What is a Private Note and Why are They Created?
A mortgage is a loan that uses real estate as collateral. Most homebuyers do not have enough money to buy a house with cash, so they need a loan to supplement their down payment. Mortgage lenders fund the purchase for approved borrowers who then repay the loan, with interest, over 10 to 30 years. A mortgage attaches a lien against the property until the loan is repaid according to the terms laid out in the 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 (which is assigned to the homeowner) and the mortgage note (which can be sold to other investors). The mortgage note can be seen as a “promise to pay” (sometimes called a “promissory note”) and lays out the terms and conditions of the loan.
The note itself has nothing to do with the property’s ownership as the mortgage does. In addition to providing the terms for the loan (such as the interest rate, repayment period, etc.), the mortgage note also gives the lender the right to foreclose on the property if the borrower does not make the mortgage payments as agreed.
Why Private Mortgage Notes Are Created
Most private mortgage notes originate from sellers who are willing to provide financing when they sell a home. By personally financing the home they are selling to a buyer, sellers can structure the repayment terms in their favor, receive consistent cash flow, and defer paying taxes on the proceeds.
Also, mortgage companies that specialize in making loans to borrowers who can’t qualify for conventional loans create notes. The rates on those loans are usually higher but provide high-quality financing to qualified buyers left behind by traditional banks.
Another source for notes is large investment companies that bought the notes at discounts after the last recession when they weren’t performing. These companies worked with the borrower to restructure the notes and reinstate consistent payments or foreclosed on others.
Some of the most common reasons for creating Private Mortgage Notes are as follows:
- Landlords want to continue receiving the monthly cash flow they got from a rental but no longer want the hassles of being a property owner. One solution is for them to sell the property and finance the note.
- Landlords with tenants who have consistently paid their rent on time and taken good care of the property may want to help them establish credit and buy a house. Selling the house to the tenant and creating a note can be a good vehicle for that.
- Sellers want to make their property more appealing to a broader pool of buyers by offering seller financing as part of the deal.
- A seller may carry the financing as a favor to a family member or friend who can’t get a traditional mortgage.
- Home buyers convince the seller to finance the sale, which allows the buyer to pay the seller’s asking price and creates favorable terms for the buyer.
Many notes are created to take equity out of a home without having to sell it.
What are the Advantages of Investing in Private Mortgage Notes?
Investing in notes enables you to make money in the real estate industry without the headaches of being a landlord and dealing with the three “Ts”: tenants, toilets, and turnover.
Notes provide stable, consistent cash flow with money flowing into your account every month. Plus, notes have a huge advantage over other investment vehicles because they are secured by the home itself as collateral. If the borrower defaults, you have the right to foreclose and take full ownership. As the new owner, you can either rent the house or sell it to recover your investment. Your investment amount is much less than the value of the house, which provides you with a great margin of safety. Even if the house loses value, the mortgage amount and your cash flow remain the same. Can you say that about stocks?
Notes Create a Diversified Investment Portfolio
Financial advisors consistently counsel their clients to have diversified, balanced portfolios. If all your investments are in stocks and there’s a crash, you’re in big trouble. Investing in notes can be a great way to achieve diversity while getting consistent, incoming cash flow. Investing in notes from different regions of the country or in notes structured to provide either short-term or long-term income can allow you to achieve balance. Your income can also be tax-free if invested using a self-directed Roth IRA.
Notes Are Assets That Can Be Used as Collateral
The Merriam-Webster Dictionary states that hypothecation means “to pledge as security without delivery of title or possession.” For note owners, it means that you can use a note that you own as collateral to borrow more money. In most hypothecations, a note holder wants to recoup some of their original investment and is willing to share the monthly payments with an investor for a lump sum.
For example, let’s say an investor owns ten performing notes, and they all cash flow monthly. The balance on those notes might be $500,000. So, the note holder could hypothecate the notes and offer an investor half of the monthly payments in return for a $250,000 lump sum using the notes as collateral. In the case of default, the lender would assume the full payments for the notes until it is paid in full.
When you buy a mortgage note, you are not buying property—you are purchasing 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 being a landlord because you are “the bank” and not the landlord. Maintenance and upkeep of the property, along with property taxes and insurance, remain the borrower’s responsibility. Your responsibility as a note owner is simply to receive payments!
Get Started Investing in Notes
Investing in real estate notes is a great way to build your wealth and start planning for your financial future. And we’d love to help you get started. Get in touch with us today!