What Happens If a Private Lending Deal Goes Wrong? The Honest Answer

If you're thinking about lending your own money on a house, the first question to ask anyone is not "what could I make?" It's "what happens if this goes wrong?"

So this article starts with the bad news and stays there for a while. This is education, not an offer. Nothing here is legal, tax, or investment advice. In the previous article in this series I explained why we say no to most houses. This one covers what happens when a house we said yes to still goes sideways.

How does a deal go wrong?

A deal goes wrong when the borrower stops doing what the note says. Plain English: the note is the written promise to repay, and a default is a broken promise, usually missed payments or no payoff at the end.

In our business it usually traces back to one of three things. The rehab ran longer than planned. The costs ran over. Or the house sold for less than we expected. Any of those can happen to anyone, including us, and careful screening lowers the odds without removing them.

What can a lender actually do?

A lender holds two documents: the note, and a mortgage recorded on the land records against the house. If the loan isn't paid, the mortgage is what lets the lender go after the house itself.

That means foreclosure, which is a lawsuit. In Connecticut foreclosure goes through the courts. It isn't a lockout and it isn't quick. Here is the general shape of it:

The lender's attorney files a complaint and serves the borrower.
If the lender wins, the court either sets a law day, a deadline by which the borrower must pay what's owed or lose the house to the lender, or orders the house sold.
If the house is sold, the money goes to pay what's owed. Anything left over after everyone is paid goes back to the borrower.
In some cases the lender can ask the court for a deficiency judgment, which is a ruling that the borrower still owes the gap if the house didn't cover the debt. Whether that gap is ever collected is a separate question.

Every step takes time, costs legal fees, and has a human being on the other side who may fight it or file for bankruptcy. A lender's own attorney runs this process, which is one reason I tell every lender to bring one.

What is lien position, and why does it come first?

A lien is a legal claim against a house. A house can have more than one. When a house is sold in a foreclosure, the money gets paid out in order, and lien position is the name for where you stand in that line.

A lender in first position is paid first. A lender in second position gets paid only after the first is made whole, and may get nothing if the sale price falls short. That's why lien position is the first question a lender should ask anyone, including us.

You shouldn't take my word on it, either. Your own attorney and the title search show what is recorded against the house, and whether anything, such as unpaid property taxes, could sit ahead of the mortgage. If anything does, you want to know before the closing, not after.

What is the equity cushion?

Equity is the part of a house's value that isn't borrowed against. A cushion is the room between what a house is likely to sell for and what's owed on it.

In our deals, we put our own money in beneath the lender's loan. So if the house sells for less than we planned, the shortfall comes out of our side first. That's the whole idea of the cushion, and it's why our buy box insists on one.

But a cushion has a size. If a house loses more value than the money we put in, the lender can lose too. If a house sells for less than the loan after costs, the lender takes the loss no matter where we sit. Nothing about the cushion changes that, and I'd be misleading you if I said it did.

The honest list

Borrowers can default. That includes us.
Values can fall. A house is worth what a buyer pays on the day it sells.
Foreclosure takes time and costs money. Months can pass with no payments coming in.
A lender can lose money. If a sale doesn't cover what's owed, the lender may not be made whole.
The money isn't liquid. Once it's lent, it's lent until payoff. You can't pull it out early because you need it.
Nothing is guaranteed.

If that list doesn't sit right with you, private lending is the wrong fit. That's a perfectly good conclusion, and I'd rather you reach it now than after a closing.

Questions to ask anyone who offers you a deal

Who is first in line? Ask about lien position, then verify it with your own attorney and the title search.
Whose money is hit first if the numbers are wrong, and how big is that cushion? A good answer gives you both. An honest one says the cushion can run out.
What does foreclosure look like, and who pays for it? You want a realistic answer about time and cost, not "it won't come to that."
Has anyone's attorney other than yours read the documents? Bring your own attorney. I want you to.
Is anyone else's money in this? It should be one lender, one note, one property, one recorded mortgage.

Where we stand

Turning Point Properties is a family-owned real estate company in Enfield, Connecticut. We buy and renovate houses along the I-91 corridor. We're registered with the Connecticut Department of Consumer Protection as a real estate wholesaler, registration number six in the state, because our habit is to do the paperwork before anyone makes us. Telling you what can go wrong, before you ask, comes from the same habit.

Frequently asked questions

What happens if the borrower stops paying? That's a default. The lender can ask a court to foreclose on the mortgage. In Connecticut that's a court process that takes time and costs money.

What is a law day? In a strict foreclosure, a deadline set by the court. The borrower has until then to pay what's owed or lose the house to the lender.

Can a lender lose money even with a mortgage? Yes. If the house sells for less than what's owed after costs, the lender may not be made whole.

What does lien position mean? Where a lender stands in line to be paid from a sale. First position is paid first. Ask your attorney to verify it against the title search.

Who loses first if a deal goes wrong? We do, because our own money sits beneath the lender's loan. But the cushion has a limit, and a large enough drop in value reaches the lender too.

Is this article an offer? No. It's education. We don't advertise any loan, rate, or opportunity, and nothing here is a solicitation.

If you've ever wondered how this actually works, call me. I'll walk you through a real deal, documents and all — no pitch. And if private lending isn't right for your situation, I'll tell you that too.

Turning Point Properties LLC is a real estate investment company in Enfield, Connecticut, registered with the Connecticut Department of Consumer Protection as a real estate wholesaler, REW.0000006. Sean Wilder is a licensed real estate broker in Connecticut (REB.0794687), Massachusetts (1000680), and Rhode Island (REB.0005242), and a Connecticut licensed debt negotiator (NMLS 828273). This article is general educational information, not legal, tax, or investment advice, and is not an offer or solicitation of any kind. Consult your own attorney, CPA, and financial advisor about your situation.

Turning Point Properties LLC · Enfield, CT · (860) 337-3379