One of the best real estate investment opportunities available is also one of those that’s rarely discussed: mortgage note investing. Mortgage notes are also known as real estate lien notes and borrower’s notes. They have become a popular asset class over the past few years. Investing in mortgage notes has many benefits such as — rates of return that are higher than the bank's traditional low yield bonds; and higher than most stock dividends. Let's first discuss the meaning of a mortgage note. A real estate mortgage note is a promissory note secured by a mortgage loan.
When you take out a home loan, the lender will probably require you to sign both a promissory note and a mortgage. Suppose you want to buy a property worth $150,000 but you don't have enough cash. In this case, if you can apply for a loan whereby you can pay part of the purchase price as a down payment and borrow the remaining amount from a lender. Normally, you need to pay 20% as a down payment.
Therefore, the loan amount would be $120,000. In exchange for $120,000, the lender would make you sign a promissory note and a mortgage. Here a promissory note is being signed by you as a borrower, and it is a promise to repay the debt incurred by you in the purchase of your property. The note will state who borrowed money from whom, the loan amount, the interest rate, the tenure of repayment, and what happens in the event of a default.
A mortgage is a separate document that collateralizes the lender and is secured by the property. It is a contract that hypothecates a lien on the property, or the mortgage deed may be updated to specifically give the lender foreclosure property if contractual terms aren’t met. It will say who is personally responsible for the debt, whether it is an individual, a couple, or a corporation.
What Is the Difference Between a Mortgage and a Mortgage Note?
A mortgage is a loan used to purchase real estate. When you take out a mortgage, you will either sign a mortgage document or a mortgage note. Both are equally binding. With a mortgage contract, they may have to sue you and win in court before they claim the property. With a mortgage note secured by the mortgage deed, they don’t have to go through foreclosure proceedings to seize the property. Mortgages are registered at the local recording office since it typically requires updating the property deed.
They’re the primary type of mortgage loan issued by banks and credit unions. They are rarely available for sale to private investors because the banks prefer to bundle them and sell them to institutional investors. Mortgage notes are not always registered, though they are legally binding documents. It is generally easier to buy private mortgage notes than by a mortgage loan from a bank. This is why investing in real estate notes typically requires searching for the private market for such opportunities.
The Different Types of Real Estate Mortgage Notes
There are both commercial and residential mortgage notes, and both are open to investors. They’re both promissory notes secured by a certain property. All mortgage notes should specify the roles and responsibilities of all parties and what qualifies as a breach of the agreement. One of the major differences between real estate mortgage notes is the loan terms.
Fixed-Rate Mortgage Loans
The fixed-rate mortgage or FRM is a loan that has a fixed interest rate and set payments. This is the most common type of mortgage offered by banks, but it can be offered by private individuals, as well. The greatest benefit of this loan is that the borrower has the same payment every month.
The Graduated Payment Mortgage
The graduated payment mortgage or GPM has a fixed interested rate with adjusting payments. It typically has a low initial monthly payment that increases over time. These loans are sometimes used for student loans, but they can be found in real estate, too. This is a type of negative amortization loan. There is a risk that the person who purchased the home will be unable to make the later, higher payments.
An Adjustable Rate Mortgage
An adjustable-rate mortgage or ARM has an interest rate tied to some third party indices. Banks will tie the interest rate on the adjustable-rate to the interest rate offered by the Federal Reserve, and the interest rate on the mortgage will rise and fall with it. This is why they’re sometimes called variable-rate mortgages. For consumers, the ARM may result in lower payments when interest rates are low.
However, it brings the risk that they can’t afford their house payment when interest rates rise. Lenders are protected from losses if interest rates rise. Private lenders have to deal with more complicated loan administration. Buyers have the option of sending in the same monthly payment, but the amount of principle applied to the loan with each payment varies.
A Balloon Payment Mortgage
A balloon payment mortgage is generally a fixed-rate mortgage with a large payment due at the end. This is in contrast with traditional mortgages where the final payment pays off the debt entirely. Balloon payments may be accepted by a borrower who can’t manage the monthly payments without it. They may hope to qualify for a conventional home loan at the end of the private mortgage to get the money to pay off the balloon payment. The occupant runs the risk of losing the home if they can’t make the balloon payment. This is separate from the mortgage acceleration clause that makes the entire amount due after a payment is missed.
The Interest-Only Loan
An interest-only loan is a mortgage where the person only pays interest on the loan. Some people take out an interest-only loan because they can’t afford to pay on the principle. This borrower demographic is very high risk. Yet interest-only loans are attractive because of the low monthly payments. This is a popular loan for property developers. You get the money to buy the property. You expect to sell it for a profit and pay off the mortgage note.
Interest-only loans were commonly used in hot real estate markets before the Great Recession, but they’ve almost disappeared from the residential real estate market because the people aren’t making progress on the loan balance. This left many people underwater, owning more than their home was worth. In these cases, people expected to be able to refinance the interest rate mortgage into a fixed-rate mortgage once the home’s value appreciated. The interest-only mortgage had the benefit of allowing them to get into a home now before prices went up further.
These loans often became negative amortization loans, because financially stressed people missed payments and saw the total loan balance increase. Minimum payments that didn’t even cover the full interest payment led to an accrued interest to compound, as well. We consider interest-only loans to be a high risk unless you’re dealing with a real estate developer. Interest-only hard money loans would fall into this category. You can issue an interest-only loan with a recast period, where you force them to refinance the loan or pay off your loan with a third party mortgage after a set period of time.
Real Estate Mortgage Notes: How Can You Earn Money By Investing In Them?
