How Private Lenders Assess Risk Differently Than Banks

Some borrowers in Australia struggle to fit the neat criteria that traditional banks demand to secure a loan. If you’re looking for a commercial loan broker who truly understands your situation or you need a short term loan to bridge a gap between properties, a private lender may be the perfect solution for you. Of course, understanding how private lenders assess risk differently to the banks can help you judge if you’re able to finance your next project.

Hodgestone Finance works with a wide network of non-bank lenders in Melbourne, Sydney and all across Australia. These financial institutions take a fundamentally different approach to assessing a person’s risk when it comes to borrowing money. Rather than letting algorithms decide, we check you for your assets, your equity, business context and goals.

Within this article, we’ll define what risk is when it comes to banks and private lending institutions and why private lenders are better for you when it comes to borrowing money under certain conditions.

In Financial Terms, What is Risk?

The definition of risk, in financial terms, has some specificity associated with it, much more than the general definition of risk. The broad definition is ‘the exposure to the chance of injury or loss, a hazard or dangerous chance’ (https://www.dictionary.com/browse/risk). The financial sector takes this definition and focuses it onto businesses and people, from a monetary risk point of view.

In banking terms, risk is defined as the uncertainty of an event, action or inaction, that may result in financial loss or damage to their reputation, or it can mean the failure of an entity to achieve business objectives as per the plan presented to the institution. It is the probability of a negative outcome weighed against the severity of that outcome.

The three components of this uncertainty are a business’s:

• Expected Loss (EL)The average amount of money the bank expects to lose over a specific period of time, usually considered the cost of doing business.
• Unexpected Loss (UL)The potential for losses that exceed the expected amount. Banks are then required to hold ‘capital reserves’ to remain solvent.
• Risk-Return TradeoffThis is the principle that higher returns are associated with higher risks.

The most common types of risks associated with commercial lending are:

• Credit RiskThis is the possibility that a borrower will fail to repay their loans or meet contractual obligations.
• Market RiskThe potential loss due to movement in market prices. These can include changes in interest rates, foreign exchange prices or equity prices.
• Operational RiskThe risk of a business failing due to failed internal processes, people or systems, or external events such as fraud, cyber attacks and the like.
• Liquidity RiskThe risk that a bank won't be able to meet its own cash flow obligations without incurring unacceptable losses.
• Reputational RiskPotential public negativity from being associated with commercial or industrial projects. This can cause a loss of trust with their customer base and hence a loss of income.
• Compliance RiskThe potential fines or lawsuits resulting from failure to comply with laws, regulations and ethical standards.

Now we’ll look at how both banks and private lenders assess the risks involved in lending money.

How do banks assess risk?

Banks assess risk by evaluating a borrower's credit-worthiness using the “5 C’s” and data analytics, credit scores and stress testing. It is very objective and based on data and a client’s history.

Banks do customer due diligence where they monitor your transactions, ask for banking history to look for patterns or inconsistencies. They also use audits and risk-control self-assessments to help identify if there are any internal failures with a business, which would prevent a bank lending to them.

The 5 C’s are:

• CapacityWhat is a borrower's capacity to repay the amount? What is their income, their employment and their debt-to-income ratio)
• CharacterWhat is the borrower's reputation and reliability to be able to repay the amount.
• CapitalThe borrower’s own financial contribution, what savings and assets they have.
• CollateralWhat is the borrower using to secure the loan? Is it property or business assets?
• ConditionsWhat is the purpose of the loan and any external economic factors that may influence the loan.

How do Private Lenders Assess Risk?

Private lenders focus heavily on the quality of the underlying collateral, such as property or business assets, what is the borrower’s exit strategy and what is their Loan-to-Value ratio. They don’t rely so much on credit scores. They conduct fast, deep due diligence, including property valuations, financial reviews, and site visits, to ensure they can recover capital within 1–3 years.

