Friday, August 30, 2013

Buying Loans from Other Lenders

Buying existing loans is a popular way to invest in loans without all the paperwork and screening that comes with loan origination. Many lenders work closely with a business that originates loans, cherry picking their favorite loans from the loans the business is looking to sell. Most commonly, I’ve seen this with car dealerships, but it’s also very common with mortgages, personal loans, construction loans, and many other types of loans. If you are considering purchasing existing loans here is some information to help you get started.

Purchase price isn’t necessarily the principal balance on the loan.

The loan may have a face value of $4000, but you might buy the loan for $3000 or $4500, depending on various circumstances.  Most commonly, a loan will be priced higher if the rate on the loan is higher than the current industry rates.  You might pay $4500 for that $4000 loan if it’s at an interest rate of 12% where currently, an equivalent borrower would be able to get a loan at 8%.  You pay a premium for the extra profitability.  If the borrower is very well qualified, stable, and pays exactly as scheduled you might pay a little more than the principal balance for the loan.  Paying more than the balance is common in the mortgage loan market.  Prepayment penalties are frequently written into loan agreements to ensure mortgage buyers will recover the premium paid for the higher interest rate even if the borrower repays the loan suddenly – for example, by refinancing.

Loans at a discount often come from businesses with internal financing available.  A car dealer might only have $3000 “invested” in a car that the borrower borrowers $4000 against when they buy it.  The dealer only needs $3000 to make that sale profitable, and might sell the loan for $3000 even though the principal balance is for $4000.  Also, if a loan has a rate below the prevailing market it may sell for less than the principal balance.  A loan at 6% will cost less if you could make a new loan at 10% with your funds instead.

Purchase price affects the amount of taxable income you have from the loan.  (Discount Earned)

If you make the loan and service it to maturity, your taxable income is the interest plus any fees you charge.  If you buy a $4000 loan for $3000, the extra $1000 in payments you receive that are labeled “principal” must be reported as taxable income.  This taxable income is called the “discount earned”.  As the payments arrive on the discounted note, the extra profit is taxable income.  Loan servicing programs like Moneylender Professional will be able to track the discount earned on a loan and help you report your income accurately.  In this example, by the time the borrower has paid the balance down to $2000, you’ll have earned $500 against the discounted purchase price.  The discount earned must be tracked and added to taxable revenue for the entire period of ownership, whether resold or paid off in months or years.

Loans can be traded like commodities, but require consistent servicing to retain their value.

When investing in loans, unless your strategy is very short term, like many originating banks that sell mortgages before the first payment is actually due, you’ll need a mechanism to service the loans and keep them productive to retain their value.  A loan with late payments or problematic payment histories is worth less than one with all payments on time.

Purchasing a loan and subsequently servicing it poorly will deteriorate the resale value of your investment.  On the other hand, purchasing troubled loans and rehabilitating them into good standing and consistent payment can drastically improve the resale value of the note, just like buying and fixing houses.

Loans can be sold individually or in bundles.

For many private lenders, loans are bought individually.  Deals are often made between acquaintances or friends, and negotiated one loan at a time.  The majority of the users of Moneylender that buy loans rarely buy more than a few loans at a time.  Very well funded investors, however, might purchase loans in bundles.  It’s a good way to transfer many loans at once, hundreds or thousands of loans might be bundled into a single sale.  Similar to group health insurance, there may be a majority of healthy loans with a few sub-par notes peppered in.

Hopefully this brief orientation to loan resale and marketability has helped clarify a little bit about the resale value and tax implications of purchasing loans.  While researching this article, I found these easy-to-read articles on ehow.com about mortgage resale.  Check them out if you want more information.
(I disagree slightly with how they suggest doing business in this last one, but that’s probably because I’d prefer to service the notes directly.)

Friday, August 9, 2013

Internal Funding vs. Bank Backing vs. Investor Backing

Of all the lenders I’ve talked to who use my loan servicing software (Moneylender Professional), there are three underlying financial structures they typically use for lending money.  I’ve personally done a few loans that were internally financed and a couple that were investor financed.  There are advantages and disadvantages to each.

