In-house servicing requires infrastructure, relationships, and technology, but its rewards can outpace the risk.

Many lenders have chosen to outsource their servicing function in an ever-complex lending environment. Maintaining your servicing function in-house, however, has many benefits and risks that must be managed carefully and cohesively to ensure a fluid relationship between the lender and the borrower.

Servicing Infrastructure: The Devil Is in the Details

What must a lender consider before opting to keep servicing in-house? You must first consider your preliminary infrastructure and its ability to manage efficiently and cost-effectively, including:

Human Capital. Proper staffing and hiring are often the lender’s biggest challenge. This is especially true when it comes to servicing in-house.

The servicing function is critical in your operation, because servicers are often the eyes and ears of the business. In-house retained services are generally the first contact between a lender and the borrower and are responsible for unrivaled customer service, timely collection of interest payments and fees, review, and release of rehab draw payments, budgeting-related issues, default and foreclosure management, extensions, inspector relationships, and many other critical functions.

Hiring, training, and maintaining the proper staff in the servicing function can be a challenge. The lender must ensure staff have the appropriate training, knowledge base, customer service skills, and bandwidth to operate effectively in a critical, often stressful, environment. A servicing associate must know how to diagnose and diffuse a difficult situation while maintaining strict protocol and a caring attitude.

Be prepared to invest tremendous resources into staffing and continued training, which takes time and money. You are responsible for ensuring minimal turnover and adequate coverage in all areas of the servicing function.

Policies and Procedures. There is nothing more critical than proper, documented policies and procedures across all business areas. It becomes even more crucial when you self-service a loan portfolio. Calendar due dates must be adhered to, and communication with the borrower must be regular. How are payments being made, and what is the documented policy for late payments, defaults, and returned payments?

Nothing should be left to guesswork. The lender must have documented guidelines for all borrower situations. Invoicing must be timely and 100% accurate, which includes tracking loan balances on interest as drawn loans and knowing when extension fees are payable. When borrower payments are not made, the lender must communicate swiftly and regularly. Scheduled reviews of delinquent payments and problem loans are necessary and require standardized methods of mitigation and resolution.

Every borrower will have a different situation, and regular communication and documentation will allow the servicing department to provide customized solutions when regular payments are not made, budgets change or are questioned, or fraud or other nefarious situations are suspected.

Technology. The proper technology partner is critical to any successful servicing operation. Lenders must understand the needs of their operation before investing in technology. The scale of operation, functionality, and cost are all important considerations when you work with a technology partner.

Is the software (and hardware) scalable to your business? Does it give both lender and borrower the necessary functionality and transparency? Will the technology integrate seamlessly with other company technology, such as general ledger and treasury functions? Does the lender’s technology give the borrower access to critical loan data such as draw history, payment history, loan documents, and payoff information that is accurate and easy to access?

To run a cost-effective, highly functional servicing operation, the lender must consider all these questions when investing in technology infrastructure.

Standard Servicing Scenarios: The Good, the Bad, the Ugly

When you implement a self-servicing model and strategy, you must remember that private lending is a people-first business. The key to business growth is building relationships with your borrowers, educating them, and guiding them to long-term success and profitability.

A repeat borrower can and will be one of a lender’s largest and most profitable segments. The effort and cost, including marketing dollars and acquisition costs, are significant to a lender. Maintaining a high volume of repeat business significantly reduces overall costs and increases margins. It is no secret that real estate investing can be stressful. When a lender provides in-house servicing with a high-touch experience, stressful situations can often be avoided and lessened with proper guidance. A strong, highly communicative servicing department is critical to mitigating common servicing scenarios such as:

Loan Terms. Does the borrower genuinely understand the terms of the loan? Explaining the loan terms and how construction draws work is everyone’s responsibility, including the loan officer, account managers, processors, underwriters, and closers. When the first interest payment is due, or the first inspection is ordered, it is often the job of the servicing department to honestly explain and guide the borrower through questions and concerns.

