To Collect or Not to Collect: The Great Payment Debate

                 Flexibility and the lack of rigid standardization is considered an attractive benefit of private lending as an investment tool. The ability to choose your loan opportunity and design rates and terms around your own personal risk and investment needs, within legal and ethical responsibility, gives a level of autonomy not always afforded by other investment strategies. For example, you could purchase a rental to own, but the market will determine how much rent you can command. Yet, with private money lending, you could potentially lend on a rental and charge whatever interest rate legally allowable that you and the borrower agree upon.

            The high degree of subjectivity in private lending can be both burden and blessing. The sheer volume of options available to a lender can be stifling and intimidating for those who have difficulties making decisions. Over time, experienced lenders can set more structure to their loan terms, but this takes time and knowledge on what works, and probably more importantly, what hasn’t worked in the past.

           Many active investors (aka borrowers) have a laser focus on the annualized interest rate of the loan, often ignoring some other rather important aspects to the loan that may have more benefit to them as an investor. For example, origination points, other lender fees, vesting requirements, and length of the loan are all crucial parameters to take into consideration and are determined completely by lender preferences. One point of debate in private lending circles is personal preference on frequency of payments, which almost always tend to be interest-only on short-term, business purpose loans.

          For simplicity, we will assume there are three options: monthly interest payments; deferred interest and prepaid interest. These three schools of thought often work under very different circumstances. For example, a lender may feel there is more work in bookkeeping and accounting to have monthly payments coming in, especially for very short loans that are measured in months as opposed to loans that are 12 months or longer. Servicing may not be an option for loans that are only three to four months in length, as many servicers have some backlog of loans to get set up in their systems. By the time a servicer gets to collect the payments, it is time for a payoff demand, and some servicers can take weeks to get that ready.

          The idea is to create loan terms that sets up the lender and the borrower up for success. Let’s look at these three common ways to address interest for the loan in more detail.

Monthly Interest-Only Installment Payments

          The first one we will discuss is the option most investors and individuals are familiar with, monthly interest installment payments. This is where the borrower is required to provide a monthly interest-only payment to the lender each month the loan is active until maturity, or when the borrower is ready to pay off, if sooner than the intended maturity date. Interest is paid in arrears, meaning that you pay for the previous 30-days of interest accrued. For example, in May, you would receive interest payments for the month of April.

          If you prefer interest payments it is important to review the amount of capital the borrower has before closing to be sufficient to cover carrying costs. Then compare the amount of capital they have for renovations, adding in interest payments while the borrower is holding your private loan. 

          There are several benefits of requiring monthly payments as the lender. Monthly payments allow for early detection of problems, which can offer a lender a way to begin a discussion with a borrower. Requiring a monthly payment offers a way to discuss the project and offer earlier interventions to solve problems. Monthly payments allow a lender to know if the loan is defaulting much earlier than when the loan is coming due, allowing for potential alternatives to be pursued such as refinancing the loan, collecting default interest, deed in lieu, or paying for extensions if they were written into the loan documents. Monthly interest income can also be used as recurring cash flow to supplement a lender's cost of living.                    

          In addition, showing a track record of payment by the borrower makes the loan potentially an asset that can be sold as a performing loan. Should you need to be recapitalized quickly before the maturity of the loan, showing consistent and timely payments may allow a lender to garner a higher amount at the time of sale. 

          Loan servicing can be set up to handle collection and disbursement of the monthly payment according to directives given when setting up the loan with the servicer.  This may be helpful to lenders who do not want to worry about a check arriving in the mail while they travel, or if there are multiple partners on one loan and each partner is entitled to a certain percentage of the interest being paid. Loan servicing companies also traditionally handle statements such as 1099-INT's showing collection and payment of interest, which is a great benefit come tax time. 

          Like everything else, there are downsides of the monthly interest installment payments. The lender may worry about monthly payments being made on time, especially if the lender needs those payments as income. Some lenders may not want that hassle or worry, especially if the loan is a short duration. Borrowers may be facing greater challenges with cash management for a project that requires significant renovations. Even moderate renovations cause the borrower to hemorrhage money for the first few months as supplies and the heavy lifting of updates happens. Assessing if the borrower has access to adequate  capital reserves for renovations and payments upfront might filter out a good borrower who isn’t as liquid as you would like because of the amount of capital you are underwriting for the borrower to have upfront, even if it’s just two or three months of a payment being required.

Deferred Interest Payments

          The next option a lender could consider is deferred interest installments. This option does not require the borrower to make monthly payments and will pay all interest owed when the loan is paid off in full. The most common scenario for this would be a fix and flip loan where the property would be put up for sale in the near term and the interest payments, along with principal balance balloon payment, would be paid out of escrow at the close of sale on the property to a retail buyer.

          The largest determining factor for many lenders on whether they will allow interest to be deferred until the loan is repaid usually comes down to the length of the loan and how comfortable the lender feels about the borrower and the project. Interest that rolled into the loan payoff usually happens with shorter loan terms and in lending situations where the borrower and lender have history of successful deals together.

         As a side note to those lenders who allow the interest to be deferred, they generally charge a flat interest fee or just collect interest for the number of days the loan is outstanding. Very few lenders build into their loan terms a compounding interest term for loans that do not have 30-day payment schedules. For example, if the loan had compounding interest, there would be a higher amount of interest at the payoff, as opposed to just simple interest charged on a daily basis that many lenders do for having loans without monthly payments. The method for calculating the interest due at the time of payoff needs to be clearly outlined in the promissory note for the loan. It is especially important in these cases that borrower understands all the loan terms, including the possibility of interest compounding.

