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.
Before the housing crisis in 2008, there were many types of mortgages available to the consumer. There was “A” Paper for those with perfect credit, provable income and a property in good condition.
There was Alt-A (alternative to A paper) was for borrowers who almost qualified for an A paper loan but who had a minor flaw that prevented them from qualifying.
Then there was subprime, which was available for those who didn’t have good credit.
Finally, there was hard money. It was for those whose credit wasn’t good enough for a subprime loan or who needed a small loan, often a 2nd mortgage.
After the market crashed in 2008, the only things left were A paper and hard money. If someone couldn’t get an A paper loan, their only option was hard money.
The result was that many borrowers with reasonably strong profiles were getting hard money loans. In some cases, these people had credit scores well over 700 but either had trouble proving their income or had a property in poor condition.
Investors were funding these loans with rates in the 10-12% range and had little trouble finding opportunities. Then, more investors started lending. This increase in investors drove rates down on many loans, with some going as low as 7% for cleaner deals.
Then non-prime loans started to surface and took a big chunk of the hard money market. Their rates were lower and they could do more of the owner occupied properties. They could also work with lower down payments.
Over the last couple of years, I have had many investors ask me what happened to all the sweetheart deals they used to see. The answer has been that the non-prime loans have eaten lots of them up, leaving the more traditional hard money loans. These were the borrowers who had bad credit (bankruptcies, foreclosures, short sales, late payments, etc.), ugly properties and no provable income.
But with our current scene of having most businesses either closed or operating with reduced volume, non-prime loans have taken a break. Right now, they aren’t lending. You can go to the websites of these companies and see that they have “paused lending activities”.
This does add some uncertainty to the market but we don’t really know how much it will affect values or for how long. My opinion is that I think values will drop but not by a large percentage. Here’s why.
The vast majority of mortgages go through the banks. Since 2010, all mortgages going through banks have required proof of income. They have also required larger down payments on all rental properties along with proof of assets. Additionally, according to Zillow in July 2019, 37% of the homes in America are owned free and clear.
Combining these factors, you can see that this is a much stronger base than the house of cards we were dealing with in 2008. Plus, we don’t have the same problem of rampant mortgage fraud and predatory lending that we had in 2008.
Where do we go from here?
Right now is a good opportunity for private money/hard money investors to lend to borrowers who are stronger than the most common hard money borrowers. In the last couple of weeks, I have been approached by more people who had good credit and strong profiles than usual.
Some of them will wait to make a move because they don’t want to get a hard money loan but others will get the loan that will solve their immediate problem and plan to refinance when things settle down a little. And some will be interested if the rates are a little lower (7-9%).
In looking at these deals, you may need to do lower interest rates than you are used to. But if you can get stronger borrowers with more equity in the property, isn’t that better than having your money sitting in a bank earning effectively no interest? Of course it is. Just make sure you do your due diligence and make sure you have a solid loan.
If you have questions about how to analyze a deal, please call (707) 401-8080 or fill out the contact form on this website.
Since we specialize in helping those who cannot get a loan from the banks, we have a different perspective when we look at a loan file.
Rather than looking for something wrong to see if the loan should be declined, we look for reasons why the loan should be approved. In other words, we look for the strengths of the file and not just the weaknesses.
Of course we have to look at the weaknesses so that we know what they are and how our investors might view the file. But we also look for reasons why the loan could make sense. Balancing these two things gives us a more complete understanding of the loan and opens the door to getting it approved when others would say no.
As a borrower, you may only be thinking of the things that could prevent you from getting a loan. However, these weaknesses in your situation can be handled in many situations.
Here are a few common situations and how they can be overcome.
- Bad credit: If you have low credit scores or recent “credit events” like a bankruptcy or foreclosure, there is usually a reason. Giving a complete explanation of what happened is helpful. But the thing that really helps is an explanation of how it is either already handled or how the loan you are applying for will handle it.
- Property is a fixer: If you own a fixer or are buying one, the value will increase as you improve it. Having a clear plan on how you will do this can make the difference between getting approved or being turned down.
- No money for a down payment: Some people own a property already that has little or nothing owed on it. They want to buy another property but have little or no cash for the down payment and closing costs. The property they already own can be used as collateral for the down payment.
- Another little known tip to getting your loan approved is to tell us everything. If we know the details on what you are trying to do and the barriers to getting it done, it is much easier to handle the barriers and figure out a solution.
There are so many different situations that it would be nearly impossible to list everything in a single post or even a whole book. But if you or someone you know has a difficulty in getting a loan, we may be able to help.
The thing that really sets us apart from other lenders is not just that we really care and want to help. It is that we are very good at looking at your whole situation and figuring out the solution that will work to solve the problem.