Many people think of a mortgage as a vehicle for buying a home and may not realize the extraordinary investment potential in buying mortgage notes. Investing in mortgage notes is a SIMPLE, secure way to diversify your portfolio and increase cash flow, offering reliable returns without the effort of other real estate investments.
Easy, asset-backed, passive income? If you think it sounds too good to be true, you are not alone. Many people approach mortgage note investing with caution when they first learn of it. After all, if it was as good as it sounds, would not you hear about it more often?
Not necessarily. As the saying goes: money talks, but wealth whispers.
Who should consider investing in mortgage notes? If you are looking to diversify your portfolio and generate passive income with real estate investments but do not want the hassle of flipping and renting, buying mortgage notes may be just what you are looking for.
If you’re new to the world of buying and selling mortgage notes, you may already understand what a mortgage and note are. However, it is helpful to define these terms, and others associated with investing in notes and mortgages, in context.
What is a mortgage?
A mortgage is a secured loan that uses real estate as collateral. Most home buyers do not have the liquid assets needed to buy a home outright and need a loan to supplement their down payment. Mortgage lenders (typically, but not always, banks) fund the purchase for approved borrowers who then repay the loan, with interest, over a period of 10 – 30 years. A mortgage attaches a lien against the property until the loan is repaid according to the terms laid out in the note.
What is a mortgage note?
Mortgage notes are not the same as a mortgage, though both secure a loan. When a borrower takes out a mortgage, the lender produces two documents: the mortgage (see above) and the mortgage note, which is also called a promissory note. The mortgage note can be seen as a “promise to pay” and lays out the terms and conditions of the loan.
What is mortgage note investing?
Investing in notes and mortgages is a wealth generating strategy that can provide consistent, long-term returns with predictable monthly payments to the investor. When you purchase mortgage notes, you are not buying property but, instead, rights to the mortgage and note and, therefore, the mortgage payments.
What is a mortgage note broker?
Often someone selling a home finances the buyer’s purchase and “takes back” a note. They serve the same function as a bank and are called the “note holder”. After several years they may decide to sell their note and use the proceeds for another purpose like paying for a child’s college tuition or buying a new car. They can sell the note to one of several exchanges established for that purpose. Note brokers purchase mortgage notes and may hold them for their own portfolio or resell them to interested buyers.
Investing in Mortgage Notes
For many, the world of mortgage note investing sounds enticing, but finding a way in can seem daunting. As you search the internet for resources and read advice from many of the big names in the landscape, you frequently find the same challenges again and again:
- Complicated financial jargon that seems designed to fortify rather than remove the barrier to entry, so that only those with decades of experience can understand it and invest.
- Advice that is big on hype but short on specifics. You do not want to only know how much money you can make or how much risk there is in mortgage note investments; you want to know how to do it.
We have developed this guide to overcome these common obstacles, using the processes and standards we have developed at American Note Capital to provide step by step explanations and explore the risks and rewards of note investment.
If you’re considering mortgage note investment for the first time and want to learn more than just the basics, explained in plain language, so you can make an educated, informed decision about your financial future; or you have invested in notes already and wish to reinvest some or all of your returns to generate even greater wealth, this guide is for you.
Who sells mortgage notes and why do they want to sell them?
The first question that comes to mind for nearly anyone interested in buying mortgage notes is: who sells them? When you buy mortgage notes, the seller will typically either be an individual or a large investment company. In both cases, the property seller has acted as the bank for a home buyer.
- Individual Sellers. When an individual originates a note, they often do so because of the long-term income it provides them. However, another key benefit of mortgage notes that attracts buyers is the ease with which they can be liquidated. If a note holder finds that they need a large sum of money to pay for a purchase or an unexpected personal expense, or they simply wish to reinvest their funds elsewhere, they can sell the note and transfer ownership to a new buyer.
If you are considering selling a mortgage note or wish to learn more about selling mortgage notes, you can read more here.
- Investment Companies. Large investment firms usually sell their notes because they need to return investors capital.
