Private mortgage: What you should know before you borrow

Buying a home can be challenging, especially if you struggle to qualify for a traditional mortgage. Private mortgages offer an alternative, providing flexible terms and faster approvals. While private mortgages can help borrowers with unique financial situations buy a home, they also carry more risk than conventional mortgages.

What is a private mortgage?

A private mortgage is a home loan offered by private individuals or businesses that set their own loan terms and requirements for borrows. They are an alternative to conventional or government-backed mortgages provided by banks, credit unions, or online lenders.

Private mortgage lenders often use their own funds or investments to finance the loan.

Private mortgages are designed for borrowers who may have a hard time qualifying for traditional financing.

They work like regular mortgages in that you must repay the loan with interest. If you’re unable to make your monthly payments, the private lender can foreclose on your property. 

Who should get a private mortgage?

Borrowers who may benefit from a private mortgage include:

• Borrowers with lower credit scores. Though government-backed loans offer some flexibility, most mortgages have minimum down payment and credit score requirements. If you’re unable to meet these requirements, private mortgages offer an alternative. 
• Self-employed borrowers. If you’re self-employed or have been in business for less than two years, it can be hard to qualify for a mortgage from a bank or credit union. Lenders perceive self-employed borrowers as riskier, so they may have higher credit requirements and request additional documentation. Private mortgages allow you to avoid this kind of red tape. 
• Borrowers buying from a family member. If you’re buying a home from a family member, the owner may finance the property instead of going through a bank. 

What is a private mortgage lender?

Private mortgage lenders are individuals or groups that offer mortgage loans. Private lenders set their own loan terms and finance your loan with either their own funds or capital from investors. Since private lenders are not subject to the same standards or underwriting guidelines as conventional and government-backed loans, they can offer more flexible loan terms and faster closings.

Who should become a private mortgage lender?

Private mortgage lending could be a good fit for:

• High-net-worth individuals looking to diversify their investments
• Real estate professionals who understand local market values and how to evaluate property risks
• Experienced investors who are comfortable with managing private contracts and navigating state lending regulations

Private lenders must be prepared to handle underwriting and servicing the loan. And if the borrower defaults, you’ll have to start foreclosure proceedings.

Private home loans vs. traditional loans

While both private and traditional mortgage loans help borrowers finance a home purchase, each comes with different regulations, borrower requirements, and loan structures. The table below shows the primary differences between the two.

Pros and cons of private mortgages for buyers

Private mortgages can be a good alternative for borrowers who don’t meet traditional lending requirements, but there are risks to consider. While the easier approval and flexible loan terms are appealing, you may have fewer legal safeguards.

Pros

• Smaller down payments: Private lenders may accept a smaller down payment than traditional lenders. 
• Lower credit requirements: Private lenders may be willing to work with borrowers who have a lower credit score or a limited credit history.
• No PMI: Private lenders don’t usually require private mortgage insurance, even if you make a smaller down payment. This can save you hundreds of dollars on your monthly mortgage payment. 
• Faster approval process: Since private lenders don’t have the same regulatory requirements as banks, they can approve and fund a loan much more quickly. 
• Flexible loan terms: Private lenders may offer more flexible loan terms, especially if you’re working with an individual or smaller company. 

Cons

• Fewer borrower protections: Private mortgages don’t offer the same legal protections you’ll receive from a licensed financial institution. That means if the lender suddenly changes the terms of your agreement, you may have limited recourse. 
• Possible balloon loan: Some private mortgages are structured as short-term loans with a large final payment, also known as a balloon payment. This can be risky if you’re unable to refinance or pay off the balance.
• Higher origination fees: Though they don’t charge PMI, some private lenders charge higher origination fees.
• Stiff penalties and fees: Private mortgage contracts may include late fees, prepayment penalties, or default clauses that you won’t find with a traditional lender.

How to get a private mortgage

Securing a private mortgage requires a slightly different approach than working with a traditional lender. The process tends to be more informal, but also comes with more risk if you aren’t careful. Here are four steps you can take to protect yourself. 

1. Consult a real estate professional

Before taking out a private mortgage, it’s a good idea to consult with a real estate attorney who can draft or review contracts and ensure your loan complies with state and local laws. This is important because private agreements often lack some of the safeguards built into conventional mortgage agreements.  

2. Find a private mortgage lender

You can find private lenders through real estate networks, investment groups, mortgage brokers, or online platforms. If you’re considering multiple lenders, be sure to consider the loan terms, interest rates, and fees. It’s also a good idea to ask questions to see how transparent the lender is and how well they communicate. 

3. Stake out the terms of your agreement

Once you’ve found a lender, you’ll need to negotiate your loan terms. Private mortgage agreements can vary depending on your lender, so it’s important to understand the fine print. In particular, note the annual percentage rate, repayment schedule, amortization, and fees.

4. Prepare your paperwork

Here are the documents you’ll need to provide or review:

• Promissory note: A promissory note is a written document that states your agreement to repay the loan. It outlines the loan amount, interest rate, repayment schedule, and maturity date.
• Deed of trust: The deed of trust secures the loan by tying it to the property and gives the lender permission to foreclose if you stop making payments.
• Bank statements: Bank statements show proof of funds and that you’re able to make the monthly payments.
• Tax returns and pay stubs: These verify your income and help lenders assess how much of a lending risk you pose.

Alternatives to private mortgage loans

While private mortgage loans can be helpful in certain situations, they’re generally used as a last resort due to the lack of borrower protections. If you’re not sold on private loans, consider these safer alternative mortgage financing options first. 

Alternatives for borrowers

Before turning to a private mortgage loan, borrowers should consider the following options, which are more affordable and offer better legal protections:

• Federal Housing Administration loans. FHA loans are designed for borrowers with lower credit scores or smaller down payments. They come with more flexible qualification requirements than conventional loans.
• Improve your credit. Taking time to boost your credit score can increase your chances of qualifying for a traditional mortgage with better terms and lower interest rates.
• Save for a larger down payment. A bigger down payment reduces the amount you need to borrow and increases your appeal to lenders. It may also help you avoid PMI on a conventional loan.
• Seek down payment assistance. Many state and local programs offer grants or low-interest loans to help eligible buyers cover their down payment or closing costs, easing the burden of homeownership.

Alternatives for investors

Private lending isn’t just risky for borrowers — lenders must manage the risk of default and legal issues. Here are some alternatives to consider:

• Cash-out refinance. If you need cash for further investments, a cash-out refinance allows you to borrow the equity in a property you already own. It provides immediate capital without the risks of direct lending.
• Portfolio loan. A portfolio loan is held by the lender instead of being sold on a secondary market. These loans often have more flexible underwriting requirements and are ideal for investors with multiple properties or complex financial situations.
• Residential REITs. Real estate investment trusts allow you to invest in residential properties without owning or managing them directly. They offer passive income and liquidity through publicly traded shares.
• Rental properties. Purchasing and managing long-term rental properties can offer a steady cash flow and provide tax benefits.

The bottom line: A private mortgage is one of many options

A private mortgage can be a good option for borrowers who don’t meet traditional lending criteria, but it does come with risks. Before committing to a private mortgage, it’s a good idea to explore safer financing options. If you’re unsure where to start, a Rocket Mortgage loan expert can help you review your options.