As a private lender, I am presented with the following scenario almost daily. Let’s set the scene. Someone in your network wants to buy an investment property. Your loan provider requires them to put down a down payment and closing costs at closing, so they’re looking to you for the extra money.
You have the extra $20,000, so you can lend money to your cousin’s best friend to finance the gap. After that conversation, people usually start reaching out and asking how to do this, and usually, my answer asks Because you want to do this
Why Gap financing is too risky
First, let’s remove some loan conditions. The first mortgage (or deed of trust, depending on your state) will provide a percentage of the purchase price of this investment property (and potentially some money for renovations). To keep things simple, let’s assume this is a $100,000 single-family home that the borrower wants to convert to a rental. Their lender requires them to bring 20% to the closing table in addition to paying closing costs. The borrower is now asking you to bring that 20% ($20,000) to the closing table as a loan.
Does that sound familiar? In this scenario, under the best terms, the borrower would end up with an $80,000 first lien (mortgage/deed of trust) and then a $20,000 second lien on a $100,000 home. Usually, someone gives the borrower $20,000 on a very simple promissory note, and nothing is ever recorded. The document is likely not even legal because it does not have the required language and may be outside the legal limits for a loan. This scenario is commonly called “gap financing,” but other settings may also use this moniker.
Now that we have a loan scenario constructed, let’s discuss why this loan is out of my personal risk tolerance. I won’t tell anyone not to lend, as everyone will have different risk tolerances.
From where I stand, this loan is extremely risky. From the borrower’s point of view, they have little or no money tied up in the deal. This could be out of necessity if they don’t have the capital to close, or by choice if they want to remain liquid for some other reason. Either way, it could mean a shortage of capital if something goes wrong with the property. If a major mechanical system breaks down and the borrower doesn’t have the cash reserves to do it, it could very easily tip that loan into default for non-payment. A month or more of not having a paying tenant could also tax a borrower’s cash reserves, as we saw in the early stages of the pandemic.
What happens when the borrower cannot repay the loan
So what happens when a cash-strapped borrower can’t cover the first mortgage on a property or make necessary repairs to the property? Well, they’re likely to pull the “ostrich trick” and bury their heads in the sand, hoping it all works out.
Depending on the situation and the borrower, they may choose to walk away from the property because they don’t have much attached to it and don’t have the money to fix it up or continue paying the mortgage on a property that isn’t. does not generate any income. From the lender’s point of view about the loan, this would be a big reason why this type of loan could be very risky.
If the first lien holder initiates foreclosure proceedings, it is very likely that the second lien holder will be struck out with default interest and legal fees. The $20,000 you put into the deal as a second lien will likely be removed, unless the property has appreciated considerably and sells at auction for much more than the original $100,000 value.
The property itself can also be a deterrent to this type of loan scenario. In the example, the property did not need any renovation. The borrower was purchasing a single-family home as a turnkey rental. They probably bought it close to home value (since it’s been a strong seller’s market, and the property has already stabilized with renovations completed and possibly a tenant).
A residential property like this derives its value from other comparable properties in the local area. The value of that home is dictated by someone other than the borrower or lender. If the market moves or softens, the 20% down payment you provided will now be underwater compared to the home’s value.
For example, the $100,000 home drops in value to $90,000 due to higher interest rates and lack of buyer demand. The total outstanding debt on the house is $100,000. If the homeowner is trying to sell the home, they would have to bring cash to closing just to get rid of the property. The borrower was likely cash strapped to begin with, which is why they wanted the 20% down payment in the first place, so this is not an attractive situation as a second lien lender. Also, similar to what was mentioned before, if the house goes bust, the $20,000 is even more underwater because delinquent interest and first lien holder legal fees will wipe out any money left after the auction, especially if that property has lost value. the initial value of $100,000.
Other issues that may arise
The market is not the only thing that can affect the value of this property. If the borrower has significant loss or damage to the property and there is no adequate insurance to cover it, the condition of the property will significantly affect the value of the home. This is not as far-fetched a scenario as it seems.
A tenant leaves a candle burning, someone turns on the stove and leaves, the wiring in the attic is old and broken, someone leaves two chemicals together in the garage and they ignite, so the property could catch fire very easily Things happen.
There are also natural disasters like hurricanes, tornadoes, earthquakes and hail to contend with! If there was no adequate or adequate insurance coverage, or the damage was not covered by an insurance policy, the borrower could be left with a property that is worth far less than what is owed on it, with few financial resources to obtain the property return to its previous condition to reset the value.
Another common scenario is an investor looking to buy a home with a short-term loan, such as a hard money loan. The lender, in this case, may require a certain percentage of the purchase price to be paid as a down payment, and then if there is any capital left over, they will also cover the renovation costs.
In this loan scenario, the borrower is theoretically buying the property at a discount and will add value through renovations and upgrades. The second lien loan in this situation may seem less risky, but it can present its own challenges. If the borrower runs out of money before the renovation is complete, the property may not reach the expected value after the renovation and may even lose the value of the original purchase price because demolition work has been done , but substitution does not. Also, if renewals take longer than expected and the borrower has reached the end of their loan term and is unable to pay the balance of the lump sum payment, this can also push the first loan into default.
Finally, the other common scenario seen is that a borrower will request that the $20,000 be placed directly into their bank account, sometimes even before they close on the property. This borrower must show money for the down payment, closing costs and reserves to close the loan. This loan scenario isn’t even secured against real estate, so you’ve basically made a $20,000 personal loan to someone else or their LLC. When taking out a real estate loan as a private lender, having the property as collateral makes it a secured loan. A secured loan means that there is an asset to cover the capital invested to acquire that asset. In this loan scenario, there are no assets to back the $20,000 borrowed. There is no guarantee that the borrower will not take this money to Vegas! You have no guarantee that the money will go toward that property, the renovations, or anything else the borrower says they will do with the funds. Unfortunately, this is the most common scenario I see when people come to me to inquire about their first private loan agreement. They often approach after the money has already changed hands, with a promissory note from a template they pulled from the Internet.
This brings me to my final point on making loans like this. Each state will have usury laws. The documentation and verbalization required within this documentation are required by law for the loan to be valid and enforceable. In addition, these laws will set upper limits on interest rates and fees associated with the loan. These laws will also guide licensing requirements and in what situations you may require a license to lend your own money.
For example, in some states, if you are an LLC that lends money to another LLC that is a loan for business purposes, you may not need to be licensed. In this same state, if you are a person who lends money to another person, you may be required to be licensed. For all states, you only need to lend on one investment property! The federal government has strict guidelines regarding licensing and lending activities associated with a consumer’s primary residence, so make sure the property is only intended to be an investment property.
Your best bet is to talk to an attorney familiar with lending in the state you’re borrowing in, who may not be the attorney you previously closed your home loan with. Many real estate attorneys are emailed documents by the lender to have a sign from the borrower. They are often not the ones generating these documents. If you’re sending money to someone for a loan, all you’re getting is a piece of paper legally charging you to be repaid. Why would you trust a free template you found online?
While this loan may seem easy and simple when first presented to you, I hope this article will give you pause for a moment and realize what you may be getting yourself into. If you feel that at the end of the day, you can sleep at night with a loan deployed, feel free to do the loan your way. Everyone’s risk tolerances are different, and as you saw above, there are many that are above my comfort level. Unfortunately, this scenario often presents itself to people who are new to private lending, perhaps even real estate in general, blinding them to the real risk of making a loan like this, especially in today’s economic climate.
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Note from BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.