- Banks, credit unions, and other lending institutions also sell mortgage notes. While not impossible, finding performing or re-performing notes that you can buy directly from the originating lender is often too cumbersome and involved a task for those who are not running an investment firm or buying and selling notes full time.
Many financial “gurus” sell high priced courses and books claiming to teach you how to buy notes directly from the bank in your spare time. In reality, they are typically focused on buying non-performing notes (notes on which the borrowers are no longer paying) and your results will hinge greatly on not just your ability to find them, but also the number of hours and dollars you can invest to buy enough notes to buffer the risk and see returns. This approach to buying notes comes with high risk as well as high levels of involvement for the buyer.
For those interested in secure, long term, truly passive income, an approach that only includes non-performing mortgage notes misses nearly every mark. To recoup your initial investment, let alone profit, you may need to foreclose on and flip the property. While some level of risk is expected and even welcome for many investors, this approach espoused by the “gurus” often glosses over the hard work and potential losses that bridge the gap between high risk and high reward.
Why should I work with a mortgage note broker?
Finding sellers and analyzing notes is often a large enough hurdle to send interested investors off in search of more familiar assets, such as hard real estate. Working with a mortgage note broker can remove that seemingly large hurdle by giving investors a knowledgeable partner who can help them navigate the process and manage their investment, payments, and even help mitigate risks.
When we partner with new investors at American Note Capital, they often ask a set of similar questions. We have identified those we are asked most frequently and provided answers below.
Where are the properties?
When you buy a mortgage note, you are not buying property. Instead, you are buying an income stream. When the borrower makes monthly payments on their mortgage loan, you will receive the payments.
This payment structure is not unlike the income you receive from rent payments when you own a rental property. However, unlike investing in rental properties, investing in mortgage notes does not saddle you with the administrative and maintenance costs that come with becoming a landlord.
This is because you do not become a landlord when you buy mortgage notes, you become “the bank.” Maintenance and upkeep of the property remains the responsibility of the borrower. Your responsibility as a note owner is simply to receive payments.
Nevertheless, the location and condition of the property securing the note is important to consider, as is the borrower’s ability to repay the loan. These factors will help to shed light on how much risk is associated with a given note and help you determine if it is the right investment for you.
Most of the properties we buy are located in clean, safe, working class neighborhoods in the Midwest and Southeast, in areas that have diverse sources of employment, low home prices, and high rents. Buying notes in these areas increases the likelihood that borrowers will be able to continually make their mortgage payments.
Who are the borrowers?
They are working class people like you and millions of other Americans. They work in factories, stores, warehouses, schools and many other places. These borrowers were approved for a home mortgage and have a demonstrated ability to repay the loan according to its terms.
When purchasing mortgage notes, we do our due diligence and analyze the FMV (fair market value) of the property, review title reports, review the borrower’s payment history and credit reports, and take other steps to assess the value of each note as well as its risk. Because of this comprehensive analysis, we are able to project the likely earnings we can expect for the life of the note. And because mortgage notes are backed by tangible property, notes offer an added degree of security than stocks, bonds, and other paper securities.
How much do people usually invest in mortgage notes?
Most mortgage note investments range from $20,000 to $50,000 per note. The cost will vary based on several factors, including the age of the note, payment history, loan-to-value ratio, and more. When we buy a note, we first complete a note analysis to evaluate a note’s performance and assess its current market value.
Whether you buy mortgage notes through a mortgage note broker or seek out and broker your own deals, there are certain factors you should always consider to gain a complete picture about the health of a note and the returns it is likely to yield. For a more in-depth study of how to assess a mortgage note and understand the ROI on your investment, read our Guide to Mortgage Note ROI.
How long does the investment last?
Investing in mortgage notes is not a get rich quick scheme, and brokers who say otherwise, unfortunately, do not have investors’ best interests in mind. These are long-term investments lasting 10 to 28 years. Many loans will be paid off early, while others will run for the entire term. Before buying a note, you should be able to estimate the number of payments that remain on the loan and the amount of each payment, so you can explore various scenarios wherein a borrower may pay off their loan early.
