marketwatch.com
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Barry Jekowsky wanted to build "legacy wealth" to pass down to his
children. But the 58-year-old orchestral conductor, who waved the baton
for 24 years at the California Symphony, didn't trust the stock market's
choppy returns to achieve his goals. And the tiny interest earned by
his savings accounts were of no help.
Instead, Jekowsky opted for an unlikely course:
He became a subprime lender, providing his own cash to home buyers with
poor credit and charging interest rates of 10% to 18%. It may sound risky, but “it helps me sleep better at night,” he says. “Where else can you find [these] returns?”
It has come to this. Unable to save enough for retirement with
traditional investments, baby boomers in search of yield are becoming
their own private Countrywide Financials. They’re loaning cash from
their deposit accounts and retirement plans and hoping for a big pay
day: specifically large returns that will boost their income and maybe
even allow them to pass an inheritance on to their children. There is no
official data, though it’s estimated that at least 100,000 such lenders
exist — and the trend is on the rise, says Larry Muck, chairman of the
American Association of Private Lenders, which represents a range of
lenders including private-equity firms and individuals who are lending
their own cash. “We know the number of people who are doing this is
increasing dramatically — over the last year it’s grown exponentially,”
he says.
Often referred to as hard-money lending, the practice has undergone a
significant shift in the past three or so years. It used to be that
individual lenders were millionaires who could afford to loan cash and
handle the risk of not being paid back. Now middle-income pre-retirees,
ranging from chiropractors to professors, are joining their ranks.
These lenders say the arrangements are a win-win: They are helping
buyers who would otherwise be shut out of the housing market while
earning an attractive return.
Critics say they are gambling with cash they cannot afford to lose. If
borrowers stop paying the loans, lenders may not be able to take back
the cash they invested, which could put their retirement at risk. On a
larger scale, there’s also the threat of a new wave of foreclosures.
“You’ve got unsophisticated lenders and unsophisticated buyers [and] it
sounds like a very risky combination,” says Doug Miller, a real estate
attorney and executive director of Consumer Advocates in American Real
Estate, a nonprofit based in Navarre, Minn., which assists consumers
with conflicts of interest in residential real estate.
Many of these so-called mom-and-pop lenders are using their retirement
accounts — self-directed individual retirement accounts and
self-directed 401(k)s — to fund other people’s mortgages. Unlike regular
IRAs and 401(k)s, self-directed accounts permit investing in
alternative assets, like real estate. Cash is not technically withdrawn
from the account, but rather a portion of the account equal to the
dollar amount the borrower needs is invested in loan. The borrowers’
monthly payments, including interest rates that can be up to 15%, are
paid into the retirement account, which ends up taking ownership of the
property if the borrower defaults.
Lending from these accounts has been on the rise over the past few
years. Pensco Trust Co., a custodian of self-directed retirement
accounts, says it has more than $600 million in secured loans, most of
which are mortgages — a figure that’s been growing at a 15% clip since
2009. Another custodian, Polycomp Trust Co., says the number of loans
secured by real estate has grown 18% over the past two years.
The move toward mom-and-pop lending comes in the wake of what experts
say is the creation of a perfect storm: Banks are still skittish about
lending to home buyers with poor credit. Meanwhile, investors who have
endured years of low returns from plain-vanilla investment portfolios
are itching for something more.
How the loans work
The operations often function like a game of telephone. Subprime home
buyers, who know they have no shot at getting a mortgage from a bank,
start spreading the word to friends and acquaintances that they are on
the lookout for anyone who will lend to them. Eventually, the word
reaches someone who is willing to lend his or her cash. Other times, a
group of individuals pool their cash together to fund the loan.
There is no official checklist used to decide who gets approved or
denied for these loans. Some individual lenders will only work with real
estate investors who plan to renovate and resell the property or want
to rent it out. Others are open to lending for owner-occupied homes. The
loans can be hundreds of thousands of dollars or much less than that:
say, $25,000.
What all these lenders have in common, however, is their willingness to
lend to borrowers with low credit scores. In some cases, they do not
even check their scores. They point to examples of otherwise reliable
borrowers who fell on hard times during the recession and were unable to
keep up with loans. Many say they work with borrowers who intentionally
stopped paying mortgages (even though they could afford the payments)
when they ended up owing more on the loans than the home was worth.
Some will even consider borrowers while they’re in foreclosure. A few
weeks ago, mortgage broker Mark Goldman received a call from a homeowner
in distress. A 60-year-old architect in San Diego had fallen behind on
his second mortgage and was facing foreclosure. The caller wanted to
know if he could refinance his way out of this mess. Complicating
matters, his credit score was in the low 500s. (FICO scores range from
300 to 850.) Goldman knew that traditional lenders would not consider
the homeowner — so he offered a different lifeline: He directed the
homeowner to his friend who offered to loan him $357,000 of his own cash
at a roughly 10% rate.
