Five Critical Mistakes Made in Private Mortgage Investing

The five critical mistakes listed here are certainly not the only mistakes private mortgage investors make, but they are common mistakes that are repeated over and over until a hard lesson is learned. Private mortgage investing can be very rewarding, but you must avoid these critical mistakes to be a successful private mortgage investor. Learn from the mistakes of others!
1. First Critical Mistake: The Mortgage Investor Does Not Inspect The Property That Is Or Will Be Mortgaged.



Would you negotiate a price to buy a car without seeing it? Would you negotiate a price to buy a house without seeing it? Well if you commit your money to a mortgage without seeing the real estate it is just like buying that house (real estate) without seeing it. Why? Because, if you have to foreclose on the property that you did not physically inspect before you committed your money, then it is just like negotiating a price to buy the house without having seen it. Only the foolish would buy a house without seeing it.



Let us imagine for a moment that you have to foreclose on a house you did not see with your own eyes before closing the mortgage transaction. Sometime during the foreclosure process you go to the property to see what soon will be yours. Surprise! Surprise! It is not what you thought it was or what you were told it was. You were shown pictures of the house before, but now it just does not seem like that house you saw in the pictures.



You knew it was wood frame, but you did not realize (until now) that when you walk up the stairs of the front porch your foot breaks though the wood. As you walk through the house you soon find out the house is infested with termites and seems ready to collapse.



You begin to panic thinking you made a big mistake investing in this mortgage secured by this property. Then, you remember that at the closing you only invested or loaned 40% of the perceived value of this house. Now you begin to think, “if I have to bulldoze the house down and just sell the land; then I will probably come out even, and everything will be OK”.



But wait! Right then, as you are walking back out the front door you see the neighborhood is not what you thought it was or what you were told it was. This house, which will soon be yours, is across the street from an abandoned gas station that has a hazardous waste sign on it from the Environmental Protection Agency. That sign can often mean that the ground around that gas station (within hundreds of feet) is also contaminated. Now, you not only have a house that you cannot sell, you also may have a property that will costs thousands of dollars to clean up. What a nightmare! Do not think this has not happened. How do you reduce this kind of risk as a private mortgage investor? Go look at the property before you commit your money to the mortgage! Appraisals can help reduce some of this risk in private mortgage investing, but not as well as you physically looking at the property for yourself!



2. The Second Critical Mistake: The Mortgage Investor Fails To Require A Flood Check Before Closing The Transaction.



How many private mortgage investors had their money invested in mortgages in the New Orleans area in 2005 or Biloxi, Mississippi without making sure these properties had federal flood insurance? You know they are crying “The Blues” now. After Hurricane Katrina, how many of these mortgage investors wished they had checked to see if the mortgaged property had flood insurance?



Typical homeowners insurance policies do not cover for such floods. The mortgagee (investor) needs to be sure they are listed as a loss payee on the homeowners policy, but when it comes to a flood those policies do not protect the homeowner or the mortgage holder. Private mortgage lenders often fail to check the flood zone of the property they are going to loan against or the property securing the mortgage they are going to buy.



There are a number of private companies out there that will do the check for you, or you can have your surveyor put the flood zone information on the survey. The appraisal also has a place to make note of the flood zone, but that is not as accurate as a survey. Sometimes, the property is at the edge of a flood zone and only a survey can determine the properties exact flood zone status.



In private mortgage investing you need to know the flood zone of the property that is mortgaged or going to be mortgaged. If the property is in a federal flood zone make sure the borrowers have the federal flood insurance in place or are getting it in place. This protects the borrowers (note signors) as well as the investor who owns the mortgage. They can get it in place through their own insurance agent. Having a survey with an elevation certificate issued by the professional surveyor may save the borrower some money on the costs of this federal flood insurance. The elevation certificate helps to measure the exact risk within a particular flood zone.



3. Third Critical Mistake: The Mortgage Investor Makes Or Buys A Mortgage That Is Not A First Mortgage.



Successful private mortgage investing is dependent on a number of important factors. One of these most important factors is known as The Loan-To-Value Ratio or LTV. The LTV formula is simply the amount of the loan divided by the value of the real estate. A $100,000 first mortgage loan against a $200,000 property is a 50% LTV ratio. A 50% LTV ratio is a typical private mortgage investment.