Because mortgage notes are an easy to liquidate investment, you can also sell all or part of a mortgage note if you need to at any point before the end of the term. For many investors, this ability to access greater sums of capital by selling a note when needed offers the type of flexibility they want and which they have found lacking in many other asset classes.
What yield should I expect?
Most performing notes have returns in the 6% range, with non performing notes yielding higher returns. Your return will depend somewhat on the level of risk you are comfortable with and how actively you want to manage your investment. As the holder of the mortgage note, the borrower’s payments are deposited into your account on a monthly basis. You receive returns on a monthly basis.
Depending on your investment goals, you may want to direct these payments to an account that gives you immediate access to them or to a retirement or investment account. Each of these options can impact the tax implications of your mortgage note returns. Some can even provide a tax-free returns.
What are the risks of buying mortgage notes?
Buying notes offers a lot of security for investors. If you invest in stock, you are subject to the market’s variability with no safety net. When the market drops, your investment may lose value.
All investment vehicles carry an element of risk, and mortgage notes are not immune to this. As with any asset, performing due diligence before you invest is a crucial component of managing investment risk. For note investors, there are several ways to mitigate potential losses, some of which are detailed below.
Invest in notes with a broker you trust
A mortgage note broker’s primary interest should be in the quality of the note and whether it fits your investment objectives. They should also be not just willing, but enthusiastic, to answer your questions and help educate you so that you can make an informed, responsible decision and invest in notes that align with your goals.
As mentioned above, if a broker positions mortgage note investments as a get rich quick scheme, you can safely conclude that they are looking after their own interests, not yours. Buying mortgage notes isn’t a scheme at all—it is a way to diversify your portfolio with a reliable and secure wealth building strategy. A broker you can trust will be honest about your risk and returns, and will tell you if they do not feel that it is the right investment for you.
When deciding which note broker to work with, ask them questions to understand how they find and evaluate the notes they buy and sell, and what you can expect from them as the note matures, such as:
- What criteria
do you assess when reviewing a mortgage note?
- When you partner with a broker to buy a mortgage note, it is important to know that they are doing due diligence in evaluating each prospect and presenting them honestly to potential buyers.
- Do you have
experience working with people whose financial goals are similar to mine?
- A broker‘s experience in the field can be assessed by their time in the industry, but a more relevant yardstick may be their experience with portfolios and goals similar to yours. Not only will experience with your situation help them to identify the best investments for you, but it will also ensure that you are not a “small fish in a big pond” that is not given attention until the bigger fish are fed.
- What level of
risk would you suggest for someone with my goals?
- No two investors are the same, and a mortgage note broker who leads all of their clients in the same direction will do many of their clients a disservice.
Before beginning a relationship with a broker, have a candid discussion about your goals and the level of risk you are comfortable with. As experts in their industry, your broker may suggest investments outside of the risk level you’ve described, but they should be able to explain their thinking, answer your questions, and ultimately help guide you, not pressure you, as you make a decision.
- How will you
assist me as my notes mature or until they are repaid?
- A broker who understands your goals and is familiar with your current investments is the ideal partner. Unlike brokers who treat each deal as a one and done sale, a broker who partners with you for the life of the note will be able to identify additional notes that you can re-invest your returns in to generate even greater wealth.
Additionally, all investing comes with risk, and mortgage notes are not immune to this. A mortgage note broker who signals that they are available to assist you in the future should your note stop performing, either by offering guidance or concrete assistance, is also signalling that their invested in more than just the sale—they are invested in your success, and they are offering a level of service that reflects this.
Make sure the borrower has made a substantial down payment or has equity in the property
Buyers who have made large down payments and those who have amassed significant equity in the property through long-term ownership have more to lose if they default on their mortgage. While there are no guarantees, these borrowers are statistically more likely to keep current on their loan payments and less likely to strategically default (a strategic default occurs when an borrower owes more on their home than the home’s value and, finding themselves unable to make loan payments, walks away from the home.)