Instead of focusing on credit scores, lenders say they require borrowers
to make a large down payment, typically at least 30% to 40%. Similarly,
homeowners who are trying to refinance will need the same amount of
equity. (In Goldman’s case, the homeowner had 35% equity.) Lenders say
this lessens the chances that they’ll incur a loss should a borrower
default. Also, by requiring a lot of equity, the chance that a borrower
will walk away from the home if values suddenly drop is diminished.
Separately, some will only work with borrowers in markets where home
prices are rising. That way, if they have to repossess the home, they
can resell it at a higher price in the future.
These lenders require quicker repayment than banks. Repayment periods
vary from as little as six months to as long as 10 years. Many of these
loans require interest-only payments, and at the end of the repayment
period a payment of the total balance (often referred to as a balloon
payment) is expected. Lenders say the terms can work for borrowers who
are planning to sell the home within this time period or who plan to
refinance with a regular lender in the future and need this time to
improve their credit score.
Lawless territory
Critics say the loan terms are reminiscent of the subprime lending that
led to the recession. If borrowers are unable to make the balloon
payment or to refinance into another loan at the end of the repayment
period, they could face foreclosure.
Another concern: Lenders are operating in an anything-goes territory
with little federal or state oversight. In most cases, private lenders
are expected to follow the same mortgage lending regulations that banks
have to adhere to, but there’s little way for the government to know if
lenders are complying with the rules unless borrowers complain to a
government agency. “The problem is how do you find them, and it’s
something the federal government is not equipped to deal with,” says
Richard Painter, corporate law professor at the University of Minnesota
and former chief ethics lawyer for President George W. Bush and the
White House.
Separately, lenders are supposed to be registered with the state where
they are originating loans, but many mom-and-pop loan officers are not,
says Guy Cecala, publisher of Inside Mortgage Finance, a trade
publication. And since most of these lenders do not originate a large
number of loans per year, they are not required to report their
activities to the federal government. “It’s a shadow business,” says
Cecala.
Many lenders are looking for cover by sticking to investment real estate
only. New mortgage rules announced by the Consumer Financial Protection
Bureau kick in next year, which primarily impact mortgages for
owner-occupied homes. But the rules laid out by the bureau don’t
necessarily exclude investors, which means these lenders could find
themselves in hot water. For instance, lenders who provide interest-only
loans starting next year won’t be protected should borrowers who end up
in foreclosure file lawsuits against them. Those borrowers could claim
the lender didn’t do a thorough job confirming that they could afford
it.
Unstoppable trend?
In a sign that the trend may be here to stay, boot camps are training
average Joes to become private lenders. Last month, Wealth Classes, a
financial-education company based in Walnut Creek, Calif., that launched
in 2007, hosted a networking retreat for 250 students who recently
became lenders. Many of the company’s students end up lending to
subprime borrowers, though others lend to real estate investors who
don’t want to wait weeks to get a mortgage from a bank, says George
Antone, founder of Wealth Classes. (Private lending transactions
typically take about a week or two to go through, while a mortgage from a
bank usually requires at least one-month of waiting time.)
Randy King, 61, joined Wealth Classes about three years ago when he
started using his own cash to fund other people’s mortgages. A former
U.S. Air Force servicemember, King, who is based in Colorado Springs,
transitioned to buying fixer uppers and selling them and is now a lender
for borrowers — many of whom are subprime — who are buying investment
properties.
It’s not just mom-and-pop lenders who are becoming subprime loan
officers. The strategy is picking up on an institutional level as well.
Experts say a growing number of private-equity funds and hedge funds are
pooling together individual investors’ cash and using those funds to
lend to subprime borrowers at high interest rates.
Going forward, experts say, it will be difficult to slow down privately
funded subprime loans. This funding spreads mostly by word of mouth, so
there’s no official advertisement plug that anyone can pull. Consider
King. He recently visited his chiropractor who inquired about his
lending operations and then asked if he could jump into one of the deals
as well. The chiropractor explained where he would get the funds to
become a loan officer: He would use some cash he had saved and withdraw
equity from his home using a home-equity line of credit.
Most of all, though, the appeal of profits unavailable anywhere else are
likely to keep fueling this lending. Mark Goldman, who is also a real
estate lecturer at San Diego State University, says a student earlier
this year mentioned he was $50,000 short of the cash he needed to
purchase a home that he planned to renovate and resell. Banks wouldn’t
give the student a loan because he could not provide documentation that
proved his income. Goldman was intrigued and offered to loan him the
cash at a 17.25% rate. The student accepted, and after a few months of
renovations sold the home in September and paid Goldman back.
MarketWatch was on the phone with him after he closed another deal with
this borrower this month. “Make me proud and make us both money,” he
said as he walked away to his car.
Need a hard money lender?:
Great Falls Commercial Lending
1 Howe Ave, Suite 303
Passaic, NJ, 07055
Tel. 973-767-2850
Fax. 1-877-767-2150
info@gfcommerciallending.com
www.gfcommerciallending.com
1 Howe Ave, Suite 303
Passaic, NJ, 07055
Tel. 973-767-2850
Fax. 1-877-767-2150
info@gfcommerciallending.com
www.gfcommerciallending.com
