First Step towards Passive Lending Income

I personally don’t like keeping more than $2000 in bank account, be it Chequing or Savings, they provide minuscule interest on the money and barely keeps up with the inflation rate. While there are situations when you still have to have some liquidity and keep the money in low interest bearing accounts, I mostly prefer to keep it in TFSA* account parked in Stocks. For bigger amounts that I surely don’t need for 1-2-3 years, I prefer to lend it on high interests mainly under following two categories.

Real Estate Lending

When I was first introduced to the field of high interest lending, my first reaction was – WTF! Who borrows money at these rates? Is it even safe? How can a borrower afford to pay so much in interest and still return the principal in the end? Is this a scam?

All logical doubts and concerns.. and I recall my real estate agent sat with me at a Tim Hortons somewhere, and on a piece of brown (not even white!) paper-napkin, front-and-back, jotted down the numbers and reasons why a decision to borrow money at a high interest still makes sense. Before I indulge you with details, keep in mind the most important dynamics here, we are ONLY talking about Greater Toronto Area Real Estate market investment where as you can see below, the price appreciated by more than double in last decade! This chart is sourced from TRREB where you can also find this data in a tabular format. I added the Green arrow (or should I have used Red?!) to show how steep the price rise was!

We migrated to Canada in 2013 when the market was fiery HOT already and prices in some areas of Toronto was increasing at an average 15%-20% yearly, that’s an insane ROI for any investment! The market was so lucrative that rich foreigners were dumping their cash in real estate here along with other major cities across Canada. The ballooning price got the government worried as it may become a bubble which could burst and have disastrous impact on the economy, besides home ownership was getting out of reach for majority of the millenials. They intervened and introduced several measures like mortgage stress test, tighter down payment requirement, foreign ownership tax etc and to some extent they were able to reign in the price. The rules are still evolving and Covid-19 also helped with the cooling a bit, but as per many analysts and publications, Toronto prices are still expected to grow by 10% in 2020! The whole situation is so enticing that I personally known quite a few people who jumped into getting Real Estate agent license to work part time to ride the wave and make money!

While I will share our Real Estate ownership & Investment journey separately under Rental Income topic, the reason there is no dearth of people willing to borrow money at high interest rate is primarily hot real estate market here. I have seen short term lending interest rate as high as 20%, effectively costing the borrower in the range of 22%-25% including finder’s fee, legal paperwork and other formalities.

As per Canadian Criminal Code Section 347, it is a Criminal offence to 1. Enter in an agreement 2. Receive interest rate; beyond the maximum allowable annualized interest rate of 60%!

Honestly I personally would never want to see myself on the other side of this equation! Other reasons to borrow at this exuberant rate are:

1. Poor credit history due to which mortgage with traditional banks is difficult to get approved
2. Insufficient time in Canada to build a credit history, again resulting in banks declining the mortgage application
3. Above two points may also result in getting mortgage approved but at a higher rate. I was in this situation and had to go with a B lender for first year at double the normal mortgage rate!
4. Insufficient down payment funds due to which mortgage application is denied or approved at higher rate
5. Less than 20% down payment also attracts CMHC insurance charges and they aren’t cheap

These reasons should be enough to give you an idea why people borrow at high rates and why lending money is a booming business. There could be several other reasons and factors leading a person to go this route but I am not into judging people, so will stop here. As I mentioned earlier, I personally won’t be comfortable borrowing like this and don’t wish this situation arising for others too. Having said that, high interest borrowing shouldn’t always be seen in bad light or risky all the time. There are deals where even after paying interest, people manage to make money. There could be a tight short term financial situation or money stuck elsewhere and a real estate (or any other opportunity) deal comes up which is too good to ignore and hence a person is inclined to borrow money. I guess in the end it all depends on one’s ability to crunch the numbers and putting the money to good use. Here I will present you with an oversimplified example on how money can be made in Toronto real estate even after borrowing at a high interest rate of 20%.