Buy mortgage notes with low loan-to-value ratios
What is loan to value ratio? Calculating the loan-to-value ratio (LTV) is a way to evaluate the risk on a secured investment. In the case of mortgage notes, the loan-to-value ratio is found by dividing the amount of the mortgage (the loan) by the value of the property securing it (value.) A mortgage note with a loan-to-value ratio of less than 60% is considered less risky than a note with an LTV of 90%, for example. If the borrower experiences an unexpected life event that causes them to default on the loan and they are unable to become current again, a home with a lower LTV offers a higher likelihood of being sold quickly and at a discount so the note holder can recoup their investment.
Research rent prices and ensure that they are higher than the borrower’s loan payments
Part of assessing the risk of any investment is identifying your options to recover what you can if the investment is not performing optimally. Nobody hopes to foreclose on a borrower, and many note holders will explore alternatives before taking this step. If it does come to pass, however, note buyers who have done their research may still be able to recoup the full value of their investment. Mortgages are secured by property which means, if no other solutions are available, the note holder may foreclose on the borrower and take ownership of the property. If rent prices in the area are higher than the borrower’s mortgage payment, you can fall back on renting the property to ensure you receive a return on your investment.
What do I have to do to ensure reliable returns on my investment?
One of the most compelling draws for mortgage note investors is that notes are not shaped by market fluctuation in the same way as other investment vehicles, nor do they require the ongoing maintenance and upkeep of other real estate asset classes.
Once you have made your initial investment in a mortgage note, your money goes to work for you and provides passive income that is truly passive. As a note holder, you become “the bank.” The borrowers mortgage payments are sent to you each month and will continue until the loan repayment is complete. For many investors, partnering with the right note broker and servicer is all that is needed to find, purchase, and manage their mortgage notes.
Does American Note Capital service my loan?
Loan servicing companies that specialize in investor loans handle the necessary communication with borrowers, receive, post, and distribute loan payments, and can also handle insurance and tax escrow services as well as collection and foreclosure activities, in some instances. American Note Capital partners with several well-known servicers in the industry.
While the loan servicer will collect payments from the borrower and deposit the funds into your account, we recommend that all of our clients also check their account on occasion to ensure that payments are being deposited properly.
What happens if the borrower refinances or sells the property?
If the borrower on a note you hold refinances or sells their home before the loan’s maturity date, the unpaid balance of your investment will be repaid when the sale closes. Another benefit to investing in notes is that a portion of your principal (the amount you invested) is returned with each payment you receive. It’s not like investing in stock, where you hopefully get all of your money back plus a return when you sell the stock. Thus, your risk is further reduced since you consistently receive a portion of your investment each month.
What do I do if the borrower’s payments are late, missing, or they stop making payments altogether?
In a perfect world, a performing or re-performing mortgage note would always continue to perform until it is paid in full. In reality, sometimes things go wrong. If a borrower is not making payments as agreed, the loan servicer will take the necessary steps to communicate with them and try to bring them back to current. This may include sending overdue payment notices and other notifications.
In these situations where a mortgage note is no longer providing consistent returns, American Note Capital will also assist you in taking steps to recover your investment, which may include connecting you with a lawyer in the state where the property is located in order to foreclose on the loan. If you own only a portion of the note, we handle this aspect of the process entirely.
Investors who are looking for an investment alternative that will diversify their portfolio and offer consistent returns often find precisely what they are looking for in mortgage note investment. These secured assets are not without their risks, but these can often be mitigated while providing a more stable option than stocks that yields higher returns.
The market is unpredictable and can wreak havoc on a portfolio that is not designed to withstand its whims. If you’re looking for a more stable and predictable avenue to save for retirement or supplement your income, mortgage notes may be the investment you need to start growing your wealth.
Whether you are looking to sell a mortgage note, buy mortgage notes, or just have questions and want to learn more about investing in mortgage notes, we invite you to call us at 510-918-9001 or email us at email@example.com.