marketwatch.com — 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.
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.
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.
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