However, if the borrower owes $40,000 on a $200,000 house and they want to borrow $60,000 as a second mortgage interest only loan from a private mortgage investor. What would be the LTV ratio for that second mortgage? Well, it would be the same thing as the above scenario a 50% LTV. Yet, the risk for the second mortgage holder here is greater than the risk for the mortgage holder who is owed $100,000 on a first mortgage against the $200,000 house.



The problems begin for the second mortgage holder when he finds out three years later that the first mortgage is going into foreclosure. The first problem is that the borrower now owes $71,000.00 on the first mortgage. He is over 30 months behind on the first mortgage, which is also with a private investor who is charging 18%. The first mortgage holder did not foreclose sooner because they felt well secured and tried to work with the borrower to resolve the financial crises. The interest has been adding up fast.



The second problem for the second mortgage holder is the mortgagor (borrower) is counter-suing the first mortgagee because the borrower thinks the original first mortgage was not disclosed properly. Now things are dragging out for another two years. Now the first mortgage balance owed is over $100,000 with back interest, late charges and attorney fees. The borrower eventually loses the case, but the borrower decides to appeal. They lose the appeal, but now the balance owed on the first mortgage is $115,000.00. Now your $60,000 second mortgage is an 87% LTV.



Now if the mortgage investor wants to protect his $60,000 interest in the property he will have to pay off the $115,000. Need I say more? Many more risks come with making a second mortgage. As a private mortgage investor you should not be taking unnecessary risks. Pass on the deal that is a second mortgage position. The best position a private mortgage investor can be in is a first mortgage. The very experienced mortgage investors know this. Do not make the mistake others have made, always be in a first mortgage position. Read your title commitment closely. Be sure that when you close, your position will be a first mortgage and that the title insurance is for that purpose! Make sure all liens shown on the title commitment are required to be paid. Make sure these liens are paid, either before closing (with releases in hand for recording), or paid from the loan proceeds at the closing.



4. Fourth Critical Mistake: The Mortgage Investor Does Not Verify The Legal Description Of The Mortgaged Property.



This critical mistake can lead to real losses for the mortgage investor. This mistake can be the result of an innocent mistake by the property owner who supplies the legal description of the property to the mortgage lender. When a borrower applies for a mortgage they generally are asked to bring in a copy of their warranty deed or property tax statement so a legal description can be obtained of the property. This legal description is then given to the title company to conduct a search of the title to that property. The mortgage investor needs to know the condition of the title. This is routine.



Yet, this simple routine procedure can go very wrong. Consider this example. A borrower wants to use their home as security to do a mortgage loan. The borrower brings in a copy of the warranty deed to the lender or mortgage broker. The deed looks to be in order. The deed has the borrower’s name and address on it as well as a simple legal description with a lot number and subdivision name. The buyers (borrowers) and sellers’ names are on the deed and appear to be spelled correctly and the marital status is referenced, as it should be. Now a copy of this deed is given to the title company to search the title to the property.



However, the problem is the legal description is not of the property the house is on. It is the lot next door to the house. The borrower owns two separate lots next to each other and innocently picked up the wrong deed to bring in. I have seen this happen more than once. If everyone including the title company assumes the legal description brought in is the legal description of the lot the house is on, then the process could actually make it all the way to the closing without anyone catching the mistake. Have loans actually closed with this mistake? You bet they have! However, none of mine have! I know how to look for these kinds of problems.



There are a number of ways to be sure you have the proper legal description before you close the mortgage transaction. The best way is with a survey. The survey should show the address of the property along with its proper legal description, and the house will be shown within the boundaries of the lot. It is not always possible to close the mortgage transaction with a survey, so the investor must do a little extra homework.



The investor needs to go to the county records office and look at the plat map, property tax map or subdivision map and examine what lot numbers match up to the location of the subject property. For instance, a physical inspection of the house shows the house to be on the east side of the street and appears to be the third lot down from the corner of the intersection. The investor can compare the legal description given and see if that lot number in the legal description is the third lot down from the corner on the plat map or county property tax map. The investor can see the lots all have 100 feet along the front of the road by examining the map. Yet, the physical inspection of the property suggests the house is on the biggest lot on the street. This raises the question; perhaps the borrower actually owns two lots instead of one? Then a few questions to the borrower can clear this question up or a further examination of public records may show two separate deeds for the borrower. Now the proper legal for the house can be obtained for the title search and mortgage transaction. Make sure the legal description matches the subject property before closing any mortgage transaction whether you are funding a new mortgage or purchasing one. In this above case the mortgage investor may want to be sure both legal descriptions are on the mortgage.



