Consider these insights for being your borrowers’ watchdog—and building your reputation as an ethical lender.

Originating to foreclosed on is also known in the lending business as “loan to own.”  Loan to own can be intentional, or it can be accidental. Regardless, it’s bad business.

Intentional loan to own typically occurs because the asset in question is desirable. For example, a high-end property could be in a desirable area that doesn’t see much change in ownership, or it could be a multifamily property that generates great income. In either case, you know the borrower doesn’t have the income or credit to refinance out. Simply put, predatory loan to own is practiced because the lender wants the asset at an even higher discount (i.e., the borrower’s down payment less the cost of foreclosure).

Accidental foreclosure, on the other hand, can occur for a number of reasons. Let’s take a look at several and how to avoid them.

Be Diligent

The most common culprit is laziness.

Your first question to someone who wants to borrow money from you, regardless of the amount, should always be, “How can you pay me back?”  Of course, you should also ask about their exit strategy.  When the exit is to refinance out and hold long-term, always ask questions such as: Who’s your takeout lender? What is your current credit score? and Can I speak to your takeout lender with your permission to discuss any potential problems that may occur?

A good and ethical lender should be able to point out if there is an issue with credit, rental income, debt-to-income ratio, or appraisal and know right away if there is a possibility of any hiccups in the refinance process.

Don’t Get Complacent

Another risk is getting too comfortable with your borrower. This can occur with long-term hold refinances as well as with flips. Things change—income, DTI, etc. Maybe renters are not paying, so your borrower’s DTI goes up, or maybe they missed a payment and now their credit has an issue. Not continuing to do due diligence and not checking back with your borrower’s takeout lender are risks to avoid, especially with borrowers who plan to hold long term.

Look for Trends

For your borrowers involved in flips, watch for trends in their projects. Consider requesting an REO schedule. The biggest things to check are locations and price points.

If a borrower steps out of their normal territory, it isn’t usually a red flag. But you should question, “Why this area?” Maybe it’s a one-off, or it’s a great deal, or competition has priced the borrower to look beyond their usual location.

Similarly, review the borrower’s price point history on the REO schedule. As the lender, always make three columns:                           (1) purchase price, (2) rehab budget, and (3) resale price. Look for the average of each column. A buyer on a fix-and-flip should always be close enough to the mean of each one.

Seasoned investors tend to not stray from their standard deviation. When that does occur, question the change. Ask whether they can handle a rehab budget of that size compared to their previous projects and whether they have experience with a remodel of that size. Also question their experience at a resale price at this value. You want to beware of high-end sellers getting involved in low-end properties and vice versa. For example, a borrower most familiar with high-end properties may pay too much on materials that don’t fit the property’s profile when they are fixing a low-end project.  Conversely, a low-end flipper might end up not budgeting the right amount for the materials required on a high-end flip.

Pay Attention to DSCR

Next, consider the debt servicing coverage ratio. A good private money lender should always have a rough estimate of how big their borrower’s portfolio is. An easy way to know whether a borrower’s DSCR is healthy is to look at late fees. If the borrower starts paying later and later and incurring late fees, the borrower might not be in good DSCR health. If you know your borrower doesn’t have a healthy DSCR and you lend more to that borrower, you are setting the borrower up to fail.

Portfolio Stability

Finally, review the borrower’s portfolio. It’s always important to look at the average loans for a borrower’s typical projects. If a borrower usually does between five and 10 flips a year, but their portfolio is now at 10 open projects, be cautious. A change in bandwidth that fast will definitely hinder the borrower’s ability to perform. The ultimate goal is your borrower’s success, and their success is also the lender’s success (yours!).

You Can’t Control Timing of the Sale

It’s easy for clients to assume the property they have on the market will sell quickly.  The truth is, neither the borrower nor the lender can control the time in which a property will sell. Transactions can fall through for a many reasons. Counting profit before the funds are sent is an easy trap to get sucked into.

Some lenders make the mistake of lending at low points for a short-term loan because a closing is coming up. But in one personal instance, financing for the buyer fell apart at the last minute due to a verification of employment. The buyer lost his job a week before closing. The borrower was stuck in default, and an extension was required. Even with the extension, the borrower had to redo his calculations. Quite frankly, the lender’s decision cost the borrower a lot of money. The lender should have been more cautious and looked after the borrower. But at the time, that lender was counting the transaction for the week.

The situation was uncomfortable for both parties: The borrower didn’t perform, and the lender agreed to something that wasn’t best for the client. Looking back, the transaction could have been a lot worse. Although the financing fell apart, it was a sellers’ market, so it was easy to find a new buyer. But if the transaction had fallen apart because of something bigger like a failed inspection, there’s a chance that borrower wouldn’t be a client anymore.

A responsible lender must act as the gatekeeper, looking out for both the company and the borrower. Accidentally lending to foreclose on is as much the lender’s fault as it is the borrower’s. Both parties must know when to say “no” to a transaction. Yes, it is a rush to see the loan amount (either dollar amount or loan numbers) increase, but at the end of the day, you must protect your clients from being their own worst enemy.

Being a watchdog for your client using the insights outlined here protects your client, protects your business, and builds your reputation as an ethical lender.