Common private loan documents and why they matter
Private mortgage lending has one fundamental advantage over banks and other traditional financing institutions: its flexibility. Not only are private loans outside of the purview of the OSFI (Office of the Superintendent of Financial Institutions); they are also unshackled by rigid bank requirements and red tape.
Some private lenders (mistakenly) take this independence to mean that they don’t have to draw up any real paperwork and that they can simply rely on how good they are as judges of character when it comes to assessing whether or not they’re going to make their money back. You would be surprised how many private loans have fallen through based on no more than a homemade, handwritten document—and sometimes not even that.
However, not only are the risks huge when this excessively lenient approach is put into perspective; forgoing proper documentation also does the deal’s potential a great disservice. Opportunities are lost, time is wasted, and partnerships are ruined unnecessarily.
Private mortgages can yield high returns, but you need to employ prudent measures to optimize your capital and chances of success. Professionalizing a private lending business through excellent underwriting practices is paramount to responsible and profitable investing. Proper documentation is necessary at every step of the lending process and requires the legal expertise of real estate lawyers.
While private mortgage lenders may have different requirements based on their own unique criteria, there are some documents that prudent dealmakers consider to be the bare minimum.
True to its name, a promissory note states a borrower’s promise to repay a loan owed to a specific person or entity. This written record, signed by the borrower, makes the obligation legally enforceable and outlines the deal’s basic terms, like the principal, interest rate, and payment schedules.
Deed of trust or mortgage
In terms of securing the loan, this is arguably the most important document a lender must require. While the equitable title remains with the borrower, the deed of trust transfers the legal title of the property to a trustee, who then holds the collateral as security for the loan. Once the debt has been fully paid and the deal completed, the lender must instruct the trustee to release the property back to the borrower through a legal process called “reconveyance.”
The mortgage, while it is more commonly used interchangeably with an amortized home loan or debt, is actually a document collateralizing the asset. Unlike a deed of trust, the borrower gives the mortgage directly to the lender, bypassing the need for a third party.
The borrower is referred to as the trustor in a deed of trust and a mortgagor in a mortgage. In both documents, however, the lender is called the beneficiary. Should the borrower fail to meet his/her obligations, these documents will grant legal rights to the lender and permit them to foreclose on the property.
Issued by a title company, the title insurance is issued after the property’s records are scrutinized for any mistakes, omissions, fraud, and other abnormalities. The seller, for example, may have failed to disclose an active lien on the property, rendering it un-viable as collateral. Consequently, the mortgage would also become unenforceable. The title insurance protects both buyer and lender from expensive incidents like these, and while this document is optional for the former, the latter must make it mandatory in order to manage the risks associated with the loan.
In practice, any costs incurred in the acquisition of the title insurance are shouldered by the buyer.
Many novice lenders often gloss over the need for property insurance, especially when most of the loans they issue are short-term. More experienced investors, however—especially those who have experienced the difficulty of liquidating a damaged house—will understand that property insurance hedges against the added risks of force majeure.
There are many types of property insurance, and policies will differ in both coverage and face amount. Fire and liability insurance is considered reasonable for a private mortgage. Damage from mould, earthquakes, sewer back-ups, floods, and other water-related phenomena are usually not covered by regular policies. Insurance for this type of damage must be purchased separately or as a rider to an existing policy.
As the private lender, you will determine which specific policies you will require. For example, if you know that the asset is located in an area that is prone to monsoons and floods, you may want to require insurance for water damage, even though such a policy is less common and may cost the borrower more.
These four documents should be mandatory for every private mortgage deal you enter into as a lender. It is your prerogative, however, to require other paperwork. Some lenders, for example, may prefer a more extensive loan agreement to a promissory note. Other relevant documents are the power of attorney, which authorizes a representative to act on the borrower’s behalf in the event that the latter is incapacitated; deed of reconveyance, which the lender issues to certify that the borrower has been released from the debt; the sales contract between the buyer and the seller; and a survey, which is costly for the lender who orders it but may provide valuable insights as to the viability of the collateral.
It may be arduous for an independent mortgage investor to collect all these documents, and for these reasons, they work with companies like CLI (Canadian Lending, Inc.) who have a dedicated underwriter department that handles requesting / reviewing and validating all required documents.