When lenders self-service their loans, they provide borrowers access to highly trained staff who understand the product and process. This service can provide a critical knowledge source, especially for novice investors. From explaining how interest is calculated, construction draws work, and the loan extension process, the lender’s servicing department provides meaningful guidance throughout the loan term and beyond.

Budgets. A proper, detailed, and complete budget is the key to any successful project. No matter the size or complexity of the project, however, changes and issues with the initial budget do and will occur.

One of the key advantages of a self-servicing model is a lender’s ability to be highly communicative with the borrower, especially when the scope of the project changes. A borrower may come to the lender with small modifications and reallocation requests. Some are simple, such as paint and flooring changes, while others are large, such as additions/deletions of living space that can significantly impact the after-repair value of a project.

An in-house servicing team will work with a borrower in person, via phone, or computer meeting to discuss the scope and impact of budget changes. The skill and knowledge of the servicing team are crucial when approving budget changes. The lender must guide and educate the borrower to ensure sufficient funds to complete the project on time and within budget. A self-servicing model provides flexibility and guidance, protecting both the lender and the borrower.

Project Management. Private lenders provide short-term financing to real estate investors. Terms vary, but generally range from 12 to 24 months, depending on the scope and type of project. From the borrower’s perspective, time is of the essence. A lender must carefully monitor each project to ensure that progress is going forward.

The key to success is consistent communication with a borrower, which is the ultimate responsibility of the lender’s servicing team. As a self-servicing lender, it is even more important to develop policies and procedures that monitor all projects’ status to ensure progress is being made. Regular phone calls, emails, or meetings with borrowers are crucial. Set scheduled reminders each month to speak with borrowers about their projects. Listen to and document their concerns, including areas where you can improve as the lender.

Set guidelines to monitor draw progress. Call the borrower to understand the issue if a draw has never been taken or has not been taken recently. Often, a borrower is making significant progress and has chosen to wait to draw the funds at the end of the project. Consider having a dedicated person responsible for calling borrowers who have not taken draws. This contact is generally appreciated by the borrower and helps the company understand what is happening at the property. Other times, a lender may discover substantial red flags that put the project at risk. Permit issues, construction issues, bad contractors and subs, and personal issues can all impact the progress of any project. Getting ahead of such problems is critical to loss mitigation.

Draw Management. A lender’s ability to efficiently manage the draw process is critical to the overall business. On the one hand, the borrower is relying on the quick and seamless release of draw funds to keep a project moving; on the other hand, the lender must protect their investment and ensure that all funds released follow strict protocol and ultimately follow an agreed-upon budget and are proper in nature.

In a self-servicing model, a lender’s team must review each draw in detail to ensure the borrower has completed the work per the budget and the inspector’s report adequately documents each draw line item.

Often, the borrower will disagree with the inspector’s work and analysis, which puts the lender at risk from a customer service perspective. Many times, it is necessary for the lender to communicate with a borrower to understand their frustration. Due to the complex nature of construction and rehab, obtaining additional reports, pictures, or analyses is often required to comfort the lender when releasing draw funds. A simple picture, permit, or documentation of a paid invoice or warranty can resolve a miscommunication. As a self-servicer, the lender’s team is incredibly motivated to protect the firm (and the firm investors) from substandard work or fraudulent activity.

Timing Issues. Often, a borrower will need additional time to complete a project and execute their exit strategy. This can include selling the property, refinancing it into a long-term loan, such as a DSCR product, or obtaining short-term bridge financing.

A lender must communicate with the borrower throughout the process, reminding them of loan terms and timeframe. Send reminder letters with extension options at 90, 60, and 30 days before loan maturity. Understanding why the borrower needs an extension is helpful, as it allows the servicing team to guide and educate the borrower on their options. Often, it is as simple as slight construction delays, while other times, it can be more nefarious, such as a significant change (or mismanagement) of a budget, extreme permitting issues, fraud, personal issues or damage, or substantial changes to the real estate market.

A lender’s in-house servicing team must communicate and document issues regularly to avoid “surprise” scenarios.

Fraud. Unfortunately, private lenders can fall prey to fraudulent activity like any other business. False inspection reports, title issues, wire fraud, and various other schemes are prevalent in today’s complex lending environment. Knowing what to look for and asking the right questions is vital to preventing fraud.

