Have you ever been given an opportunity to loan someone money at an attractive interest rate?

Driven by the prospect of higher “guaranteed” returns, prospective lenders sometimes look to opportunities in their communities to provide loans to businesses or individuals. Often, the prospective lender knows the borrower, or at least knows the intermediary who plans to facilitate the lending.  

Why is it that these potential loans appear to be so lucrative … and is the opportunity too good to be true? The answer is that the lender is usually taking on far greater risk and should only engage in this lending with a clear understanding of the tradeoffs.

To start the comparison, let’s analyze a very common, commercially reasonable loan – the loan for the purchase of a primary residence.

Assume a borrower wants to buy a house and the current average 30-year fixed rate mortgage on a residential property is 7%.

Banks’ due diligence

Before the bank grants this loan, there are several important steps the bank takes as part of its due diligence. It collects personal and financial information (income, assets, debts) through the application process and verifies the same information. It performs a credit check.

The bank requires title insurance on the property to verify appropriate ownership and a clear title on the subject residence. It orders an appraisal of the subject property to ensure the asset can cover the proposed debt. The bank puts the application through professional underwriters to verify identity and assess the viability of the loan and its repayment.

Finally, if approved, the bank not only takes a promissory note promising repayment, but it takes a security interest in the property by way of a first position mortgage giving the bank the right to take the home in the event of nonpayment.

Now let’s turn to back to other proposed opportunities for lending.

Again, assuming an interest rate environment where a 30-year fixed mortgage is 7%, let’s assume a lender has an opportunity to loan someone money with 7% interest (equal to the current, assumed bank rate). Remember, that rate presumes the due diligence described in the paragraph above.

Reducing lender risk

The lender would be well served to engage in the same commercially reasonable due diligence as the bank.

What are the finances of the proposed borrower? Did the lender run a credit check (and as an aside, what credit score is high enough)? Did the lender appraise the collateral and take a first position mortgage in the property to secure against nonpayment?

To the extent the lender chooses not to engage in the same due diligence, the lender is taking on risk. The lender should ask himself or herself – why you are willing to take on risk that a traditional bank would not?  

The examples above compare identical interest rates. Assuming the lender can go through identical due diligence as a bank, then the interest payment at 7% is presumably fair. Regrettably, individual (non-bank) lenders rarely engage in the appropriate due diligence to justify an interest rate equal to that offered by banks. Accordingly, they are taking on more risk.

Safeguards

What happens if the interest payment is 10%? It’s a more compelling opportunity, for sure. But, what typical safeguards should the lender be willing to give up and at what cost?

That’s a tougher question.

For example, if the lender does not get security (e.g., mortgage) on the asset that is the subject of the loan, is that worth a 3% increase in interest rate, a 5% increase?

If the lender doesn’t get a title report or conduct a credit check, how does that additional risk translate to an increased interest rate? Any deviation from standard due diligence and collateral should result in a higher interest rate because the lender is necessarily taking on more risk.

Consider personal loans offered by a bank. These types of loans are not secured by a mortgage. And for that risk, the bank might charge an additional 4% interest rate above the rate of a comparable amount of money secured by a home.

Further, the bank will require repayment in a much shorter time frame. But, even a personal loan from a bank typically involves due diligence in the form of application, credit checks, and debt to income analysis. And, that due diligence then translates to the offered interest rate.  

When all is considered, the lender might find that potential “guaranteed” loan is too good to be true because it lacks the due diligence protections that would otherwise apply to bank-financed loans. The prospective lender might be trading additional risk without knowing it. The key is to understand the risk and price the loan accordingly – something banks are typically better suited for than individuals.

Beau Ruff, a licensed attorney and certified financial planner, is the director of planning at Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick.