Private Lending Between Investors

Some investors stop buying buildings and start lending against them. The capital is their own, the borrower is another investor, and the loan is secured by a property the lender has gone and looked at. It is a quieter business than ownership, and it carries one problem that ownership does not.

The problem is the gap. A loan is repaid, the money lands back in the lender's account, and nothing happens to it until the next borrower appears. That interval is the real subject of this page. What follows covers what a private loan needs in writing, what registration against title accomplishes, how the interest is taxed, what happens when a borrower stops paying, and where uncommitted capital can wait in between.

What is a private loan between investors?

Money advanced by one investor to another, on written terms, secured by real property, and repaid with interest. The security is registered as a hypothec in Quebec or a mortgage in the common law provinces, and the written terms set the amount, the rate, the term, default and the discharge. The interest is taxed as ordinary income.

The lender is an individual or a holding company with capital and no immediate use for it. The borrower is an investor who needs money faster than a lender with a credit committee can move, or on a property that does not fit an ordinary underwriting box: a building in the middle of a renovation, a purchase closing in ten days, a second position behind an existing charge. The lender prices that speed and that risk into the rate, and the borrower pays it because the alternative is losing the deal.

Nothing about this makes the lender a passive party. The capital is at risk against one property, held by one borrower, for a fixed term. If the borrower stops paying, the lender is the one who has to act, retain the lawyer, and live with whatever the property turns out to be worth. That concentration is the defining feature of private lending. It is also the reason the paperwork matters more here than in almost any other use of an investor's money. A landlord with a bad tenant still owns a building. A lender with a bad borrower owns a file.

Where does the lender's own capital sit between loans?

Usually in a chequing or savings account, earning very little, waiting for a borrower. The capital is committed to nobody during that interval, and the lender is paid nothing for holding it. The gap opens on the day a borrower repays and closes when the next file has been found, underwritten and closed.

This is the part of private lending nobody describes at a meetup. A lender with capital committed to a borrower is earning the rate on the note. A lender between loans is earning whatever a deposit account pays, which is close to nothing once tax is taken, and the money is doing nothing at all in the meantime. The return an investor quotes on private lending is almost always the rate on the note. The return they actually receive is that rate applied only to the months the money was out.

The gap is not a rounding error. A loan repaid in March and replaced in June is three months of idle capital in a year, and the annual result is the note rate diluted by a quarter. Lenders who run several loans stagger the maturities to shorten the gaps. Lenders with one or two loans cannot. Either way, the question of where uncommitted capital sits is not a side issue. It is the whole difference between the rate written on the paper and the rate that arrives in the account, and it is a difference most lenders discover only at the end of the year.

What does a private loan need in writing?

Seven things, and the absence of any one of them is where the disputes start. They cover the money advanced, the security taken, what counts as default and what follows one. A lawyer or a notary drafts them, and the cost of that drafting is small beside the amount advanced.

The amount advanced and the date it is advanced. The interest rate, stated as an annual rate, with the method of calculation and the compounding period spelled out, because Canadian law is unforgiving about how a rate is disclosed on a loan secured by real property. The term, with the maturity date, and whether the loan is open or closed to prepayment. The payment structure, interest only or blended, and the day of the month on which the payments fall due.

Then the security. Which property, at which municipal address and which legal description, and in what rank behind any charge already registered. Then default: what counts as one, whether a missed payment has a cure period, and what the lender may do once the cure period passes. Then the personal guarantee, if there is one, signed by the individual behind the borrowing corporation, because a loan to a numbered company holding one building and nothing else is a loan against that building alone. Then discharge: what the lender must sign, and how quickly, once the loan is repaid.

A lawyer or a notary drafts this. Not a template, not a two page letter, nor a handshake between people who have done a deal together before. The cost of the drafting is small beside the amount advanced, and it is the only part of the transaction that will still be working for the lender on the day the relationship stops being friendly.

Why does registration against title matter?

Because an unregistered loan is a different instrument, with a different remedy and a different place in line. Registration tells the world the property is encumbered and fixes the lender's rank against everyone else who registers. Without it the lender holds a personal debt and lines up with the borrower's other unsecured creditors.

