The strategic advantage of first mortgage private loans
In what scenarios does opting for a first mortgage, through a private lender offer a strategic advantage over a traditional bank mortgage?
The strategic advantage of private lender mortgages comes down to the reason for the loan.
As they say, beauty is in the eye of the beholder!
If you were to get a 100m champion sprinter and put him or her into a long-distance marathon, would that be the right way to compare his or her ability? No, is the short answer.
Private lending first mortgage loans are made for unique financial situations, specifically they are made for business and investment purposes! First mortgage private loans offer both strategic and tactical advantages over bank lending, for short- and medium-term debt. This is where it excels. Private lending does not excel for long-term holding debt and this is where banks do better.
Think of private lending as your sprinter, and a bank as your marathon runner
Private lending isn’t a competitor to bank funding, it is happy to workout outside of the normal lending parameters of banks, for business purposes. It provides urgent liquidity, on business-friendly terms and makes deals possible, that otherwise wouldn’t be.
Think of urgent cash flow loans where money is needed quickly, land banking, capitalised interest options, property development funding, site acquisition funding for developers, petrol station acquisitions, alternative asset loans (heritage plates) and second mortgage loans. With private loans, funds can be provided within 5 business days!
A bank simply can’t do that. Banks struggle to write good loans within 3 months, yet alone a challenging one within 5 days.
The regulatory landscape for private lenders
There are several regulatory influences regarding private lender mortgages ranging from ASIC , Austrac and the courts. Think of KYC (know your customer) laws, and strict laws as to when non-coded private loans can be applied. For the purposes of this article, we will only discuss private loans that are non-coded.
Non-coded private loans
What is a non-coded private loan? A non-coded private loan is a loan that falls outside of the National Consumer Credit Protection Act of 2009. This Act awards certain protections to consumers from lenders, and forces certain steps to be taken by lenders such as responsible lending practices, for consumer lending products. These laws essentially put the burden of correct and responsible lending decision making on the lender, rather than the consumer.
When a borrower opts for a non-coded private loan, they are doing two things. Firstly, they are confirming that the use of funds is for commercial / investment reasons, and not for their own personal use as a consumer. Secondly, they are opting out of the protections of the National Consumer Protection Act 2009, because the nature of capital use is for business purposes, not consumer. This is important if they are to receive funds on flexible business terms, that borrowers can’t get from banks in a personal capacity.
The whole point of private lending is to be able to offer solutions and market liquidity that the banking system can’t. As such it requires flexibility in being able to provide this liquidity. Without the private lending / shadow banking/ secondary lending market the entire banking system would collapse.
This is not to say that private lending is not regulated, and without borrower protections.
Court protections for borrowers
Strict borrower protections still exist at a court levels. There is still a degree of responsible lending that is required by private lenders that is enforced by the courts, based on common sense.
For example, if an elderly lady in her 70s had a struggling business, that took a private loan and later defaulted, and the lender tried to take possession of her property. The court would likely side with her, asking the lender how they could reasonably expect for a lady in her 70s to repay or enter such a loan. The courts are very strict now about predatory lending, and as such private lenders have become largely self-regulated, due to court rulings.
Interest rates and private lenders
Interest rates are also a factor at an RBA level, because typically private lenders work on a certain margin above the BBSW rate.
The risk-free rate of return is the rate of return that you could get on a term deposit / government bond, that carries close to zero risk. Therefore, the risk premium, the premium paid for taking on more risk, will be a margin above the risk-free rate, and adjusted for the level of risk. As the risk-free rate increases or declines, the total interest rate charged on a private loan will go up or down, depending on the risk premium margin.
There are situations however, where you may have a high bank rate, and the delta between private lenders and the bank becomes marginally smaller. Because as the risk-free rate rises, private lenders may reduce their risk premium margin to be more attractive to the market.
How private lenders asses risk and creditworthiness differently to banks
Banks primarily assess a client’s borrowing capacity via three perspectives. The first is their credit score, the second is their serviceability (income to debt ratio) and the third is the LVR of the loan against the security value. This is a time-consuming process for borrowers and may not provide all the funds a client needs or on terms that is suitable.
Private lender risk assessments are primarily focused on the quality of security, rather serviceability or credit score! This is because private financiers take into consideration the exit as the primary focus for repayment of funds, as well as the quality of the security they are holding.
The exit being a sale of asset, refinance, or business venture that the funds are utilised into. Whereas a bank focuses on serviceability, because its repayment of debt usually occurs over the long term.
The creditworthiness evaluation in private lending is supposed to be simple for quick deployment of funds, and skips many bank hurdles. At Royce Stone Capital we source funds from a family office for our first mortgage private loans. This ensures certainty of funds, it removes settlement risk, and it allows for tailored loans at a lower cost of capital compared to other private financiers.
Long term considerations with private lenders
There are many benefits to using a private financier for a first mortgage private loan. However, borrowers need to focus on the exit strategy of the loan (repayment method). Unlike a bank loan which is P&I repayments over a long period of time. Private loans are 3 months to 36 months in nature, making principal reductions over that period unlikely.
This requires a bulk repayment of funds on maturity of the loan. This can come via a refinance of the underlying asset, a sale of asset or profits from a business venture from where the funds were used.
Real estate market impact of private mortgages
The performance of the real estate market largely depends on the financial liquidity available to borrowers. The more relaxed lending regulations are at banks, and the lower the cost of funds, the higher the capital growth of real estate. Typically, during such times, private lending provides acquisition funding for businesses and property developers alike, as business owners can’t get the growth capital they need from a bank.
When liquidity is tight, and the cost of capital is high, prices in the real estate market tend to soften. This is coupled with tighter lending regulations at the banks. During such times, private lending provides capital to business and developers that can’t get funds from a bank. This is mainly in the form of emergency liquidity, refinancing, urgent settlement funding and bridging finance.
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