There are a lot of aspects to qualifying for a mortgage, and no two borrowers are alike. In some cases, a person might not meet traditional bank mortgage lending requirements but still have the means and ability to become a homeowner. That’s when turning to a private mortgage lender – in some cases, a close family member – might be worth trying.
What Is a Private Mortgage?
A private mortgage is a loan that’s provided by an individual or company, rather than a financial institution. “Homebuyers usually consider a private mortgage when they’re unable to qualify for a mortgage from a traditional lender,” says Leslie H. Tayne, founder and head attorney focusing on consumer and business debt matters at Tayne Law Group.
In many cases, a private mortgage is an intrafamily loan in which one family member is lending to another. This is also sometimes referred to as a “non-arm’s-length transaction,” says Tayne, meaning you have a personal relationship with the party that’s lending to you.
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Private Mortgage Lender vs. Traditional Mortgage Lender
When going through a private lender, the borrower isn’t subject to the same formal borrowing criteria and guidelines as with a bank or credit union, according to Tayne.
“The private lender can make up their own lending terms, which the borrower agrees to,” she says. “This may be convenient for both parties, but it also means the loan is riskier on both sides.”
Another major difference is that a private note does not show up on your credit report, says Ralph DiBugnara, senior vice president at Cardinal Financial, a mortgage lending company. That’s because most private lenders do not report to the credit bureaus.
Who Should Consider a Private Mortgage?
Private mortgages are generally for people who cannot qualify for a traditional mortgage for one reason or another. You might consider getting a private mortgage if you:
- Are self-employed. People with non-traditional income or who haven’t been in business for at least two years can find it challenging to get a bank or credit union home loan. That’s because lenders typically want to see at least two years of business tax returns for non-W-2-earners. “It may be that someone has a lot of income or assets and can’t prove it on paper,” says DiBugnara.
- Can’t qualify for a traditional mortgage. While there are some government-backed mortgage programs that are a bit more lenient when it comes to minimum credit requirements, they still have minimum scores, and not everyone will meet other eligibility requirements.
- Plan to buy a home from a family member. Some private mortgages are owner-financed, says DiBugnara. “A lot of times what happens is if someone wants to sell their home to a family member, they will offer owner financing for the property,” he says, which means the borrower pays the seller directly instead of going through a bank.
Pros and Cons of Private Mortgages
Pros
- There is no traditional underwriting. Private lenders may ask to verify certain aspects of your finances, but the process is usually less rigorous than a traditional home loan would be.
- Your past matters less. It’s tough to get a traditional mortgage if you’ve had major credit events in your past such as losing a prior home or claiming bankruptcy. But a private mortgage lender – especially if it’s a close family member – may be willing to overlook that.
- You may pay less interest. Because private mortgages don’t have to follow current interest rates, in a high-rate environment, you can actually get a much more favorable rate if a relative is willing to offer you one. However, the IRS does have a minimum interest rate that must be charged on private loans, called the applicable federal rate. This amount changes each month, but it’s typically lower than the average mortgage rate.
Cons
- There are fewer borrower protections. During the COVID pandemic, many homeowners were entitled to apply for forbearance or similar hardship programs if they were struggling financially. That’s not something that would be available to private mortgage borrowers. “If you run into trouble repaying a private mortgage, there are fewer protections in place to help you through it,” says Tayne.
- Your personal relationship is on the line. Think about what might happen if things go south and you can’t keep up your end of the bargain, says Tayne, especially if you’re borrowing from a close relative. It could make for very awkward holiday gatherings, to say the least.
- You may pay higher interest rates. While family might be willing to extend a loan at a low rate, a private lender who has no personal connection to you will likely charge you higher-than-average rates and/or require a large down payment in order to offset their risk.
How Does a Private Mortgage Work?
Getting a private mortgage – whether it’s from a family member, friend or someone you don’t know – involves creating a loan agreement between the borrower and the lender. Loan terms are entirely up to the two parties as they are not bound by the parameters of entities like Fannie Mae, Freddie Mac or the Federal Housing Administration.
As far as getting approved for the loan, the lender decides the criteria. They might ask to see proof of income or assets, and could potentially run a credit check – though credit is usually not as big of a consideration as it is for traditional lenders. They may also want to get information about the property or conduct an appraisal. If the private mortgage lender is a family member, the process could be even more streamlined.
It’s customary to work with a real estate attorney to draw up a formal note that will spell out all the terms and protect both parties as much as possible.
How Is a Private Mortgage Structured?
In some cases, a private mortgage can look very similar to a traditional bank mortgage. It might have a 30-year fixed term structure, for example. But that’s not always the case, says DiBugnara.
Some private lenders might want to get paid back well under 30 years, so they might structure the loan for 10 years with a balloon payment for the balance at the end. “They would base your monthly payment on a 30-year term, but you’ll make payments for 10 years and then the balance is due,” says DiBugnara. “The borrower then usually refinances or sells.”
Ultimately, because private mortgages really don’t have any boundaries or rules to follow, the structure can be set up however the parties agree.
Alternatives to a Private Mortgage
Right now there is some financing out there for those with nontraditional income, says DiBugnara, but some of it is only available for investment properties. “If you’re buying for yourself, in many cases, you’re going to need a private mortgage,” he says.
There are a couple of alternatives to consider, however:
- Bank statement loans. For self-employed borrowers who don’t have the tax return or pay stub documentation that traditional lenders usually look for, a bank statement loan will rely on 12 to 24 months of bank statements instead. These loans are non-traditional and typically have a higher interest rate than conventional and federally-backed loan programs.
- Government-backed loans: Federal Housing Administration, Department of Veterans Affairs and U.S. Department of Agriculture loans do have more flexibility when it comes to income, credit and down payment requirements. For example, with an FHA loan, you only have to wait two years after bankruptcy to apply. Each of these loans has specific eligibility criteria, however, so work with a professional to see if you qualify for any of them.
- Wait it out. If there is something specific holding you back from a traditional mortgage, such as your income or credit status, figure out what you need to qualify and create a plan. If it’s raising your credit, you can work with a credit counselor or take measures on your own to improve your credit score. For non-traditional earners, once you have two years or more of consistent income, you can try exploring conventional loans.
How to Find a Private Mortgage Lender
If you’re getting an intrafamily loan, or borrowing from family to buy a house, then you’re set. But if you don’t have a rich uncle to turn to, there are also private mortgage lenders who work with borrowers they don’t know. Often, these are real estate investors or companies who work with investors, but you’ll want to do your homework.
Speak with your realtor and other people in the industry for their thoughts and referrals. And if you do find someone reputable and trustworthy in your area, be sure you have a real estate lawyer to review the mortgage to make sure the terms are acceptable to you.