In Quebec, the security taken on immovable property is a hypothec, governed by the Civil Code of Quebec at article 2660 and following, and it is published in the land register. In the common law provinces the equivalent charge is a mortgage, registered under the provincial land titles or registry system. Registration does two things. It tells the world the property is encumbered, so a later buyer or a later lender takes subject to the charge. And it fixes the lender's rank against everyone else who registers, a rank decided by the order of registration and not by the order in which the money was advanced.

A loan without registration is a personal debt. The borrower owes the money, and the lender who wants it back sues on the promise and takes a judgment like any other unsecured creditor. There is no property to seize as of right, no priority over the borrower's other creditors, and nothing standing between the lender and a borrower who sells the building, keeps the proceeds and stops answering the phone. Some investors do lend on that basis to people they trust. They are not doing the same thing as a lender who registered, and the rate should say so. Registration costs a few hundred dollars and takes a week. The absence of it costs whatever the building was worth.

How is the interest taxed?

As ordinary income, at the lender's full marginal rate, in the year it is earned. It is included in income under paragraph 12(1)(c) of the Income Tax Act, with none of the treatment that softens a capital gain. For most individuals it is taxable as it accrues, so the tax can arrive before the cash does.

Interest received on a loan is included in income under paragraph 12(1)(c) of the Income Tax Act. It is not a capital gain, only half of which is taxable. It is not a dividend, which carries a credit. It is the most heavily taxed form of investment income a Canadian individual can receive, and a private lender is receiving almost nothing else. An investor comparing a lending rate against the return on a building should compare the two after tax, because the building produces a mix of rental income, deductible interest, capital cost allowance and an eventual gain, and the loan produces one thing only.

There is a second point that catches lenders in their first year. The income is taxable when it is earned, on an accrual basis for most individuals, and not only when it is received. A loan that accrues interest for a year and pays everything at maturity still produces income in the accruing year. A lender who has spent that year with no cash arriving can face a tax bill before the first payment does. Lending inside a corporation changes both the rate and the character of what eventually comes out, and those are questions for a CPA and not for a website. What does not change is the character of the income itself, which is interest in every structure.

What happens when a borrower stops paying?

The written terms take over, and the lender finds out what the drafting was worth. A missed payment is a phone call, two missed payments a demand from the lender's lawyer. What follows depends on the province and the security, it is slow, and the lender pays for it first.

A missed payment is usually a phone call. Two missed payments is a demand, sent by the lender's lawyer, on the terms the loan agreement already set out. What follows depends on the province and on the security. In Quebec a hypothecary creditor exercises one of the recourses in the Civil Code, beginning with a prior notice of the exercise of a hypothecary right, which is published and starts a delay during which the borrower may remedy the default. In the common law provinces a registered mortgagee has power of sale or foreclosure, each with its own notice periods and its own procedure.

All of it is slow, all of it is conducted by a lawyer or a notary, and all of it costs money the lender advances before recovering anything. Meanwhile the loan is not paying. The property may need taxes paid, insurance kept in force and a roof kept watertight, and a lender who lets any of those lapse is protecting a smaller asset by the time the process ends. A lender in second position has a harder version of the same problem, because the first charge has to be satisfied in full before anything at all reaches them, and the party holding that first charge controls the timing of the sale.

This is why the underwriting happens before the money leaves. What is the property worth on a bad day and not on a good one. How much of the borrower's own money is in the deal. What is ahead of you on title. Who signed the guarantee, and what do they own that a judgment could reach. A lender who can answer those four questions has priced a loan. A lender who cannot has priced a hope.

What does the idle period between loans cost?

Everything the capital would otherwise have earned, and the lender is paid nothing at all during it. It begins on the day a borrower repays and ends when the next deal appears, is underwritten and closes. The cost that matters is the pressure it creates, because a lender watching idle money approves files they would otherwise decline.

