Table of Contents
Introduction
When discussing investing in mortgage notes, many people are unfamiliar with the concept and often confuse it with their own mortgage on their homes. However, investing in mortgage notes involves being the lender rather than the borrower. Despite the potential for high rates of return, ranging from 9% to 20% or more, and the fixed rate of monthly ACH income, why aren’t more people aware of these investments or participating in them? The answer lies in the fact that mortgage notes are considered alternative investments and cannot be purchased through common investment platforms like Robinhood. Investing in mortgage notes requires creativity, effort, and the ability to find good notes to purchase. This article will cover what mortgage notes are, how to invest in them, the risks involved, and why investors should consider investing in notes through funds or buying partials.
What are Mortgage Notes?
A mortgage note is essentially an IOU backed by a property. It represents a promise from the property owner to repay a loan, with the property serving as collateral. There are two components to a mortgage note: the promissory note and the security instrument. The promissory note is the borrower’s promise to repay, while the security instrument (either a mortgage or a Deed of Trust) attaches the note to the property through a lien. If the borrower fails to make payments as agreed, the lender (the mortgage note owner) can sell the property to recoup their investment.
For example, let’s say you’re purchasing a house for $270,000 and have $55,000 in cash. You borrow $215,000 from a lender and sign a promissory note and a mortgage, tying your promise to repay to the property. If you default on the loan, the lender can take ownership of the property.
Types of Mortgage Notes
There are two main types of mortgage notes: performing notes (PNs) and non-performing notes (NPNs). PNs refer to notes where the borrower is making their scheduled payments. The primary consideration when investing in PNs is the current income the note offers. On the other hand, NPNs are notes where the borrower is at least 90 days behind on their payments. Investing in NPNs requires negotiating new loan terms with the borrower or initiating foreclosure proceedings. While NPNs offer the potential for higher returns, they also come with higher risks and require more active management.
The Ethics of Buying Mortgage Notes
When it comes to NPNs, some funds and asset managers specialize in residential non-performing real estate loans. They have systems in place to contact property owners, inform them of their intent to collect on the mortgage, and offer loan restructuring options that are favorable to the borrower. This approach has helped countless homeowners stay in their homes, often at the expense of banks that are unwilling or unable to renegotiate loan terms due to regulations. This ethical way of buying and managing mortgage notes benefits both investors and borrowers.
Advantages of Investing in Mortgage Notes
Investing in mortgage notes offers several advantages, especially for investors looking to generate predictable cash flow. Some of the benefits include:
Be The Bank
Investing in mortgage notes allows you to take on the role of the lender, similar to a bank. Instead of making monthly payments as a borrower, you receive monthly cash flow as the lender.
Predictable Income
Mortgage notes provide a predictable income stream, as they pay interest at a set rate and offer monthly payments based on an amortization schedule. This makes them ideal for investors seeking consistent cash flow.
No Property Management
Unlike direct real estate investments, investing in mortgage notes requires minimal property management. As the borrower is responsible for the property, they are typically motivated to maintain it in good condition.
Higher Returns
Mortgage notes often offer higher interest rates compared to traditional investments like treasury bonds or CDs. The higher rates compensate for the higher risk associated with these alternative investments.
Security
Mortgage notes are secured by the underlying real estate property. In the event of default, the investor can foreclose on the property to recover their investment. This collateral provides a level of security, although the property’s value must be sufficient to cover the investment.
Diversification
Investing in mortgage notes can diversify an investment portfolio and improve cash flow. These notes offer a different risk-reward balance compared to stocks, bonds, or traditional real estate investments, reducing overall portfolio risk.
Control
As a private note holder, you have control over the terms of the loan. Unlike corporate or government bond ETFs, you can negotiate interest rates, repayment periods, and other terms, giving you greater control over your investment.
Ability to Buy at a Discount
Investors can purchase mortgage notes at a discount, allowing them to earn higher yields than the borrower is paying in mortgage interest. Buying notes at a discount increases potential returns, but careful evaluation is necessary to ensure the note is in good condition.
Low Correlation with Markets
Mortgage notes tend to have a lower correlation with stock and bond markets, making them a good diversifier in a portfolio. They provide a stable source of income, even during periods of stock market volatility.
Liquidity
While not as liquid as stocks or ETFs, mortgage notes can be sold if needed. Note buyers are available, although selling a note may result in a lower price. However, mortgage notes offer more liquidity than many other alternative investments.
Passive Income
Once a mortgage note is purchased, it requires minimal management unless the borrower stops making payments. This makes it a more passive investment compared to direct real estate investments that require active involvement in property management.
How to Buy Mortgage Notes
Buying Notes Directly
To purchase mortgage notes directly, you can explore various platforms such as PaperStac or NotesDirect. These platforms connect buyers and sellers of mortgage notes. Additionally, you can find mortgage note brokers through forums, trade shows, or by networking with real estate investment groups.
Investing via a Fund or Platform
A more convenient way to invest in mortgage notes is through funds or platforms that specialize in acquiring and managing these notes. Examples include BlackcoreREI, LendingHome, and PeerStreet. Investing through these platforms allows for a more passive experience, as professionals handle the management and administration of the notes.
Buying Partial Notes
Investors can also buy partial notes from existing note holders. This involves purchasing a portion of the note, rather than the entire note. Buying partial notes allows investors to avoid direct contact with the borrower and transfer the responsibility of debt collection and foreclosure to the original note holder.
Risks of Investing in Mortgage Notes
While investing in mortgage notes offers several advantages, there are risks to consider:
- The borrower may stop making payments, requiring the investor to navigate debt collection or foreclosure proceedings.
- Purchasing a fraudulent note can result in a worthless investment if proper due diligence is not conducted.
- If the underlying property’s value is insufficient, foreclosure may not recover the investor’s full investment.
- Rising interest rates can decrease the value of fixed-rate mortgage notes in the marketplace.
- A downturn in the real estate market may lead to borrowers walking away from properties, leaving the investor responsible for managing and selling the property.
- Improper debt collection practices can result in legal issues if the investor violates state regulations.
- Selling a mortgage note may be challenging if there is limited demand in the market.
- Investing in partial notes carries the risk of the original note holder being unable to fulfill their obligations in the event of default.
Conclusion
Investing in mortgage notes can be a valuable addition to an investment portfolio, providing a predictable income stream and diversification. However, it is essential to understand the risks involved and conduct thorough due diligence before investing. By networking, conducting research, and utilizing platforms or funds specializing in mortgage notes, investors can enjoy the passive income and potential returns offered by this alternative asset class.