What is a deed of trust, you ask? Well, an ordinary deed is the document that transfers ownership of real estate. By contrast, deeds of trust are private mortgage loans secured by real estate. So the property is held as collateral. So basically, you become a private lender when you choose to invest in trust deeds. In essence, you are the bank and you are lending to a qualified borrower. Eventually, when the loan is paid off, the deed of trust is honored and the title is returned to the borrower. You earn money from the interest charged on the loan or deed of trust, but more on that later.
So, we are talking about buying land or property and allowing the lender to hold temporary title to the property until the terms of the mortgage or loan are met. It’s an investment device used by “hard money” lenders who are actually mortgage brokers, helping people buy real estate, who can’t go to a traditional bank for “soft money.” This could be for a variety of reasons, including bad credit, a new job, other loans, bad debt, or any other factor the bank deems problematic. So they use one of these other lending businesses, but they will typically only lend up to 65% of the appraised value (LTV or loan to value) and for a short term, say 1-3 years.
Let me paint a simple scenario. Fred wants to buy a property in his city. It’s worth $100,000. He only has a few weeks to close the deal and he needs the money fast. The local bank told him it could take him a month to close and also, due to a recent divorce, his credit is questionable. So he goes to ABC Funding, which is a hard money lender. They tell you they will do a quick screening and background check. The next day they explain that they can offer you $60,000 LTV for 18 months with 12% financing, plus 4% of the loan amount for points and closing costs. They also want a personal guarantee letter to further secure the loan. In other words, if he doesn’t pay, they can sue him personally. Also, there are big late fees and if even one payment is missed, they have the right to foreclose on the property and sell it at auction. Wow.
So why would Fred agree to such harsh terms? Because he only needs the loan for a year before he can remodel the mall and then start earning good money from the rents. Even paying the $60,000 plus $2,400 in fees (4%) and another $7,200 in interest (12%) for the year, he’s way ahead once the mall pays his rent. He knows that no bank will touch him, so he says yes right away. He signs the paperwork, a deed of trust goes to the lender, and Fred gets the financing. Now this is where investment comes in. Where do you think ABC Funding gets its money to lend to Fred? Well, it comes from private lenders.
That could be you, me, a local business owner, or any other investor who wants to earn 12%. That’s right; the lender receives the interest payment from Fred each month. ABC made its profit from the points or fees that are part of the 4% charged up front. So the private investor, say Harry, gets to keep the deed of trust in exchange for the $60,000 they gave to ABC, which they then pass on to Fred. It’s a good deal for everyone, right? But I see you shaking your head. What if Fred doesn’t make the payment, then what? Well, let’s take a look at that possibility.
First, Fred receives a warning that he is 10 days late. Then he gets another warning at the 30 day mark. They tell him that if he doesn’t make the payment within 24 hours, the property will go into foreclosure and be sold at auction. In the worst case and Fred doesn’t pay, the property is now owned by the lender. That would be Harry, the private investor, who now owns the deed of trust. Harry has a commercial broker sell the property at a substantial discount, say 20% for a quick sale. Still, since the loan was only for 60% of the appraised value, there’s plenty of room. The property costs $80,000, less commissions, and Harry gets $75,000. However, he only lent $60,000 for one year and now receives a profit of $15,000 or a 25% return on his investment. That’s even better than the 12% Harry was getting at the start.
While no one wants this to happen and it usually doesn’t, this explains what can happen in a severe case. In the worst case, the property never sells and Harry, the investor, loses everything. That is almost impossible due to the greed factor. Someone will snatch up a property that is severely undervalued every time. Under normal circumstances, all payments are made, the loan is repaid, and the deed of trust is returned to the borrower. Later, Harry lends the money back to him. Do you think you understand all that now? If not, please reread the above. And yes, this is a simplified example, but the concept is sound regardless of the amounts and percentages involved.
Finally, you may be wondering, why am I telling you all this? And no, I’m not a hard money lender. Instead, I’m doing this as a public service because I realize that 12% with almost no risk is a better return than stocks, bonds, and money market accounts. Many annuities promise only 6%. But if you have $50,000, your normal minimum, or more, you may want to consider investing in a trust deed. Remember that you are insured by the property and you receive a monthly check. You can even use your IRA money from a self-directed LLC account. And yes, at that rate (12%), your money will double every six years. It sure beats worrying about the market day to day like you used to. I say that because I recently became a trust deed investor after losing tens of thousands in the market. Sounds familiar? And that’s why this is the last thing your stockbroker will discuss.
