In this article, we’ll explore at a high-level what exactly it means to invest in mortgage notes.
We are familiar with a traditional mortgage in which a lender–often a bank or large financial institution–issues a promissory note in which the borrower promises in writing to pay a sum of money to the other upon an agreed schedule. In exchange the lender issues the money that purchases the property, which acts as security for the loan. In the event of default, the lender may take possession of the property. Essentially, when you invest in mortgage notes, you play the role of the lender.
To go any further, we must first explain one common scenario in which mortgage note investing is possible: seller-financing. Although not the only scenario, understanding the seller-financing context provides a necessary foundation for the notion of investing in mortgage notes. Let’s imagine that a buyer wants to purchase a property, yet prefers to not use institutional financing. It could be that their income history is inconsistent, their faith in corporate institutions is minimal, or it could be a variety of other reasons. The buyer may in fact, obtain financing for the purchase of the home from the seller instead of an institution. The seller now takes on the additional role of the lender. The interest rate, down payment and amortization schedule are all among the variables that can be negotiated between the buyer (borrower) and seller (lender). The terms of these loans are not subject to the same constraints of institutional lenders, therefore in many cases there is additional flexibility in how these variables are arranged according to the wants and needs of each party. Of course, in the same manner as a bank or any holder of a promissory note, the seller may foreclose on the property in the event of borrower default. For an excellent run-down on the pros and cons of seller financing, I’d recommend this Investopedia article: investopedia:
One element normally worked into the seller-financing arrangement is a “balloon payment”. The idea is that the loan is amortized over a 20 or 30 year period, however a balloon payment is due at a shorter interval, say 5 years. Why have a balloon payment? Lenders prefer these arrangements because they provide the flexibility to either exit early, or hold onto the income stream. The five-year period also gives the buyer (borrower) the opportunity to build equity in the property, improve their financial situation, and work towards refinancing the property with a conventional lender. Note that terms of these loans are not subject to the same constraints of institutional lenders, therefore
Here is the kicker: One can invest in these types of private mortgage notes by repurchasing the loan made by the seller/lender to the borrower/purchaser. So, for example, the seller/lender extends seller financing to the buyer/borrower, then turns around and resells the note to an investor on an open exchange. What is the advantage of reselling the note? The seller now can get the cash for the entire note from the investor, while the investor now earns the income stream paid by the borrower. Many mortgage notes that one finds are the result of seller financing in this scenario.
What does the purchase of this mortgage note entail to the investor? Am I the homeowner now? No. The borrower still stays on title. The only thing that has changed is who collects the mortgage. The seller/lender no longer collects the income stream from the mortgage, the investor does. Essentially, what we have done is gone from owning the property itself, to just owning the loan on the property.
Why go to all this trouble, when you could simply own the property outright? Investors like mortgage notes because they offer passive income delivered on a regular, predictable schedule. Often, there is a servicing company that serves as the intermediary between the investor and the buyer/borrower. Owning the mortgage note doesn’t require as much direct involvement as direct property ownership – no late night calls, property management, searching for renters, etc. Technically the investor doesn’t own the property; however, should the buyer/borrower default on the property, then the investor may foreclose and would then directly own the property.
In sum, investing in mortgage notes provides a streamlined, passive investment, with many of the benefits of direct ownership of real estate minus the headaches. We’ve really just scratched the surface on the topic. Stay tuned for further articles where we discuss metrics of importance in note investing, performing versus non-performing notes, and other topics.