A private mortgage is a real estate loan made by an individual or a small private lender rather than a bank. You can invest in private mortgages in two main ways: lend the money yourself and create a new note, or buy an existing private note from the person who holds it. Both put you in the lender’s seat, with the property as collateral, but they carry different rules, costs and risks.
This guide focuses on private mortgages specifically: how they come about, the two ways in, the legal points to check, and how to protect yourself.
Where private mortgages come from
Most private mortgages start in one of three ways:
- Seller financing. A property owner sells and lets the buyer pay over time. The seller holds the note.
- Private money loans. An individual lends to an investor or a homeowner, often for a purchase or renovation, with a mortgage or deed of trust as security.
- Family loans. A relative lends money to buy a home and records a mortgage.
In each case, the borrower signs a promissory note, and a mortgage or deed of trust is recorded against the property. Our page on the private mortgage covers the documents in more detail.
Two ways to invest
| Make a new private loan | Buy an existing private note | |
|---|---|---|
| What you do | Lend cash to a borrower and draft new documents | Pay the current holder for the right to the payments |
| Price | You lend at face value | Usually at a discount to the balance |
| Payment history | None yet | Can be reviewed before you buy |
| Rules to watch | Lending and licensing laws, especially on owner-occupied homes | Transfer documents, servicing rules, state licensing in some cases |
| Main work | Underwriting the borrower and property | Due diligence on the note, the documents and the property |
Making a new loan gives you control over the terms. Buying an existing note gives you a track record to judge and, typically, a discount. Many private investors start with existing notes for that reason.
The legal points to check
Lending to someone who will live in the home is regulated. Federal rules under Dodd-Frank cover ability-to-repay and loan originator requirements for many residential loans. The SAFE Act and state laws require licensing for people who originate residential mortgages as a business, with some exemptions. Usury laws cap interest rates in many states. Loans to businesses or for investment property are generally less regulated, but not unregulated.
Buying an existing note has fewer origination concerns, but some states license note buyers or servicers, and how you collect and communicate with the borrower is governed by servicing and debt collection rules. See do I need a license to buy notes. In every case, talk to a local real estate attorney before you fund.
Underwriting the deal
Whether you lend or buy, the questions are the same:
- How much equity is there? Lenders use loan-to-value (LTV), the loan balance divided by the property value. Buyers of existing notes also use investment-to-value (ITV), the price paid divided by the property value. Lower is safer.
- Can the borrower pay? Credit, income, other debts and, for an existing note, the payment record.
- Is your lien where you think it is? A title search confirms lien position and any taxes or judgments ahead of you.
- Is the property insured, with you named as mortgagee?
A worked example
Here are two illustrative private mortgage opportunities, each on a property worth about $200,000.
| New loan | Existing note | |
|---|---|---|
| Property value | $200,000 | $200,000 |
| Loan balance | $130,000 | $120,000 |
| Cash you put in | $130,000 | $102,000 |
| LTV | 65% | 60% |
| ITV | 65% | 51% |
| Payment history | None | 3 years on time |
The existing note costs less cash for a similar balance and has a track record, but you did not choose its terms, and you need to check every document the original lender used. The new loan is yours to design, but you are trusting a borrower with no history with you. Neither is automatically better. The price you pay should reflect what you can and cannot verify. See loan-to-value on a note for more.
Protecting yourself
- Use a title company or attorney to close, with a lender’s title policy.
- Record everything: the mortgage or deed of trust, and any assignment.
- Hold the original note, or know exactly who holds it. Review the collateral file before you buy.
- Use a licensed loan servicer. It keeps records, sends required notices and handles escrow for taxes and insurance. See note servicing for investors.
- Do not concentrate. One default on a single large loan hurts more than one on a small loan among several.
Using retirement money
Many investors hold private mortgages in a self-directed IRA. The IRA, not you, is the lender or buyer, and there are strict rules about dealing with yourself or family members. Check with your custodian and tax adviser first. Our guide to buying notes in a self-directed IRA explains the basics.
Bottom line
Private mortgages put you in the role of the bank, with the property as your safety net. You can create one or buy one; either way, the result depends on the equity, the borrower, the documents and the rules in that state. Start small, verify everything and have an attorney check the first few deals. If you would like to see existing private notes as they become available, you can join the buyer list.
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