This is a transcription of part two of our video series, Investigating Mortgage Notes.
Hello. Thanks for joining us today in this second podcast in our series of investing in mortgage notes. In our previous installment, we discuss a general overview of what mortgages notes are.
Today we’re going to be talking a little bit about the process itself, the note versus the deed, land contracts, and subprime mortgages.
Let’s talk about the process. How are these notes even created and why do we focus where we focus? We look primarily in the Midwest for these mortgages because homes are less expensive there. I’m here in the San Francisco Bay area and I could easily pay anywhere from $800,000 to a million dollars for a two bedroom, one bath house that was built in the 1950s or 1960s. I can buy that exact same house outside of Indianapolis or Akron, Ohio, or Saint Louis for that matter, for probably $50,000 to $60,000, which might make you doubt my sanity for living here in the Bay Area, but that’s a whole nother question. If you have a, say $50,000 house, and the borrower puts down $10,000 and you have a $40,000 mortgage, a lot of borrowers or buyers can’t get a mortgage of $40,000. It’s not because they don’t have perfectly good credit history. It’s usually because banks don’t want to make loans that are that small. They’re inefficient. They are restricted by federal requirements as to how much they can charge. And, in a nutshell, they’re just too small. Some banks will, and that’s … they cater to their small town clients, and that’s great, but in a lot of cases people can’t get mortgages.
Also, there are a fair number of people out there who aren’t American citizens, people who come into the country from Canada, or maybe Europe, or maybe they have a large number of loans already. Maybe they’re an investor and they already have eight investment properties with Fannie Mae or Freddie Mac loans and both of those companies restrict the number of loans that you could have a to eight. So if you applied for your at ninth mortgage, guess what? You couldn’t qualify and therefore it would be difficult to get financing. There are any number of reasons that people can’t get these smaller loans.
There are two things that you need to understand about these investments. There is the mortgage, or a land contract, and the note. The mortgage actually is evidence of ownership of the property. It says, I, Richard Thornton, own this property and it’s recorded with the county and every place else and it can be looked up and verified that I own the property. Now, the note is what describes the loan against the property. In our case, where we have a $40,000 mortgage, the note would say, Richard Thornton has committed to a $40,000 mortgage for 30 years at X percentage rate and payments of whatever those payments are. And I may or may not be escrowing taxes and insurance also.
When we say we’re investing in mortgage notes, it’s really a little bit of a misnomer. We’re not buying the mortgage. In the case of a land contract, we actually own the property, but that’s a little bit a different matter. But at any rate, we have a borrower and a mortgage just like you would with the bank.
Most people want to know what the mortgage is secured by. Well, it’s secured by the house. If the borrower, for whatever reason, does default, one of the nice things about these investments over some things like the stock market is that you can foreclose on the property and sell it and hopefully get your money back.
We tend to invest in … well, we always invest in first trusts as opposed to seconds, which means that we’re first in line to be re-paid anything owed, behind the federal government of course, who can collect on taxes and things of that sort. If we have a $60,000 property and our mortgage investment is only $30,000, even in a slow market, we have a pretty good chance of recouping our investment if we sell the house.
As I mentioned before, there are first trusts, second trusts, third trusts, and all those numbers mean, first, second and third, is the line of priority that one has to collect their debt. Let’s say it was a $60,000 house and we have a $30,000 mortgage for it, and the borrower put a second trust on it for $5,000. Well, if the house was sold, and they could only sell it for $30,000, and we were repaid in full, the person holding the second trust wouldn’t get paid at all. Therefore, if somebody does try and sell you a second trust or a third trust, you have to get a lot higher rate of return on that because your risk is much higher. You need to know that.
What we deal with is first trusts in conservative properties on loans and notes that have strong payment history and we hope will never default. It does happen occasionally, but that’s the plan.
Let’s talk just a little bit too about subprime loans. A lot of people want to know about them or have heard about them in the news. And after all, that’s what led us into the recession. What most people don’t realize is that only 10% of the borrowers who had first trust deeds on their house, or mortgages, defaulted during your session. During one of the worst times in our country’s history, financially, only 10% of the people defaulted.
Everyone has to ask, well, why would that have led us into recession? The simple answer is, it didn’t. There were a number of loans called subprime loans that were made to people who never should have had those loans made it in the first place, because they were made at below market rates and adjusted at a later time. And therefore, since they were underwritten at the lower rates, a lot of borrowers couldn’t make the higher payments later on. They were just expecting that appreciation, or whatever, would make up the difference for them, and that obviously did not work. 43% of the subprime mortgages defaulted, and that’s what caused the recession.
That’s important to note because if you’re saying, well, gee, what’s the probability of default? The Mortgage Bankers Association, which keeps all this data and provided the data that I just quoted you on default rates, also says that the current default rate nationally is less than 3%, so there’s a 97% chance that your loan will be kept current and you won’t have any problems.
That’s a summary of notes, our process, and how we originate loans and what you can expect from your investment in those regards.
Please don’t hesitate to call me, Richard Thornton, at (510) 918-9001, if you have any immediate questions. If not, I hope that you will watch our third episode of this series and learn even more about notes from that. See you then. Thanks, and bye.