The note is the document backing the loan to buy a home. The mortgage note holder collects the mortgage payments until the note is paid off and then the buyer owns the home. Most of the mortgages in the U.S. are held and serviced by large banks and their servicing companies. However, there are a great many private mortgage notes out there as well.
The safest note to hold is the first mortgage, so let’s only discuss those here. Second mortgage notes carry more risk, and we want to talk about low-risk investments. The first mortgage is guaranteed by the real estate. As a first mortgage note holder, you have the right to foreclose on the home if the buyer defaults. If you select properly, you can have your investment fully protected in the value of the home.
This article is for those investors who have the cash to buy the note. If you have or get a self-directed IRA or 401k retirement account, this could be a diversification strategy for a portion of the account assets. Notes come in all sizes and amounts, so you can probably find one or more to meet your needs and your available cash.
Another requirement for this discussion is only buying “performing” notes. This means that payments are being made and on time. Higher risk foreclosure notes or non-performing notes are for higher risk strategies. So, who holds these notes and why? There are some very good reasons for a seller to finance the home for the buyer:
- The buyer may not have enough down payment for a bank (often minimum 20%), but the seller is willing to accept less, maybe 10% down.
- The seller may not want to pay immediate capital gains taxes on the profit/equity they hold in the home built up over the years. With installments, the capital gains are spread out over time as received and only charged on the profit, not the basis cost in the property.
- The seller gets interest on the mortgage, much higher than they could receive if they sold for cash (buyer finances elsewhere) and puts the money into a savings account or Certificates of Deposit.
- The seller can also charge fees for servicing the mortgage over time.
With those advantages, why would a seller holding a performing mortgage decide to sell it later? Usually, it’s because of an immediate need for cash, perhaps for medical expenses or some other emergency cash requirement. Maybe they’re retiring and moving overseas, not wanting to have to deal with a financed home in the U.S.
Obviously, the advantages to the buyer of the note include:
- Getting a performing investment at a higher interest rate than available on other low-risk investments.
- Having the investment backed completely, or close to it, by the financed property.
- The ability to buy at a discount, thus increasing the return on the investment via interest rate right away.
To show how this is done, let’s look at an example mortgage note purchase. The seller of a home 5 years ago financed the home for the buyer. The price of the home was $120,000, and the seller financed 90% of that amount or $108,000 after the down payment. The buyer was willing to pay a higher rate of interest, as they were short a normal down payment and had credit problems in the past. However, they had been paying all of their obligations on time for a few years, so the seller liked the risk profile.
The seller took a 7% mortgage for 20 years, so the payment is $837/month. The current amount due to pay off the mortgage is $93,157, and the current value of the home is $120,000. So, you would be at full price, paying $93,157 for this relatively secure 7% return on your investment. However, we want to earn 8% on the investment.
However, the seller really needs to get this cash, and you would like a better rate of return. Offering a discounted price for the note below the current price will increase our yield with the same monthly payment. In this case, offering to buy the note for $87,854 instead of the balance owed of $93,157 would give us our desired 8% yield. This shows how buying notes can allow you to choose a secure investment and even tailor the rate of return for your needs.
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