting them know you might be a source of funds. You’ll quickly establish whether they have an interest in working with you and what you might expect. A second possibility: local realtors and real estate attorneys, both of whom may frequently encounter buyers in search of mortgage money. A third: take an ad in the real estate section offering to buy existing mortgages — typically, mortgages that sellers were forced to take back in order to move their homes.

It’s crucial to be represented by a knowledgeable, reputable attorney, and to get ample security — or at least an interest rate commensurate with the risk. (If it’s a second mortgage, the going rate can be 16% or more, but it’s all the more important to ascertain the true market value of the property and to obtain other collateral, if possible, such as a mortgage on a second piece of property the borrower may own.)

You must be certain there’s title, fire and flood insurance on the property and that your mortgage is recorded properly. And you should never assume that a property appraised at $200,000 today would yield anything even close to $200,000 in the event of foreclosure. The appraisal might have been high; selling costs will typically eat up at least 6% or 7% of the proceeds; the property could have deteriorated markedly in the meantime and would have to be maintained for the months and months it took to sell it even at a fire-sale price; the bottom could have fallen out of real estate prices in this area or out of the economy as a whole.

For you to lend $30,000 as a second mortgage on a $200,000 house that already carries, say, a $120,000 first mortgage might sound conservative, but it’s not. In a foreclosure, the bank holding the first mortgage would be entitled to $120,000 plus the unpaid interest and back taxes and legal fees . . . so figure maybe $140,000 . . . the property may well have been allowed to go to pot, unpainted, landscaping turned to weeds and muck . . . and on the courthouse steps, $145,000 might be the high bid. In this example, you’d be left with $5,000 of your $30,000, if that. Or else if you thought it was being stolen at $145,000, you could buy the property yourself. In this example, you’d be the high bid at $146,000, say, meaning you’d have to pay $140,000 to the first mortgagee (who might along the way have agreed to work with you with financing), and then you try to sell the place for more. Sure, you could paint it and clean up the yard, and maybe when all was said and done, you’d somehow rescue your $30,000. But you’d be risking a ton of cash and time in order to do so . . . so when push came to shove, you might well not.

All that said, and the very real risks recounted, here is a way for careful investors to earn high interest on large chunks of cash, with some additional effort but little additional risk.

Additional points to note:

The person who mortgages his property is the mortgagor. You, who lend to him, are the mortgagee. I was so excited when I finally got that straight!

When the loan matures, in a year or two or three, you may have the opportunity to renew it on similarly favorable terms. The borrower now has an added incentive to stick with you: by doing so, even at an above-market rate, he saves what may be thousands of dollars in a new set of processing fees, points and closing costs. And he saves the hassle.

The interest you earn is fully subject to income tax.

If you’d rather not deal with the borrower directly, your lawyer can serve as your trustee, disbursing the loan and collecting the monthly payments.

Always, always, always, always be prepared for the possibility you might one day have to foreclose on the property, as unlikely as that may seem today. Considering all the costs — financial and emotional — is it something you could do?

Tomorrow: Polonius Speaks