The idle period has no fixed length and no schedule. It begins on the day a borrower repays, which is often earlier than expected, because a borrower who refinances or sells pays out early. It ends when the next deal appears, is underwritten and closes. In between, the lender holds cash and takes offers as they come. The pressure that creates is the real hazard of the business, because a lender sitting on idle money for a second month starts looking hard at a file they would have declined in the first. Nothing about the file has changed. The lender has.

That is how private lenders make their worst loans. Not out of greed, out of impatience. The capital has a number attached to it, the number is not moving, and the next borrower through the door is offering a rate that makes a weak file look acceptable. The discipline the business demands is a willingness to let money sit while nothing good is available, and the difficulty of that discipline is proportional to how visibly unproductive the money looks while it waits.

Where the places uncommitted capital can wait stand against each other, attribute by attribute, is set out in where capital waits between properties.

Where does a participating contract fit?

As one of the places uncommitted capital can wait, with a particular set of attributes and a particular set of limits. The accumulated value can be reached by policy loan on a written request, with no credit decision behind it. The value continues on its own terms while it sits there, and the death benefit alongside it.

A participating whole life contract accumulates value over time, and that accumulated value can be reached by policy loan. The request is written, the insurer advances against the contract, and there is no credit decision, no application, no appraisal and no question about what the money is for. For a lender who wants to be able to fund a file without a third party deciding whether this is the year, that absence of a credit decision is the attribute that matters. The capacity is there because the contract was funded in earlier years.

The second attribute is that the capital is not idle in the way a deposit balance is idle. The contract's value continues on its own terms while it sits there, and the death benefit continues to exist alongside it, which is a different thing from a balance that does nothing but wait for a borrower. A lender who has built capacity over a decade has somewhere for capital to sit between loans that is neither a savings account nor a commitment to a borrower. That is a narrow claim and it is worth stating narrowly, because it is routinely overstated.

None of that makes the contract a lending facility. It is a place capital can wait, reachable without permission, and that is the whole of the claim being made for it.

What are the limits of that policy loan?

There are four, and together they decide whether any of this is useful to a particular lender. Time, because the capacity takes years to build. Interest, because a policy loan accrues and reduces what the contract pays out. Speed, because the advance takes days. And the contract is not a reserve.

The first is time. A contract takes years to accumulate meaningful value, and the early years are the slow ones. An investor who wants somewhere for capital to wait this quarter does not have it here. The second is that a policy loan is a loan. It carries interest charged by the insurer, it accrues if it is not paid, and an unpaid loan reduces what the contract eventually pays out. Money drawn to fund a mortgage advance and left outstanding for years is not free capital, and treating it as free is the commonest error in this subject.

The third is speed. A policy loan is advanced on a written request in a matter of days, which is fine for a closing set three weeks out and poor for a lender who promised to fund on Friday. The fourth is that the contract is not a reserve. A private lender needs cash on hand for the legal costs of a default, and those costs arrive on somebody else's timetable. The contract sits behind that cash. A lender who holds only the contract has one layer where the business requires two, and discovers the missing layer in the month a borrower goes quiet.

Suitability for a particular lender depends on the size of the capital, the tax position, the health and insurability of the person to be insured, and how long the money can honestly be left alone. Those are questions answered with an illustration and a conversation, not with a general rule. Values above the guaranteed ones depend on the dividend scale, which is not guaranteed and does change.

Who this suits, and who it does not

It suits an investor who already holds capital that is not committed, who has been through enough deals to underwrite one from the other side of the table, and who can tolerate the idle stretches without lowering the standard in order to end them.

It suits that lender more when the capital is genuinely surplus: the reserve is funded, the expensive debt is gone, and a loan that goes wrong delays a plan without ending one. It suits them less when the money lent is money needed on a date, because a borrower in default has no interest in the lender's date and no obligation to it.

It does not suit an investor whose capital is small enough that a single default would be most of it. Concentration is the entire risk in this business, and a lender with one loan outstanding has no diversification of any kind: one property, one borrower, one market, one moment in the cycle. The written terms reduce what a default costs. They do not reduce how likely one is.

As for where the capital waits between commitments, that question belongs to the wider subject of how a participating contract serves an investor who owns property, which is set out on the real estate investors page.