• Say John Doe with $25,000 cash in hand sees a house on sale for asking price of $500,000. His market understanding and business acumen makes him believe this is a good deal and could potentially give him good ROI in 2 years. With price appreciating at 15% a year, he expects to sell the same house for about $650,000!
• But having only $25,000 means he could only afford 5% down payment and with his income and other debts, he knows mortgage approval chance is slim and may not get a favourable rate with bank
• Besides anything less than 20% attracts CMHC insurance, his meagre 5% down payment would translate into $19,000 CMHC insurance premium cost. To make the matter worse, if he can’t pay this fee upfront, it gets added to the mortgage principal, on which you pay interest. I won’t even go into that calculation! So instead of $475,000 mortgage ($500,000 price – $25,000 down), he is forced to borrow $494,000 ($475,000 + $19,000 CMHC) meaning he lost $19,000 plus 2 years of interest on it right away! In other words, his $25,000 is worth only $6,000.
• Knowing the situation, he opts to borrow $75,000 at 20% interest rate. Which means he will pay total interest of $30,000 over 2 years period ($1,250 monthly) plus of course $75,000 principal at the end of the term when he sells the house.
• With borrowed $75,000, he is eliminating CMHC fee of $19,000 upfront. Also with 20% down payment now, his chances of mortgage approval and that too at a much better rate, is bright!
• So his net borrowing cost is only $11,000 ($30,000-$19,000), not to forget two other key benefit – he could actually afford to buy the house at a better mortgage rate & h avoided interest rate on $19,000.
• At the end of 2 years, he sells the house for $650,000 as planned. After paying off the mortgage balance of about $375,000 & high interest loan of $75,000, he is left with $200,000.
• Deduct another $100,000 towards expenses such as Realtor’s commission, Land transfer cost, Lawyer fee, Mortgage prepayment penalty (if any), Miscellaneous expenses towards maintenance of property, Rental fee, Capital gain etc. The list could be longer but we deducted a generous amount to take care of it all.

To summarize – on his initial capital of $25,000, John was able to convert it into $100,000 in 2 years! Is it a bad deal, did I missed anything? Of course this was a best case scenario, things could have gone wrong in numerous ways. Greater deal of risk was involved but money is made only when you know what you are doing and take calculated risk. This is not for everybody, even I won’t get into such deals myself but then there are people who take this sort of risk all the time.

Primarily our extra money is parked directly with our Real Estate agent, occasionally he also facilitate lending to a Third party. A lawyer is involved to put together the Agreement/Promissory note, where key points documented are – Amount you are lending, Duration, Annual Interest Percentage, Monthly Interest Amount, and Property details which is liened. You also get advance Interest checks for entire duration and at the end of the term, you either renew or get the principal amount back via lawyer. This mostly happens when the property is Sold or Refinanced with the bank at a lower interest rate. One can expect 8%-16% annual interest rate, now compare it against typical 2% (or less) you get in a Savings account and that too on a bigger amount! Ratehub is a great site to compare prevailing Interest rates if you still think traditional bank is still a way to go.

Lending Loop

Quoting their website – Lending Loop is Canada’s first fully regulated peer-to-peer lending platform focused on small businesses.

As it says, they provide a platform to connect carefully screened borrowers (usually small businesses) to lenders (like you and me). They charge 1.5% servicing fee on each loan/commitment you make. Depending on borrower’s application approval, financial condition, ability to payback and several other factors, they are assigned a Loan grade and annual rate of interest accordingly varies between 4.96% – 24.93%. They have a great and simplistic website and you can read about all of this in detail there, for some reason they discontinued their mobile app, which was really handy. Before we delve into details, one extremely important point to consider is, the money you chose to invest via lending loop is not insured and you may lose your entire investment. Having said that, as per statistics available on their website, there are more than 11,000 active investors who lent more than $74M CAD to 100’s of small businesses across Canada!

The steps to get this started is quite straightforward:

• Create an Account by providing basic details
• Upload required documentation
• Attach your Bank account (used to Deposit/Withdraw)
• Transfer funds, and you are set to lend to available borrowers!

If you enroll via my referral link, both you can me can get $25 each once you lend total of $1500 via their platform.

Various features that I personally find quite helpful are:

• Auto-Lend, if you opt for this and set a limit & loan grade you are comfortable with, the system will automatically lend money to any new borrower available
• Email notification for any new borrower available in the marketplace needing funds
• Monthly Earning statements
• Annual T5 – Statement of Investment Income

While the small businesses borrowing money on this platform are carefully screened and you can see their detailed plan and intention before lending, there is always a risk in high interest lending which everyone should consider. My three cents 1. You can lend as low as $25 for each commitment, and hence minimize the risk by diversifying across multiple borrowers. 2. Lend money to Borrower’s with Loan grade C+ or better, the interest you are offered for such grades are in the range of 5%-16% 3. Look at the commitment term carefully, as your money gets locked for that period.

One last point I would like to mention and it is actually the only point I don’t like about Lending Loop, the fund transfer time (both Withdrawal or Deposit) take about 4-5 business days, which at times is frustrating! It happens that a good commitment is open and gets quickly funded while you’re waiting for fund to come in!

My departing words on high interest lending – Don’t be too greedy, if you think a deal is too good to be true, it often is! Think if the interest rate someone is paying you is sustainable by putting yourself in their shoe. The decision is always yours, and there could be a better and safer deal out there, suitable for you!

Happy Lending!