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.

When is it Profitable to Sell Mortgage Loans?

How Do Mortgage Companies Buy & Sell Loans?

How to Buy & Sell Mortgage Notes

(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.)

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

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! 

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