Today is another AMA episode (Ask Me Anything). Kara asks,

I’ve been approached by a borrower to lend funds to purchase a property. I’m not interested in taking risks, so I figure if I limit the loan amount to 80% of the property value, and secure the loan in first lien position I’m going to be safe. I don’t have the time or systems to fully qualify the borrower. The property is a fixer upper which will require the borrower to bring additional funds to repair the property. He intends to hold the property as a long term rental and eventually refinance with bank financing in order to repay the initial loan. Apart from mortgage security, what else should I be concerned with?

This is a great question.

My recommendation is that you work with a licensed mortgage professional. That’s their business. For the listeners to this show, I don’t want you taking what you hear on today’s episode and making loan decisions directly. I’m not a mortgage professional and I don’t profess to be. I’m merely giving you ideas for you to discuss with your mortgage professional that might give you additional protection.

A lender is only ever asking one question. If I lend you money, how will I get it back. The more sophisticated the lender, the more ways they have of asking that same question. How will I get my money back if things go well? How will I get my money back if things don’t go well?

Whether you write one loan or 100, you’re in the lending business. In order for you to have a robust and safe lending business, you need systems and processes. That means being very clear on your lending criteria. I’m going to touch on a few, but there are many more to be considered. These are for example purposes only. Again, consult your real estate lawyer and your mortgage professional.

Let’s talk about the things that can go wrong and how you need to protect yourself in the lending criteria and in the loan agreements. You can learn an awful lot about this business by reading commercial loan documents to see what terms a lender has embedded in the loan documents. Every single one of those terms are there for a reason. They’re there to protect the lender.

You’re correct in saying that by securing your loan on title with a mortgage does provide some protection. But it’s not absolute protection. Only by understanding the weaknesses that a mortgage can have, can you plug those holes that exist.

Let’s start with the loan amount. You mentioned that you were willing to loan up to 80% loan to value. In my mind, the notion of value can be highly subjective. There have been documented cases of appraisals coming in above the true market value. In that case, the unsuspecting lender can be taking on much more risk without even knowing it. My recommendation is that you write your loan terms at a lower percentage. But not only that, you may consider limiting the loan amount to the lower of, say 70% loan to purchase price, or 70% loan to value. Whichever of those two numbers is lower, that would be the maximum loan amount.

You mentioned that the property is a fixer upper. Every time you have someone working on the property, there is risk of a mechanics lien being recorded on title. Your mortgage might be in first position, but a mechanics lien would come ahead of a mortgage in the hierarchy of payment. You need systems and process to control the payment of contractors and subcontractors.

Even with asset based lending there is a certain amount of due diligence that needs to be performed on the borrower. The lending business has a lot of moving parts.

These are just a few of about a dozen things that can go wrong even in the world of secured loans. Again, I’m not a lawyer, nor a mortgage professional. If you’re going to write a loan then you probably want to get into the lending business with all of the systems, processes and protections that come from being in the lending business.