In the self-servicing model, the lender’s team must be vigilant to protect the firm’s assets. Question everything; dig deeper and ask more questions if something seems off. Start with the basics from day one. Is the title correct, and is the title company correctly verified and insured? Are your inspectors reputable and non-biased, and do they carry the proper insurance coverage?

A lender must review every inspection report in detail. Compare the current inspection report to the original inspection and appraisal reports. Look at every angle inside and out. Is the street address visible, and does the surrounding area look correct (especially in a ground-up)? Use simple tools such as Google Maps to validate and ensure the inspection report is the correct property. Call the inspector and the borrower to validate and question if inspection pictures and notes are vague and lack detail.

Never release draw funds without proper documentation. Your servicing team must have appropriate policies and procedures with multiple review steps to protect and prevent fraud.

Defaults. At any time, a lender will undoubtedly have to deal with borrower payment issues. Late payments, defaults, maturity without extension, and, ultimately, foreclosure are things that all lenders will encounter at one time or another. In a self-servicing model, lenders must be meticulous in their documentation and communication process. Lenders must meet internally regularly to discuss problem loans and determine the correct action. Servicing loans in-house allows a lender to develop stronger relationships with a borrower, which often affords a better understanding of the why of a default.

Developing a standard schedule of default notices and carefully documenting and tracking borrower issues is crucial. When a loan goes bad, a lender must have internal asset management resources and loss mitigation policies. Ensure all guarantors on loans know their financial liability when payments are not made and the potential impacts.

To develop a plan to mitigate losses, a lender must understand why a borrower cannot (or will not) make payments. Early and frequent communication is critical to managing problem loans. When a borrower defaults, a lender must understand the terms of each loan, including differences by state. Having a network of legal representation or the resources to obtain representation promptly is essential. As the lender, understanding your rights, options, and details of the situation will help reduce and, hopefully, prevent any financial loss.

Is the Juice Worth the Squeeze?

Without a doubt, a self-servicing model has both pros and cons and requires a significant investment from a lender. Given that, a lender must determine which model is correct for their business from a financial, quantitative, and qualitative relationship standpoint.

Pros. Choosing a self-servicing model provides control over your servicing book. Keeping servicing in-house creates a heightened customer service experience; it is not uncommon for a servicing associate to know a borrower and the intimate details of their project, financial situation, and exit strategy personally.

Depending on the lender’s size, a servicing department might run lean, allowing the borrower to call in and know the person on the other side of the line. This builds trust and confidence in a lender and ultimately fosters repeat business, significantly increasing margins.

As a lender scales, building efficiencies in the servicing technologies and processes reduces the need for excessive staffing, saving the lender from additional personnel expenses. Money saved from outsourcing costs allows the lender to reinvest in the business and scale the portfolio. Developing a deep understanding of the borrowers allows a lender to act quickly and provide innovative solutions to avert financial loss.

Cons. Human capital is expensive, and maintaining and retaining top talent can be challenging for any organization. Investing in the technology and policies infrastructure is costly, both upfront and ongoing.

A lender must carefully weigh these costs to decide whether to service loans in-house or outsource. Being too close to a borrower can sometimes be detrimental; removing a certain “human” element from the collections process can often benefit the lender. Outsourcing to a company that specializes in collections ensures a standardized process in collections and regulatory and compliance matters.

The costs associated with employee turnover, continued training and education, and investments in technology can be significant to a lender. The risk of not knowing every facet of the regulatory landscape also poses a greater risk to a self-servicing lender. A lender must carefully weigh the risks and rewards with both methods and decide which method (or mix thereof) works best for their business model.

One can argue that loan servicing is the most crucial, high-impact aspect of any lending operation. A lender must carefully weigh their options and understand their business model and objectives when determining a loan servicing method. Each method carries risks, but ultimately, it comes down to customer experience, ease of use, and risk mitigation. A lender must carefully analyze financial and quality costs, determine the best and most efficient use of internal resources, and ultimately protect the bottom line.