Before we get started, let’s quickly clarify the terminology for the main 3 parties involved.
- Investor: mortgage investor or capital provider, not the real estate investor
- The real estate investor in private mortgage transactions is the borrower
- Lender: the loan originator, not the capital provider
- An originator is the private lending company or mortgage broker that underwrites and processes the loan, and it’s the party that is offering the opportunity to invest in the loan
Investment Method #1 – Whole Loan at Closing
With this first method, the loan originator underwrites the loan request and pitches it to mortgage investors that may want to fund it. If you make a commitment to invest, you would wire the funds for the entire loan amount when the loan is ready to close. In exchange, you will receive a mortgage note confirming the subject property is collateral for the loan, and you’ll collect interest payments during the loan term.
You may hear this referred to as “table funding.” This method of investing provides mortgage investors with more control, without having to deal with the borrower directly.
If there is a default which leads to foreclosure, you could end up owning the property. Regardless of the outcome you get to make all the decisions. You can decide when to foreclose, and what to do with the property after.
With this method, one potential challenge for both the investor and the lender is timing. Most private hard money loans are time-sensitive, and you just have to be ready to act quickly. When a loan originator is seeking capital for a particular loan, they are likely pitching it to multiple investors simultaneously, so there is a bit of pressure to make a quick decision and follow through with funding on schedule.
Investment Method #2 – Fractional Loan at Closing
Similar to the previous method, the mortgage investor wires the funds when the loan is ready to close, but some lenders will offer a fractional investment in a loan so that multiple investors have an interest in the same loan.
You may hear this referred to as a syndication. It’s a neat structure that enables investors to allocate a smaller amount for each investment, and it prevents having all eggs in one basket. So the idea is if you have a bunch of fractional loan investments and one borrower defaults, the other loans may continue to make payments.
Fractional investments are not offered in all states. When you pool funds from multiple investors, it’s a securities, and only certain states allow it, each with different rules. For example, in California a private mortgage loan can have up to 10 individual investors, but all of them must reside in California. Many lenders avoid fractional investments due to the additional compliance, and it’s a lot of work to manage multiple investors.
One potential challenge with this method of investing is if there is a foreclosure and the property ownership is relinquished, you may have to work with the other fractional note holders to decide what to do with the property. Whereas, with the first method of investing in the whole loan, you as the sole investor can make all the decisions.
Investment Method #3 – Purchase the Loan After Closing
Some lenders use their own money (or a bank credit line) to fund loans and then sell the notes to mortgage investors shortly after closing. So why would a lender do this if they can use other people’s money? It’s all about timing and control. The process of pitching a loan request to multiple investors could take a few days, and lenders don’t want to risk losing deals to competitors that may be able to close faster, because most private hard money loans are time-sensitive, and every single day counts.
One advantage to this method is there is less pressure to make a quick decision on whether you want to invest in the loan. The lender probably won’t mind if it takes 2, 3 or 4 weeks to sell the loan.
Investment Method #4 – Lend Direct to Borrower
This is similar to Method #1 – funding the whole loan at closing, but without a loan originator. In the previous 3 methods of investing, the lender has a relationship with the borrower, and the mortgage investor likely never has any contact with the borrower. However, we’ve met a number of mortgage investors who lend directly to property investors and don’t have a loan originator involved.
There are a lot of risks with this method of investing if you don’t have experience with private mortgages. It may be safer to have a professional loan originator underwrite the loan before you evaluate it. On the other hand, we’ve known some loan originators who originate very risky loans and leave it up to the investor to decide if it’s a good investment.
In some states, it’s not legal for investors to originate their own loans without a license. Or you may be able to fund a small number of loans annually without a license, but once you exceed that number, the state regulators consider you to operate a lending business which requires oversight.
Investment Method #5 – Mortgage Funds
A mortgage fund is a pool of investors that have a partial ownership of the lending entity. This is a very passive form of investing because the fund manager makes all the decisions on which loans to fund. In the previous 4 methods of investing, the investor gets to choose which loans to invest in after evaluating the subject property, the borrower and other details.
Now, the fund manager can’t just lend on any type of deal. When the fund is formed, they have to create a document which spells out the general investment guidelines such as the property locations, loan amounts, loan-to-value, property types, loan types, etc. It’s sort of a business plan, but it’s called a private placement memorandum (PPM), and it has to be filed with the Securities and Exchange Commission before the fund can start operating. Since a mortgage fund is a securities, they are regulated by the SEC, and it’s only available to accredited investors which means you need to qualify with a certain amount of income or net worth.
Some mortgage funds are structured as a REIT, or real estate investment trust, which offers some tax benefits that you don’t get from the other methods of mortgage investing.
Minimum Investment Amount
Now that we’ve covered the 5 ways to invest in private mortgages, you may be wondering how much money is required to invest.
For a whole loan investment, the minimum amount is typically $50,000. We don’t see many lenders originating loan amounts under $100,000 because it may not be worth their time, but some will go down to $50,000 and a very small number of lenders will go down to $25,000.
For a fractional investment, the minimum investment amount could be as low as $10,000. If a lender originates a loan amount of $100,000 they may get 10 investors to each pledge 10% instead of finding one investor to take down the entire loan.
For a mortgage fund, the minimum investment amount is typically $50,000. However I’ve seen some fund managers go down to $5,000 with a strategy to take on a large number of investors, and some set a minimum of $250,000 if their fund is already well established with a lot of investors. Some fund managers will accept a lower amount than their stated minimum just so they can get the investor in the door, with the hope that additional money will be invested in the near future.