Trust Deed Fundamentals
1. Security and Loan-to-Value
The most important part of the Trust Deed Investing equation is collateral. No matter how creditworthy, wealthy or impressive a borrower is they must provide good, valuable collateral for a loan. When a borrower takes a loan, it becomes their responsibility to make the payments on the debt, (or “service the debt”). If the borrower stops making their payments, the collateral that they have pledged will serve as a source of repayment. Through the process known as “foreclosure”, the lender can force the property to be sold to recoup their investment. If the lender failed to require sufficient collateral when they made the loan, they will be in a loss situation when trying to liquidate the security to recover the loan amount.
2. Credit and Income
Many lenders look at a borrower’s credit score when attempting to determine whether they are loan worthy. There’s certainly nothing wrong with doing so, but a borrower’s credit score can’t be relied upon too heavily. Remember, everyone has great credit until something goes wrong, and just because something hasn’t gone wrong yet doesn’t mean that it won’t in the future. In the case that it does, a lender needs to have adequate security for any loans that they’ve made to a borrower to protect their investment. Private lenders should never hope for repayment. Instead, they should secure their repayment at the time the loan is made.
Many lenders consider income another good measure in determining a borrower’s worthiness for a loan. Unfortunately, income falls in the same category as credit. Although a strong income is nice to have, it can change. Especially at times when unemployment and layoffs are rampant, income can’t be counted on as a reliable measure of whether a loan will be repaid or not. What’s worse, even if a borrower continues to receive income, they don’t have to give it to their lender. If the real estate market declines and the collateral that they have pledged is worth less than the amount that they owe, the borrower may prefer to stick the money in their pocket and give the lender the less valuable real estate. See why collateral is so important?
3. Terms
The terms of a Trust Deed Investment – including rate, qualifications, prepaids, insurance, title requirements, escrows, etc.; – can vary widely. Some factors are imposed by legal limits while others are entirely negotiable. Every lender is different in their requirements, and there is generally a reason behind it. However, the most important term in a Trust Deed (or loan) transaction is the term itself – that is, how long the borrower will be allowed to use the money before they are required to pay it all back.
4. Exit Strategy
Even though we’ve properly secured our investment with a valuable piece of real estate (or two), it is still necessary to evaluate whether the borrower is likely to be able to repay their loan by the time it comes due. Even in a well secured loan, we don’t want to have to go through the process of foreclosure to get repaid (it’s a pain). We would prefer to have the borrower make their monthly payments and give our investment back when they are through using it. We examine the borrower’s exit strategy to see how likely it will be that they will be able to repay when the time comes.
Common exit strategies include refinancing, selling the subject property or other real estate, selling businesses or stocks, etc. Plenty of borrowers run into situations where money will be available in the future, but their need for it exists right now. As private lenders, we are happy to bridge that gap in time if the borrower has a good exit strategy that will likely give them the ability to repay.
5. Get in Line – Security Positions
Just because a lender makes a loan that is secured by a piece of real estate doesn’t mean that they are the only ones to have done so. When there are multiple lenders utilizing the same property as security for a loan there is going to be more than one Trust Deed issued for the property. Most commonly, there will be a first and second deed of trust. What this means is that the lender that made their loan first (the 1st DOT holder) has a priority interest in the asset that comes before the 2nd DOT holder. It is extremely rare for Crawford Real Estate Services, Inc. to originate a 2nd Deed of Trust for their investors.
6. Other Considerations
There are other things to consider with Trust Deed Investing. However, they’re not nearly as grand in scale as property securing your loan. Most lenders hire outside professionals or have specially trained individuals on staff to handle these items. Here is a brief touch on a few of those items.
- Insurance: Lenders must be sure to properly insure their interest in the collateralized property. Both title and hazard insurance are necessary in every transaction.
- Licensing: Certain types of loans require lender licensing. Laws vary from state to state and every lender should understand licensing requirements before making any private loans to ensure that they are operating within state and federal laws.
- Due Diligence: Performing due diligence on a property and on a borrower can require a significant amount of time and energy. Unless your prepared to take on another full time job as a lender, these tasks are better left to the professional’s.
