Have you ever been given an opportunity to loan someone money at an attractive interest rate?

Driven by the promise of higher “guaranteed” returns, prospective lenders sometimes look to opportunities in their communities to provide loans to businesses or individuals. Often, the prospective lender knows the borrower or at least knows the intermediary who plans to facilitate the lending.

Why is it that these potential loans appear to be so lucrative? And is the opportunity too good to be true?

The answer is that the lender usually is taking on far greater risk and should only engage in this lending with a clear understanding of the tradeoffs.

To start the comparison, let’s analyze a common, commercially reasonable loan: the loan for the purchase of a primary residence. Assume a borrower wants to buy a house, and the current average 30-year fixed rate mortgage on a residential property is 7%. Before a bank grants this loan, there are several important steps it takes as part of its due diligence.

A bank collects personal and financial information—income, assets, debts—through the application process and verifies the information. It performs a credit check and requires title insurance on the property to verify appropriate ownership and a clear title on the subject residence, then orders an appraisal of the subject property to ensure the asset can cover the proposed debt and puts the application through professional underwriters to verify identity and assess the viability of the loan and its repayment.

Finally, if approved, a bank not only takes a promissory note for repayment, but it takes a security interest in the property by way of a first position mortgage, giving a bank the right to take the home in the event of nonpayment.

Now turn to other proposed opportunities for lending. Again, assuming an interest rate environment where a 30-year fixed mortgage is 7%, let’s assume a lender has an opportunity to loan someone money with 7% interest—equal to the current, assumed bank rate. Remember, that rate presumes the due diligence described in the paragraph above.

The lender would be well served to engage in the same commercially reasonable due diligence as a bank. What are the finances of the proposed borrower? Did the lender run a credit check—and as an aside, what credit score is high enough? Did the lender appraise the collateral and take a first position mortgage in the property to secure against nonpayment?

To the extent the lender chooses not to engage in the same due diligence, the lender is taking on risk. The lender should ask: Why take on risk that a traditional bank would not?

The examples above compare identical interest rates. Assuming the lender can go through identical due diligence as a bank, then the interest payment at 7% is presumably fair.

Regrettably, individual—nonbank—lenders rarely engage in the appropriate due diligence to justify an interest rate equal to that offered by banks. Accordingly, they are taking on more risk.

What happens if the interest payment is 10%? It’s a more compelling opportunity, for sure. But what typical safeguards should the lender be willing to give up and at what cost? That’s a tougher question. For example, if the lender doesn’t get security, such as a mortgage, on the asset that is the subject of the loan, is that worth a 3 percentage-point increase in interest rate, a 5% increase?

If the lender doesn’t get a title report or conduct a credit check, how does that additional risk translate to an increased interest rate? Any deviation from standard due diligence and collateral should result in a higher interest rate because the lender is necessarily taking on more risk.

Consider personal loans offered by a bank. These types of loans aren’t secured by a mortgage. And for that risk, the bank might charge an additional 4 percentage points above the rate of a comparable amount of money secured by a home. Further, the bank will require repayment in a much shorter timeframe.

But even a personal loan from a bank typically involves due diligence in the form of application, credit checks, and debt-to-income analysis. And that due diligence then translates to the offered interest rate.

When all is considered, the lender might find that potential “guaranteed” loan is too good to be true because it lacks the due diligence protections that would otherwise apply to bank-financed loans. The prospective lender might be trading additional risk without knowing it. The key is to understand the risk and price the loan accordingly—something banks are typically better suited for than individuals.

Beau Ruff is an attorney and director of planning at Cornerstone Wealth Strategies Inc., in Kennewick, Washington.