Remember, just because there is a legal description on a mortgage you are buying or funding, it does not mean it is the correct legal description of the property. The title company researches and insures the legal description they are given. If the legal description given the title company is an accurate description of a property next door to the subject property then the title insurance will be good for that property next door. If this kind of mistake is not caught by you before closing do not think you will have recourse to the title company. The title company will not always catch this mistake and could argue they gave proper insurance on the title to the property they were asked to research.



5. Fifth Critical Mistake: The Mortgage Investor Does Not Know About Section 32 Mortgages.



Anytime a private mortgage investor or private mortgage lender, originates a mortgage or purchases an existing mortgage, they must know whether or not that mortgage is subject to the federal law known as Section 32. They also must know whether or not that mortgage is subject to the High-Cost Mortgage laws of their home state (state law). When the mortgage transaction falls under these laws the private mortgage investor must be sure the mortgage transaction complies with the rules and regulations of these laws. The sad thing is that too many mortgage investors do not even know about these laws. There are serious consequences for the original lender and buyer of these mortgages if they do not make sure the original mortgage transaction has complied with these laws.



The original private mortgage lender, also known as a hard money lender, must make the proper disclosures at the proper time, and the mortgage must have the proper clauses and restrictions these laws require. So what are the serious consequences? Violations of these laws can subject the lender (or purchaser of one of these mortgages) to liability to a borrower(s) for each transaction for actual damages. The borrower has three years from closing to challenge. The lender could lose all their finance charges. The effect is the consumer could actually rescind the loan for up to three years.



As a mortgage investor you should become familiar with Section 32, which is part of Regulation Z (The Truth-In-Lending Act). Also, become familiar with any “High-Cost Mortgage” laws of your own state. Section 32 is not a difficult provision of the law to understand, but things can become difficult for you if you do not comply with it. Remember that if you buy a mortgage that was a High-Cost Mortgage (Section 32 Mortgage) when it closed, and the Section 32 disclosures were not done or the mortgage clauses are not in compliance, you will be held just as liable to the consumer as the original lender.



For a mortgage to potentially be a Section 32 loan, the mortgage would have to be (at the time of closing) against the borrower(s) residence. Mortgages to purchase a home are not subject to Section 32 guidelines. Current federal law has two triggers to determine if a loan against the borrower(s) residence is a Section 32 Mortgage. If either trigger is met then the mortgage will be subject to the proper and timely disclosures and restrictions of Section 32. The first trigger has to do with exceeding a certain rate on the note and mortgage and the second trigger has to do with the costs of that mortgage exceeding a certain level. The rate trigger is different for first and second mortgages. Since, the prudent private mortgage investor should only be dealing with first mortgages we will look at this trigger in a little more detail. The rate trigger is determined by: when the application was taken, the yield on a U.S. treasury of an equivalent maturity term of the mortgage, and adding 8 percent to that number (10 percent for second mortgages). For instance, if the determined treasury yield were 4%, then adding 8% would create a trigger point of 12%. In this case, if the Annual Percentage Rate (APR) exceeds 12% then this would be a Section 32 loan. This is no problem as long as the lender complies with all the disclosure requirements and restrictions that come with making the Section 32 loan.



Generally, the other trigger point would be if certain costs on this loan exceeded 8% of the “Amount Financed”. The “Amount Financed” is practically always less than the “Total Amount” of the loan.



Before you buy any mortgage run the numbers and see if it was a Section 32 loan. If it was a Section 32 loan be sure it was disclosed and closed properly complying with all the restrictions of a Section 32 mortgage. This is not a comprehensive overview of Section 32 loans. It is intended to give you a primer and incentive to learn more about your mortgage investing transactions.



Disclaimer: This article is for information purposes only. It is not intended as legal, accounting, tax or other professional advice. You should seek your own professional advice from your attorney or other professional about your particular situation. There are no warranties expressed or implied in regards to the accuracy of this information.

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