Internally Funded Lending


The simplest system for a lender is to loan money that the lender has on hand.  “I have $10,000 in my bank account, I’ll give it to you and you pay it back with interest.”  The main advantage is that you can control everything.  There’s no one to be accountable to except yourself (and the government, of course).

If the borrower defaults, files bankruptcy or just refuses to pay you may be forced to write off the loan as an uncollectable debt.  The money you loaned out is off earning you interest and as it trickles back in, you’ll be able to make new loans with the principal and interest but it’s going to take a while.  You accept the full risk of the loan and your funds are tied up for the life of the loan.

Bank Backed Lending


If your meticulous accounting can afford you the good graces of a bank with cash to invest, you might be able to set up a master loan at a lower interest rate and pay this money out in smaller loans at a higher interest rate.  For many businesses with a track record of reliability and financial health, especially ones that sell an expensive product, this is a viable option. 

As an example, a bank will set up a revolving line of credit you can use to pay yourself when someone buys your goods.  In turn, the customer takes out a loan from you which you use to repay the bank.  You make one payment to the bank at a fixed interest rate and receive several payments from borrowers which include the bank payment and a tidy profit for you to keep for yourself.

The huge advantage is that you can grow your loan portfolio very quickly, and banks typically have relatively massive lending power that you can tap into.  In conjunction with a business, this can mean a major increase to overall profitability as sales also increase because of the available funding.  Little cash on hand is required to make new loans because the bank often covers the full principal disbursal.  With bank backing and well qualified borrowers sufficiently available, a seven figure portfolio is right around the corner.

If a loan goes bad and is irrecoverable, hopefully the other loans will still cover the cost of the payment to the bank.  You’ll be completely on the hook for any debts that go bad, and ultimately, you are the one who borrowed the money from the bank and have to ensure it gets repaid.  Banks typically require frequent, detailed updates on the heath of your portfolios.  You may be reprimanded or have your available funding reduced if the bank is unhappy with your portfolio’s performance.  Banks are often less flexible with the structure of the loans, so you’ll usually be making standard fixed-term loans to your customers.  You’ll be blessed with rapid growth, but cursed with liability and leverage when things don’t go perfectly.

Investor Backed Lending


This is perhaps the most common among users of Moneylender Professional. Finding investors willing to purchase your loans might prove to be a challenge, but if you can do it, you’ll have access to lendable capital while offloading the liability of loan performance onto someone else. 

A loan can be made to a borrower with funds on hand.  The loan is then sold, either at full price or a discount to an investor.  If you loaned $10,000 at 15% and then sold the loan for $10,000 at 10%, you’ll be able to service the loan, making 5% on the balance without any actual cash out of pocket.  The investor’s $10,000 for the purchase of the loan is immediately available to lend again.  Also, if the loan goes bad, the investor is saddled with the risk instead of you.

Essentially, you’ve become a loan servicer – collecting 5% interest on a balance that’s not your money anymore.  You originate loans and service them, but the risk falls to the investors that own the individual loans.  Obviously, no savvy investor would just throw their money away, so most of the people I know that do this sort of origination/servicing/resale business have engineered the loans for multiple profitable outcomes that benefit both lender and investor.

To sum it up:

Internal Financing
  • Slow growth
  • Full liability for each loan
  • Total control


Bank Backing
  • Rapid growth
  • Overall liability for portfolio performance
  • Careful scrutiny
  • Limits on how loans can be structured


Investor Backing
  • Rapid growth
  • Minimal leverage / liability if a loan fails
  • Moderate oversight usually required
  • Flexibility in business structure for greater profitability

Friday, August 2, 2013

Tips for Getting Started as a Lender

Note, this article is talking about lending in the United States of America. If you are located in another country, the rules may be totally different (or nonexistent).

Investing in loans can be a very profitable and effective business. State and Federal laws affect what a lender legally can and can’t do, and licensing fees may apply in a variety of situations. Here are some pointers to help get you started on the road to profit.

