If mortgage notes were risk-free, they wouldn’t require underwriting. While these notes come with a variety of risk/reward profiles, none are risk-free and thus all require some degree of underwriting. This is important to individual investors who want to add mortgage notes to their portfolios. Although the notes are collateralized by real estate, it takes a significant amount of due diligence to determine the probable return you’ll experience from this unique investment.
To tackle the factors surrounding mortgage note underwriting, you must separate performing from non-performing notes. Our overall assumption is that risk-averse investors buy performing notes while risk lovers prefer non-performing ones, although there will always be exceptions to these kinds of generalities. In this article, we address the underwriting factors that most closely affect the kinds of notes we sell — seasoned, performing, low risk, and first lien.
Underwriting Performing Notes
A note is performing when the homeowner is making mortgage payments on time. Clearly, these are less risky than their non-performing cousins because they produce a steady cash flow to reimburse the noteholder’s outlay. Nevertheless, many things can go wrong before the last payment is made. The following are the six main risk factors to consider before buying a performing mortgage note:
- Property Owner
- House/Property Condition
- Equity in the Property
- Loan Terms
- Payment History
- Document Quality
Let’s talk about each one in order.
Obviously, you’d rather own the note of a responsible homeowner than that of a deadbeat. Many underwriters believe that the most important aspect of underwriting a loan is assessing the borrower. The stability and quality of their income is very important. Note buyers need to know things like:
- “What type of job does he/she have? Is it a job that has a narrow focus where, if they got laid off, it would be difficult for them to find a similar work?
- You’d prefer notes from borrowers without derogatory items on their credit histories. These items include delinquent payments, collections, defaults, foreclosures, and bankruptcies.
- Other factors in the underwriting mix include the borrower’s credit score, potential judgements, income, and existing debt.
Property Condition and Location
A good indicator of how dependable a borrower will be is to see how well he/she has taken care of the property. Photos of the house and yard taken by a local broker or appraiser can give you a lot of information. A house’s exterior appearance often indicates how well the interior is being maintained.
Also, in the case where foreclosure can’t be avoided, your risk is smaller if the property is in a quality location. That makes it more likely that the liquidation proceeds will cover the first lien. A less likely risk deals with the state’s foreclosure regulations. Some states require the borrower to attend court proceedings, which can cause expensive delays. You’d prefer to own a note in a state that doesn’t have this requirement. Also, some states have strict regulations that can jeopardize your lien unless it is perfectly documented.
Equity in the Property
Most people like to keep the money they have. The more a borrower has in his house, the lower your risk. Not only does the borrower’s having more “skin in the game” often indicate that they will try harder to make their loan payments, it also lowers the loan to value (LTV). The lower the loan-to-value (LTV) ratio the better chance that there will be sufficient liquidation proceeds to cover the entire first-lien position in the case of default.
The safest mortgage notes have first-lien positions. That is, if the property is foreclosed, the first-lien holder has the primary claim to the proceeds. Naturally, the absence of other liens reduces the note-holder’s risk. Even if junior liens exist, the mortgage note can specify that the first lien must be fully satisfied before any other lienholders can claim liquidate proceeds. There are many other terms to consider such as; “Is there a “balloon” payment requiring that the loan is paid before it fully amortizes?” Does the interest rate adjust over time? All these terms can decrease the borrower’s ability to repay the loan in full.
Many underwriters believe that the borrower’s credit history is more important their credit worthiness. While a borrower’s past performance doesn’t guarantee his future ability to pay, it can be a good indicator. The more payments a borrower has made the better feel you can have that he will continue his payments. Thus, the note should be seasoned. That is, at least 12 months should have elapsed before you buy the note. This gives the borrower enough time to demonstrate the ability to make the monthly mortgage payments on time and in full.
This can be the most difficult aspect for an underwriter to assess. Poorly written loan documents can have conflicting terms and affect the lenders ability to collect payments or foreclose. The note and mortgage should be carefully reviewed to ensure that they are enforceable.
Underwriting is a serious consideration for any mortgage note buyer. These can be great investments, especially for retirement accounts, and it makes sense to work with licensed professionals who can provide expertise to perform proper due diligence. Whether you are a mortgage buyer or seller, we at American Note Capital will be happy to discuss all aspects of due diligence that affect the price a note seller can expect, and the risk/return tradeoffs faced by note buyers.