Over the years I have watched more private loans fail for want of underwriting than for any market reason. A newer lender usually has the capital, the deal in front of them, and a borrower in a hurry. What they lack is the method a bank credit officer spends years learning before signing off on a loan of any size. Underwriting a private money loan is that method, run by one person instead of a department.
What does it mean to underwrite a private money loan?
Underwriting a private money loan means forming a reasoned view of the borrower and the collateral, testing that view against the structure of the proposed loan, and deciding whether the deal is worth funding on the terms offered. The checklist is a tool inside that judgment, and completing a form is not the same as underwriting. The book puts it plainly: “Underwriting is a structured judgment process applied consistently to every deal, in which the lender forms a view of the borrower’s character, capacity, and collateral, tests that view against the structure of the proposed loan, and decides whether the deal is worth doing on the terms in front of them” (The Mad Lender’s Guide to Private Lending and Note Investing, Chapter 2).
Inside a bank, a credit officer runs a set sequence on every deal. The credit officer tests the deal against policy, scrutinizes the assumptions in the underwriting, and asks what happens if the borrower’s income drops, if the collateral value drops, if a construction project runs over, or if the takeout financing falls through. Private lending has no separate person playing that role, so the same sequence has to run inside the lender’s own head or it runs nowhere.
I saw the cost of skipping it early in my banking career. A well-connected board member and referral source brought a borrower in and expected the loan to close because he had walked the borrower through the door himself. The file did not qualify, the bank declined, and the board member funded the loan with his own money and lost it. He had capital and conviction. What he did not have was credit training, and the distance between holding capital and running a credit operation cost him the loan.
How do the Three C’s apply to a private loan?
The Three C’s are Character, Capacity, and Collateral, and a private loan gets judged against all three before funding. Character is the broadest of the three. It covers how the borrower has handled credit and obligations over time, and credit history sits inside Character rather than standing as a separate category. When a borrower presents well in person but has never paid a bill he took out, that is a decline, because a polished manner is a signal and not the record. Reading that record the way an underwriter reads it is its own skill, covered in How to Read a Credit Report Like an Underwriter.
Capacity is the borrower’s demonstrated ability to service the loan from documented sources. Not the rent the borrower expects to collect, but income and cash flow the lender can verify. Collateral is the asset securing the debt, valued honestly and documented so that it holds up in default or workout. A value the borrower supplied is a starting point, not a verified number.
How do you run the LTV and debt-service math?
Run two numbers before anything else: the loan-to-value ratio and a debt-service coverage check. Take a rental property with a verified appraised value of $400,000 and a requested loan of $260,000. The loan-to-value ratio is $260,000 divided by $400,000, or 65%. Structure the note as interest-only at 10%, and annual debt service is $26,000, or $2,166.67 a month. The property rents for $3,600 a month, which is $43,200 a year. Subtract $12,000 in annual operating expenses for taxes, insurance, and maintenance, and net operating income is $31,200. Debt-service coverage is $31,200 divided by $26,000, or 1.20. The property produces $1.20 of net income for every $1.00 of debt service, and coverage at or above 1.20 gives the loan room to absorb a vacancy or a repair before the borrower has to reach into his own pocket to make the payment. Where to set the loan-to-value line for a given deal is its own question, covered in What LTV Should a Private Lender Require.
What are the five gaps that sink private loans?
Five gaps account for most private loans that go bad, and each traces back to a step the lender skipped before funding. The first is underwriting the property and ignoring the borrower, which skips Character and Capacity. The second is accepting a value the borrower supplied instead of verifying the collateral. The third is documents that do not say what the lender assumed they said, so the structure fails when it is tested. The fourth is a senior lien or title defect ahead of the lender’s position that no one checked for. The fifth is no monitoring after funding, so a problem that was solvable early surfaces late, once the options have narrowed.
What does a written verdict look like?
A written verdict is a short underwriting memo that records the decision, the terms, and what the lender is relying on to be true. It names the finding on Character, Capacity, and Collateral, states the loan-to-value and coverage figures, lists the conditions of approval, and sets out the failure modes the lender considered and accepted. A decline gets the same memo, because no is an answer, and a documented no protects the next decision the lender makes on a similar deal. A written verdict also creates a record of how the lender has thought about past deals and gives a second reader something to review before funds go out, which is the habit that keeps a loan file usable when a borrower stops paying, the subject of The Loan File That Survives a Workout. When a lender wants a second set of trained eyes on a file before funding, that is the Deal Review I run.
Doug Smith is the author of The Mad Lender’s Guide to Private Lending and Note Investing and the principal of The Mad Lender.