Banker’s Licenses, Lender’s Licenses and Exempt Lending

The licensing fees to become a lender can be pretty steep, especially for a small lender. Many states require any business that advertises itself as a lending business have a license as a lender. Payday loan companies, mortgage lenders, and personal loan companies will usually have to obtain a license to make loans in any state where they do business. The fees and bonds required that I’ve seen are usually around $10,000 annually for a banker’s license and around $2,500 for a regular lender’s license. Some states will also require proof of credit from a bank in the ballpark of $100,000, or proof of personal or business liquid assets in the same ballpark. If you’re seasoned, this is fine. If you’re getting started without major financial backing, this is probably going to sink the ship.

There’s usually an exemption to these requirements if you offer financing for goods or services you provide. This applies to in-house financing for car dealerships, in-house financing on furniture and appliance sales, retail store lines-of-credit, or financing on the charges for any kind of service provided. If you have an existing business, you can become a lender to your customers by offering in-house financing on their purchases. This is a great, low-cost-of-entry on-ramp for lenders that have some other business they can use to build a healthy loan portfolio.

Getting Credit Reports

Credit reports are critical when determining if a borrower is creditworthy. Each of the major credit bureaus has a variety of avenues for obtaining credit reports. Pick one or more bureau (TransUnion, Equifax, and/or Experian) and enroll in any of their programs for accessing consumer credit reports. Prices can range from $15 to $35 per report (or more) and there are lots of extra features the bureaus provide which may be suitable depending on the nature of your loans. Because the information they provide is the holy grail of identity theft, you’ll have to demonstrate your legitimacy before they’ll share consumer data. Once you’re enrolled, you’ll be able to access credit scores and credit reports through their websites.

Submitting Credit Reports

It’s not mandatory that you submit the loan details to credit bureaus, but it will add leverage to your position as the lender and help other lenders make better decisions when loaning to your borrower. Loan servicing software like Moneylender Professional is able to generate the Metro2 formatted data required by the credit bureaus. You’ll need to set up accounts with each credit bureau to submit data. Some lenders only submit to one bureau but most large lenders submit their data to all three. You can decide where you’re at and what submission rules you want to use for your business.

Finding Borrowers

If you’re doing in-house financing, you already have a source of new borrowers to work with. If your business is exclusively a lending business, finding borrowers can be challenging. Many lenders buy loans from other businesses. Depending on your state, you’re probably required to obtain a lender license if you want to buy and sell loans. You can contact banks, credit unions and other lenders to see if they're interested in selling loans to you. In addition to standard advertisements across whatever local media is available, contacting local retailers of large purchase items like cars, trailers, boats, ATVs, appliances, furniture, farm or industrial equipment, home improvement supplies, musical equipment, artwork, medical equipment, etc. is a good way to create relationships that bring in new borrowers.

Make sure your borrowers are well qualified before giving them your money!

If you’re making mortgage loans, this article is probably waaaaay beneath you and you’re already up to your elbows in regulations, paperwork and the mortgage market. (Or you did an owner-carry back, which is great and you’re not probably going to be making many other loans anyway!)

I hope this info was at least a little helpful for anyone looking at starting a lending business. Obviously, there’s a lot more to it than this. Read and understand your local laws – violations are often a criminal offense! 

Was this article helpful? 

Post your opinion in the comments.

Friday, July 26, 2013

Structuring Agreements for Profitable Outcomes

Risk is inherent in lending money.  Creative risk mitigation can help to ensure profitable outcomes.  Smart lenders design their loan agreements to ensure profitability in the face of excellent and terrible borrowers alike.  The interest rate and term of the loan is just the tip of the iceberg for a well designed, profitable agreement.

I chose this topic for an article after rereading the marketplace performance statistics at Prosper.com.  Even beyond my skepticism about their reports and the mathematical correctness of the figures, the outcomes are dismal.  Only the most well qualified borrowers yield a return over the lifetime of the loan – and them at a whopping 4%.  The overwhelming majority of loans end in a net loss.