Mortgage notes can be a good real estate investment for people seeking passive income. When you buy a mortgage note, you receive the monthly payments that include both interest and principle. It is a steady stream of income like you’d receive from a rental property, but there is no need to maintain the property like a landlord. It is far easier to invest in real estate located around the country because you don’t have to deal with local rules regarding real estate licensing or taxes. The mortgage note spells out the loan duration. You know how long you’ll receive loan payments, and it maybe 10 to 30 years.
You may be able to increase the value of the mortgage note by buying from a distressed note holder. For example, you may find a farm or family property sold via owner financing. The person sold their home, but now they have to manage the loan. They may be in need of the money, whether it is to allow them to buy a new home or simply get cash to fund their retirement. In these cases, you might offer 80,000 dollars to buy a 100,000 dollar note. If they accept, you receive the interest and principal on a 100,000 dollar loan but only paid 20,000 dollars for it.
Another class of desperate sellers is the private lender with a slow or non-paying borrower. They’re not getting the income they expected. They may be reluctant to foreclose on a slow-paying family member. Or they may not want the property back. You can buy these notes for far less than their face value. However, you’re going to either need to ramp up collection efforts or foreclose on the property. Only buy notes like this if you have a plan for how to monetize the property, whether you rent it out, sell it to someone else or redevelop the property.
Advantages of Buying a Real Estate Mortgage Note
- High Yield Returns – Rates of return that are higher than the bank's traditional low yield bonds; and higher than most stock dividends.
- Monthly Income – If you are looking for additional monthly income for retirement, for living expenses, or to build your savings account, we can help.
- IRA Friendly – This investment provides investors with a way to put to use their self-directed traditional IRA or Roth IRA. We can recommend several custodian companies that handle the paperwork and hold your IRA while the funds are invested with us.
- Rollover Option – Option to automatically roll over your investment so you don’t miss out on earning interest or future investment opportunities.
Real Estate Mortgage Notes: From Where Can You Buy?
It is hard to find the farmer who sold their property to an up-and-coming farmer or family member who wants to sell the note so they have the money they need to pay for long-term care. This is why many investors go through brokers to find mortgage notes for sale. These brokers specialize in locating both private and public deals. There are even online marketplaces like NotesDirect to help you find, vet, and buy notes. You can try to find deals through real estate investor groups. In this case, you’re buying notes from people who trade future income for liquid funds.
Mortgage notes are often associated with owner financing. You might find mortgage notes for sale by going through for-sale-by-owner groups and making offers to former property owners who are desperate for cash. Furthermore, mortgage notes may be sold by real estate investor groups or real estate investment trusts. In the latter case, you could even buy a mortgage for a multi-family apartment building. If you are buying a nonperforming mortgage, investing in real estate notes is one of the cheapest ways to acquire such properties.
Buying a Non-Performing Note vs Performing Mortgage Note
The homeowner who is behind on their loan payments or regularly made late payments is the reason why you have non-performing notes. Performing notes are those where the payments are made on time and in full. Performing notes sell for 75 to 100 percent of their current value. Sub-performing notes can be found for 50 to 80 percent of their current value. That lower price tag is what attracts some investors. They’re also priced to factor in the risk of someone who hasn’t paid their mortgage in the past 15 to 60 days or has had missed payments in the past.
Non-performing notes are notes that are already in default. They are attractive to investors because you might buy the property for 10 to 30 percent of its actual value. It can be a cheap way to buy a real estate investment property. It does come with the hassle of renegotiating the deal (rarely done) or foreclosing on the property. If you’re considering buying a mortgage note for a multifamily property, you cannot take property into consideration without doing detailed research. It doesn’t matter if they have almost every unit full if only half the tenants are paying their rent. What is the property’s condition? You don’t want to buy a multi-family property that is falling apart.
The Risks of Investing in Mortgage Notes
These notes are not FDIC insured. Instead, it is secured by a property whose condition may not be great. And you’re not responsible for its upkeep. Yet you want to verify the condition of the property before you buy it, or else you’re paying less than the property is worth. You run the risk of having to pay money to get what you’re owed. You will have to pay various legal fees to foreclose on the property. You may have to sue to get back mortgage payments, too. Know the foreclosure laws for the area where the property is located, especially if you’re considering buying a non-performing loan.
You can buy a mortgage note without the permission of the person who lives in the property. You do run the risk of them initially refusing to pay you because they don’t think they owe you the money. The solution to this is good communication, including the initial note holder informing them that the loan is being transferred. Do your research. Don’t buy a multi-family property note before you know the percentage of the units that are occupied by rent-paying tenants.
Know if you have a say in the property manager in charge of the property because putting a good one in could increase occupancy rates, payment rates, or even the average monthly rent. Know how to get a copy of the original note along with all amendments and assignments. You don’t want to buy a mortgage note and get sued by someone else who had the title. You may want to pay a title search company to do such a search before you buy the note, though this is an expense you have to pay out of pocket even if you don’t buy it. Know your lien position, so that the house isn’t sold to pay a different creditor while you get less than you’re owed.
Real estate mortgage notes may allow you to get a regular stream of income without the hassles of a landlord, or you can buy the note and sell it later to another investor. Or it can be a way to secure properties for less than their market value. But real estate mortgage notes are a good way to invest in real estate with relatively little work beyond the initial search and purchase.
Real estate mortgage notes Meaning
Difference between a mortgage and a mortgage note
Different types of real estate mortgage notes
How can you earn money by investing in real estate mortgage notes?
Where to buy these mortgage notes?
Buying a non-performing note vs performing mortgage note
The risks of investing in mortgage notes