The Pitfalls of Trust Deed Investing - Pitfall 2
Updated: May 3, 2021
Take a closer look at loan Underwriting.
PITFALL #2 - Loan-to-Own Underwriting Loan-to-own underwriting is pitfall number two. In this scenario, the mortgage broker focuses solely on the loan-to-value of the property. Why would a mortgage broker only focus on the loan-to-value when underwriting a loan? There are a few reasons. The first reason goes back to pitfall one, which is the mortgage is only acting in the capacity of a broker. ORGINATE, FUND and DONE could also imply predatory lender. What this means is that they determine a loan-to-value to be so low that investors imply there is no way they could possible lose money on the investment and unfortunately it is sold that way to them. This ensures the loan will fund and the mortgage broker will get paid their origination fee. Unless you understand the valuation methodology of how the loan-to-value calculation was determine many of us would not know any better than to think why not invest. Loan-to-value is a speculative determination at best prescribed by a few methodologies. Also keep in mind some mortgage brokers are governed by regulatory bodies that determine how this calculation can be marketed to potential investors. Yes, you read that correctly the governing agency may be determining the loan-to-value.
Let us discuss this further. Some regulatory agencies determine the acceptable valuation methodologies that mortgage brokers must use when marketing a Trust Deed investment. These valuation methodologies in some case only include a third-party appraisal. So, if you happen to have an appraisal completed by a less than average of first-time appraiser you may be banking your funds on their valuation. We are not here to discredit appraisers are unprofessional and not following the standard code of conduct rules to follow, but it is important to realize that every appraiser will determine a different value for the same property. Which one is accurate and how can they be different? The difference in value from one appraiser to another could be as much as 50% higher or lower. This obviously is going to have a positive or potentially negative impact on what you thought was a rock-solid investment based solely on the loan-to-value.
Aside from the appraisal what other valuation methodology was performed by the mortgage broker? Do they know something you do not? This is where you should be cautious of a mortgage brokers hidden agenda. The phrase loan-to-own has various meanings. The one you should watch out for is those that have an intent to lend on a property with the hope that the borrower defaults on their obligation, thus allowing the mortgage broker to quickly foreclose and sell the property at a significant gain to the mortgage broker, not you. To protect yourself from this happening to you, read the loan servicing agreement provided by the mortgage broker. This document should disclose the charges assessed by the mortgage broker and the use of proceeds from the sale. If the document does not clearly define this information require this information be provided to you in writing with the ability to have access to the final closing statement.
When this type of mortgage broker is underwriting the loan the most important thing to them is that they underwrite with a very low loan-to-value, because they want to take that property back. That is their goal. The broker does not focus on the borrower’s ability to pay or the exit strategy. That’s a big pitfall for you if you are an investor and the exit strategy has not been considered because all that mortgage broker is looking at is that low loan-to-value and potential back-end equity return to them.
“When this type of mortgage broker is underwriting the loan the most important thing to them is that they underwrite with a very low loan-to-value...The broker does not focus on the borrower’s ability to pay or the exit strategy"
In this situation, the mortgage broker touts that the low loan-to-value is your insurance plan so that if something goes off track with the performance of that loan that your collateralized at a low low-to-value, which is true, but they don’t focus on the borrower’s ability to pay or the exit strategy, increasing the risk for investors, rather than decreasing it. Instead, the mortgage broker wants the borrower to default on the loan so they can foreclose on the loan. They foreclose and take that property back and then on the back end when they sell the property, they will be participating in an equity paycheck. You as the investor is the one that is responsible for getting that property back, you are the one that will be coming up with the fees to pay to take that property back or hold on to that property, which means that you might have expenses that you incur along the way. That is a huge pitfall. You have all the skin in the game, not the mortgage broker. That could position you potentially, if there is a downturn in the market, for potential losses. If not, you will pay those fees upfront and then the mortgage broker will sell the property and return your fees and principle, but he will keep a portion of the equity or all the equity from the sale. That is a second payday for those type of mortgage brokers. They get paid upfront to fund the loan and then after you have paid the expenses to get your property back, they sell the property, and that equity is a second payday.