This is a guest blog written by Doug Smith of Castle Rock Capital Management to explain the best practices of loan underwriting for private lending investments.
More and more self-directed IRA owners lend money from their IRAs than ever before. Private lending investments are an amazing way to grow your IRA’s balance to new heights and secure your future with a lucrative passive income stream. But, a vast majority of people that lend out of their IRAs have no formal credit check background. This can sometimes get them into deep trouble.
Outside of hiring a firm or person with a formal credit check background to help you make loan decisions, educating yourself on the basics of how professional lending institutions make their decisions is critical to make your private lending investments successful.
The Three C’s of Credit for Loan Underwriting
Lending institutions site the Three Cs of Credit as the backbone of loan underwriting. Although there are many nuances to the art and science of lending, the Three Cs are a great place to start to understand how the pros make their decisions.
Character: Sometimes the term character is interchanged with the word credit, but the meaning is the same. A borrower’s character is the honor and integrity they show when times get tough. When the chips are down, will this borrower honor their commitment to you, the lender, by paying you?
The axiom “Past Predicts Future” is the cornerstone of a borrower’s character. Why do you think lending institutions pull credit reports? They want to see if the borrower will stand by their word or if they will shirk their responsibility when times get tough. Obtaining a credit report, or at least gathering credit references, and following up on any negative information to obtain satisfactory answers is critical to determine the character of your borrower.
Capacity: Simply put, does the borrower have the demonstrated ability to pay you back? Overlooking capacity during the early 2000s through the use of “no income documentation” loans was, in my opinion, one of the single biggest reasons the mortgage crisis occurred. A prudent lender gathers income documents, including W-2s, paystubs, and tax returns, to gauge the ongoing ability of the borrower to pay you back.
Another benefit of gathering multiple years of tax returns (at least two years…preferably three) is that you can see any other possible liabilities that a potential borrower might have that could limit their ability to pay you back. Flipping to the Schedule E, you can see any other business entities that the borrower might be involved in. Grab those returns, as well! Banks do!
Contingent liabilities of the borrower that might rob them of cash flow normally show themselves in the tax returns. If the borrower is unwilling to provide them, walk from the deal. It’s the loans you don’t make that rather than the loans you do make that keeps you out of a jam down the road.
One of my mentors from early in my career told me that the three most important things in lending are ability, ability, and ability. In other words, does the borrower have the capacity to pay you back. I have found in over 25 years of private lending investments that no truer words have ever been spoken.
Collateral: Private lenders often base their entire loan decision on the collateral and ignore other factors. Their line of thinking is they can always take back the collateral if the borrower fails to pay. Many lenders actually hope the borrower fails to pay. But, one must keep in mind that the foreclosure process is quite tricky…and expensive. In addition to legal fees, the time value of money can quickly depress yields in lien theory states such as New York, Illinois, and Florida. While it is important to properly secure your loans, over-reliance on collateral has been the downfall of many lenders.
Your Private Lending Investments, Loan Underwriting Take-Away
Learning all the nuances of private lending investments is something even those with years of practical knowledge and experience never achieve. If you lack a formal credit check background, it’s a good idea to partner or at least consult with someone who has expertise in the field. Private lending can help build an incredible, passive cash flow in your self-directed IRA, but without proper knowledge and preparation, a prospective lender could end up with losses that can equate to very expensive tuition payments.
BIO OF OUR GUEST BLOG AUTHOR:
Doug Smith spent 25 years in private and commercial banking and serves as the chief operating officer for Castle Rock Capital Management, a Tampa-based investment management company specializing in distressed real estate and real estate-backed debt (both commercial and single-family residential). Mr. Smith manages several private funds that purchase real estate-backed loans and real estate for investors. He also mentors other investors on the business.