For anyone who does private notes, it is important to know how to analyze a credit report and be able to use that information in deciding whether to lend money to the borrower.
The biggest mistake made by investors is to rely too heavily on the credit score. This can be a mistake in either direction. You can miss out on a good opportunity just because of a low credit score or you could do a loan you shouldn’t when the credit score is high.
The very first rule in private lending should be that the most important part of any deal is the loan-to-value ratio. Everything else is secondary because if anything goes wrong for the borrower, the equity in the property is the only real protection you have. When things go wrong for a borrower, their credit score is not going to provide you with any protection.
Just because the banks rely on credit scores is not a reason for private investors to do the same. There are fundamental differences between what they do and what you do. Banks will lend up to 96.5% of the property value on FHA loans and up to 100% on VA loans. But those loans are insured against losses in case the borrower defaults. Private lenders cannot get that type of insurance.
On most loans, banks lend other people’s money, not their own. So if things go wrong and the loan ends up in foreclosure, they may have some hassles to deal with but the investors are the ones who lose the most money.
These are some of the ways a private investor is different from a bank and should look at loans differently. But credit does play a part in analyzing a loan application and whether to make it. Following are some tips on how to do it.
Everyone seems to look at the credit score first and place the most emphasis on it when deciding if a borrower is credit-worthy. It would be a mistake not to look any further. I have seen credit reports with low scores but no late payments and others with high scores but without many good accounts on it.
Tip #1 is to read the credit report. Don’t stop at the score because you are missing the story. It’s kind of like looking for the score of a baseball game instead of watching it. Toward the end of the game, it might have been very close and a fun game to watch but something happened and it ended up being a blowout.
The same can happen with credit. Everything can be fine then something happens and the scores crash. Maybe there was an illness or a divorce or something else. If you look at a report, you can see when the late payments started and ended, if they have ended. Maybe they haven’t ended but the loan they are asking for will help stop the bleeding and turn things around.
Tip #2 is that you should look at trends. What is happening now as compared to earlier. If there are late payments, when were they? Is it on one or two accounts or is it on all of them.
Did the borrower go through a rough patch and come out of it? Is he still in it? Will this loan handle the rough patch or have no effect on it at all? These are all questions that should be considered when reviewing a credit report. If there aren’t any answers to these questions, ask them. If you can’t get answers, maybe it isn’t a loan to do. Maybe the loan amount needs to be lower.
Tip #3 is don’t put too much weight on the credit. As mentioned above, if you put too much weight on the credit score or credit report, you can miss some good opportunities and you can make mistakes.
Part of this tip is to balance the credit with other factors like property value and the borrower’s ability to pay. When you have a borrower with horrible credit, do a lower loan-to-value ratio than you would with someone who has good credit. If you would lend 65% of the property value to someone with good credit, maybe you lend 60% to the borrower whose credit isn’t so good. Maybe you lend at a higher interest rate.
There is obviously much more to this than can be covered in a single blog post but this will at least give you more information to use when deciding whether to do a loan or not.