Private Financing: A Conversation

Trends come and go, but one real estate trend that gained much momentum in 2006 and has shown little sign of slowing down in 2007, is private financing for mortgages and down payments.

Instead of turning to banks, many consumers are now looking to family for help. This type of intra-family lending is considered a great option not only for first-time homebuyers but for those looking to purchase a second property as well.

Specialty loan administration companies, like CircleLending, focus solely on facilitating these types of loans. Physician’s Money Digest spoke with Jim Smith, vice president of CircleLending, about this trend.

PMD: When did the trend start?

Mr. Smith: Private lending is as old as the hills. Private loans and mortgages have been used by the wealthy for years and years and are now becoming more of a middle-class phenomenon. For entrepreneurs, friends and family financing has always been a way to raise start-up capital. As banks moved away from underwriting loans based on the four Cs of credit—capacity, capital, collateral, and character— and began to rely solely on one C—credit score—it became impossible for many young companies to finance themselves any other way.

PMD: What kind of numbers are we talking about?

Mr. Smith: According to data from the Federal Reserve, there is $89 billion in private loans outstanding and 6 million new private loans transacted every year. About 10% of first-time homebuyers report using a loan from friends and family to purchase their home, and more than a quarter of small business owners got funds from relatives or friends to get started. Our own business of documenting and servicing these loans has been growing 25% every quarter for several years.

PMD: What has prompted the recent uptrend?

Mr. Smith: In real estate, high home prices made it difficult for many first-time home buyers to come up with a traditional 20% down, so these folks are turning to parents for down-payment loans at rates that are much more attractive. And, we are increasingly seeing people with variable rate mortgages refinance with loans from family members when their payments start to ratchet up. Also, in today's market, home sellers are finding that offering to finance all or part of the purchase price attracts more potential buyers and could result in a faster close.

PMD: What are the key pros and cons to private lending?

Mr. Smith: Private lending can result in a win for both lenders and borrowers. Private loans offer flexibility and can be structured to meet the needs of both parties. When the parties are related, they frequently cite being able to keep money used for interest payments in the family as one reason for doing a private loan.

Lenders can earn a higher rate of return on a private loan than they might on a fixed-income investment of similar duration. In the case of a mortgage, that income stream can be secured by real estate.

On the downside, private lenders face the risk of late payments and even default, which is why we recommend professional repayment management. Having an independent party service the loan significantly improves loan performance. Plus, in a family situation, you don't want a late payment to become a topic of discussion over family dinner. Having a third party to help deal with those issues can be very important to people.