For private lenders, the key areas of risk assessment include:

• Security PositionThis is collateral, how much equity is in the available real estate? Lenders do prefer first mortgage positions and conservative LVRs so they have the chance to sell the property at a good price if they need to recover funds.
• Exit StrategyPrivate lenders more often than not give out short term loans, so they look for how the loan will be repaid in such a quick timeline. Will it be through refinancing, the sale of a property or through business revenue.
• Borrower Profile and CapacityRather than do credit scoring, private lenders do a 12 month review of bank statements, tax returns and the borrower’s history in regards to cash flow and their ability to manage projects.
• Property and Market FactorsLenders will evaluate the property’s location, marketability and liquidity to understand how quickly a property can be sold if needs be.
• Legal Compliance. Ensuring a borrower’s legal capacity to actually borrow money and ensuring the proper insurance is in place.

These lenders, which include non-bank institutions, use these techniques to mitigate risk, often providing faster, more flexible funding than traditional banks.

Why do Private Lenders Assess Risk Differently to Banks?

Private lenders prioritise asset security and speed over credit history. They operate outside the rigid regulatory framework as banks. They use ‘asset-based lending’ to manage higher risks in exchange for higher returns and flexibility with their clients.

Here is what we mean:

Security Focussed Assessment- collateral v income

Private lenders focus mainly on the value of the collateral rather than a borrower’s ability to service a loan.

Banks place a higher priority on a borrower’s ability to service the loan through proof of income.

This means a private lender may approve a loan for someone with poor income or no credit history based on the fact that they may get a good return from a strong property asset if sold.

Regulatory Constraints

Private lenders are not tied to regulatory constraints, such as the National Consumer Credit Protection Act (NCCP) as banks are, especially when it comes to business loans. This allows them to offer more tailored solutions per situation.

Banks are ‘Authorised Deposit-taking Institutions’ (ADI), which mean they are highly regulated and must follow strict procedures which limit their risk taking, which can result in a lengthy overall process that can often end with a NO.

Speed and Flexibility

Private lenders are able to make fast decisions directly, without committee or overloaded compliances. This means loans can be approved within 48 hours.

Banks must use slow, automated systems and compliance checks that can often take weeks for approval.

Risk Tolerance

Private lenders can service higher-risk borrowers, such as the self-employed, and mitigate this higher risk with higher interest rates.

Banks prefer lower risk borrowers to protect their deposits and maintain lower interest rates.

How is This Difference Good For You?

• You get heardRather than an algorithm deciding if you get a loan or not, a private lender will listen to you and what you have planned. They will assess your assets and your equity, look at you in a business context and make a repayment plan that benefits both parties.
• Speed works for youThe speed at which a private lender can approve your loan, rather than banks going through committees and compliance, means you can have your project financed faster. This is perfect for time-sensitive opportunities.
• The asset works for youBecause private lenders focus on the asset as security, even if you’re cash-poor, if you have great equity and an eye for property, this works in your favour.
• Unconventional works for youIf you’re self-employed with an inconsistent income, but you have good assets behind you, private lenders will look at that.
• Customised loan structuresPrivate lenders have the ability to customise a loan to suit your needs and abilities, rather than having to fit into the bank’s rigid structure. Private lenders can have interest-only periods or flexible repayment schedules.

Banks are built for average borrowers with a straightforward situation. The moment you step outside these boundaries is when a private lender becomes your best option. Their flexibility means more Australian businesses have access to the funds required to build and develop for a better Australian economy. Knowing how private lenders assess risk differently can empower you to take good risks in property development and commercial ventures. Banks are built to protect deposits, private lenders are built to look at you and what you bring to the table besides an income.

Hodgestone Finance specialises in connecting you to the right non-bank lenders across Melbourne, Sydney and Australia-wide. If you need a short term bridging loan or a commercial loan to help with the next big construction project, we are here to help.

Are you ready to explore your options? Contact Hodgestone Finance today for an obligation free conversation. We’ll fit you with the right lender for the right deal.