Meanwhile, the hundreds of lenders I've talked to are reaping consistent returns – from modest to staggering.  One of the main differences between lenders using my Moneylender Professional software and lenders on Prosper.com is that professional lenders carefully engineer their deals to maximize profitable outcomes.

Profit opportunities can be built into the agreement to offset loan underperformance.  Common among users of Moneylender Professional, several tactics allow smoothing out less-than-optimal repayment:

Late fees and collections fees – Lenders can customize the fee structure to penalize late payments to the point that, aside from total loss, an overall profit is recovered when a loan becomes delinquent.  In addition to the standard late fee, additional fees are assessed for collections calls, collections letters, and visits to the borrower’s residence.  Fees that offset activities are added if the accounts become sufficiently delinquent to merit legal action, fees which must be repaid to reinstate the loan.

Seizure and repossession of collateral – Very common in the automotive and mortgage lending industry, and popular with personal loans, is securing the loan against one or more assets.  If the loan underperforms, the asset can be used to offset the unpaid balance.  For lenders with their fingers in multiple businesses, acquiring and reselling an asset multiple times leads to higher profitability than if the loan performed as agreed.  Underperformance is designed to be more profitable than performance.  That’s a smart way to turn risk into a cash factory*.

Secondary borrowers – If the borrower doesn't pay the loan, having a second borrower on the line to ensure timely payment is a great tool for sustaining the profitability of each investment.  Underperformance by a less qualified borrower becomes the interpersonal burden of friends or relatives who were willing to accept that burden when the loan was made.  Cash flow is only interrupted long enough for the lender to exercise the option of the secondary borrower and then repayment resumes, and fees typically recover the cost of the interruption.

Default rates – When a payment is late or missed one or more times, it is common that the loan changes to a higher interest rate.  Usually this rate is temporary and might last for three months to a year after payments resume timely arrival.  Adding default rates to an agreement allows lenders to recover the expense of an interruption to cash flow.

There are always ways to ensure profitability for the creative lender.  In each type of business, there is something unique that can be leveraged to reduce or offset the cost of underperforming loans.  Assess your situation and your borrower’s situation and look for ways that a loan might fail and what can be done to ensure profitability in those cases.  With a little practice, savvy lenders can engineer their agreements for consistent profit with little risk of loss of capital.

These may seem like ugly options.  We’re talking about borrowers that overestimate themselves and leverage too much.  For anyone trying to succeed as a lender, be it for a business, retirement, or other reasons, they have an obligation to ensure they don’t shackle themselves with the burden brought to them by their borrowers.  Lenders should not be the unwittingly charitable financiers of other peoples’ wants or ventures and it’s important that they protect themselves from becoming so.

On the flip side, you may be able to offer well performing borrowers with special benefits which they appreciate while adding to your profit.  Well performing borrowers have demonstrated their creditworthiness, so it makes sense that a good lender would offer credit to such a person.

Skip a payment and “add it to the end of the loan” – The holiday season is a great opportunity to increase profit in a way that borrowers appreciate.  Allowing a borrower to skip the payment for December or January in exchange for a new payment amount which corrects for the accrued interest is a great way to make a mutually beneficial profit on an existing, well-performing loan.

Loans are a fascinating investment, and they’re becoming increasingly popular.  By thinking on your feet and lending money under agreements that maximize the likelihood of a profitable outcome, you can grow your portfolio and ensure the productivity of your invested capital.

* I am personally against exploitative lending practices.  I've learned to have discipline by buying and losing several things at great personal expense.  The experience of financial struggle and loss has taught me to temper my purchasing behaviors.  I was a qualified borrower who underperformed and was subject to many of the measures I describe above, and I only had myself to blame.  I've seen it from both sides.  Caveat emptor – consumers are responsible for knowing what they can afford; it’s not the lenders job to decide if the buyer is making a good decision.  When I wanted a car and presented evidence to the lender that I could repay the loan, it is hardly the lender’s fault when my naiveté in business led to total insolubility.  It was a relief when I surrendered the car; having that repossession clause in the loan led to a win-win outcome.