         There are a few benefits to the lender and the borrower with the deferred interest option. Lower bookkeeping requirements result from this option. This can mean less time spent by the lender tracking down interest payments and accounting for the monthly payment. The borrower also has one less aspect to the property to worry about monthly, which may be highly appreciated by the borrower as they manage the active project through renovations and potentially tenant screening or sale of the property. Remember the goal is to try setting up loan terms that are a win-win for both lender and borrower.

       The downside of deferring interest payments until the end of the loan mostly center around not being aware of problems in a timely manner, but there are a few other implications to consider before offering this option to a borrower.  If the lender doesn't require monthly interest installments, the lender may not be able to identify issues with the project early on if there are not expectations of communication established between lender and borrower. If there isn't a loan payment to be made, collecting ancillary fees for things like late charges or default interest may not be possible. Depending on the wording in your loan documents and usury limits of your state, there may be a possible substantial increase in the default interest rate. While no lender should go into a loan intending to have a borrower default, this additional interest can increase the rate of return for a loan made by a lender.        

          Another consideration to this option is increasing your loan to value above the initial loan amount over the term of the loan may eat away at the healthy equity buffer a lender perceived to have at the beginning of the loan. As interest owed accumulates, there is a chance that asset devaluation happens in the market or the borrower defaults on the loan at a time when the as-is condition of the property is less than the outstanding balance with the added interest.

Prepaid Interest Payments

           The last option available to a lender is called prepaid interest or sometimes known as prepaid interest reserves. This method requires interest to be paid upfront, negating the need for monthly interest payments. Prepaid interest can be handled in a variety of ways, but the simplest is to have the interest payments taken out of the total loan amount. For example, if your loan amount is $100,000 and the borrower is paying 12% interest for 6 months, then the lender will less $6,000 in interest off the top of the loan and net fund the borrower $94,000 at closing – minus any other fees and closing costs, of course.

          In this scenario, the final balloon payment would be $100,000. The benefit to the lender is getting a slightly higher rate of return than 12% annualized rate because the money that is essentially coming out of the lender’s pocket is only $94,000, not the full $100,000. The $6,000 difference will be interest that is earned with each day the borrower has the loan outstanding. If the borrower repays the loan before the prepaid amount of interest has been used, it can be credited back to the borrower at the refinance or sale of the property.

          It may be surprising but there are benefits to both the borrower and the lender if the prepaid option is chosen for a particular loan. From a borrower’s perspective they are relieved of the monthly interest payment burden. This may help with cash flow management through the project as repairs and supplies can be purchased as needed on the borrower’s schedule rather than facing down the beginning of the month with an interest only payment.  From a lender’s perspective, the interest owed is paid upfront and essentially credited to the borrower as it is used. Some lenders may choose to use an escrow service to have the interest credited to them monthly, which may be required in      some states while others do not allow a 3rd party like the title company to escrow funds.

         The downside of prepaid interest has similarities with delaying the payment of interest mentioned above. There are not any built-in checkpoints to ensure the project is running smoothly when you do not collect payments each month. This can be resolved by setting the expectation for regular status updates from the borrower. With prepaid interest, again there isn't the option to collect additional fees or default interest, unless the borrower defaults for a reason other than missing a payment. If default interest is assessed at some point during the loan, this could eat into the interest reserves before the maturity of the loan, leaving the borrower with more owed. Reaching out to a borrower to collect additional prepaid interest may damage the lending relationship, further deteriorating communication if any is continuing by this point.

Summary

         The thought process for choosing a payment method for interest on the loan should occur early on in the loan process. As you have seen, the different methods can substantially affect how much capital a borrower needs to close the loan upon acquisition, capital reserve requirements in place after acquisition, and rate of return that can be earned from the loan. The downstream effects of the payment method chosen can include changes to the LTV of the loan, the type of lending opportunities you are willing to consider, potentially how you will fund the loan if you are working with different pools of capital, and factoring in additional costs to include a servicer in the loan if desired.

       Remember, private lending is flexible, and within the parameters of law, you are free to set terms as you see fit for each lending opportunity. Rarely is there going to be a single “right” way to do something that encompasses every lending opportunity or loan closed. If you are new to lending, keep things simple for your first few loans. Simple can be a different definition from person to person but think about what you are trying to get out of this lending opportunity, what the borrower can bring to the table in terms of capital, experience, and credit worthiness, and how various payment methods may impact their overall project performance. When in doubt, talk through the deal with other private lenders and your attorney familiar with lending. They can often help offer some clarity in their approaches to lending, even if you get different answers from different lenders!

Disclaimer: When talking loan terms, it is crucial the lender understands the lending laws in their state, or potentially the market where the borrower and/or property are because some loan terms may not be legal in all states. Reaching out to legal counsel that is familiar with lending in your market will not only allow you to have documents that are going to protect you as a lender, but also properly inform the borrower of the lending terms. For a loan to be legally enforceable, most states have some minimum information that must be contained in a promissory note and lien instrument (mortgage vs deed of trust), so if this loan is ever challenged the best way to protect yourself is to have the best legal documents you can for your market drawn up by a qualified legal professional.