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Updated over 1 year ago,
Some Due Diligence Basics on Note Investing
Recently, been seeing more and more online posts of performing mortgage notes on the secondary market as one-offs with a rise in individual investors presenting "anticipated returns". The numbers invited a closer inspection, leading me to share some key insights for those of you involved with performing mortgage notes. Here are some critical considerations:
1. ROI: While it may seem attractive initially, remember that your asset, the note, loses value as the principal goes down. Take for instance a loan with a balance of $12,000 at 0% interest, paying $500 monthly for two years. Despite an ROI of 50%, you'll net no profits after the two years. The solution? Understand the yield or the internal rate of return (IRR).
2. Monthly Payments: Be cautious of sellers basing returns on monthly payments. This can be misleading as it often assumes no fees. In reality, you will at least have servicing fees, which can consume up to 10% of a payment, particularly for loans under $500/month.
3. Loan Constant: It's crucial to grasp this concept. The lower the interest rate and longer the term, the more you'll need to discount the loan, yielding a lower loan constant. To reach their targeted return, investors might discount the loan further. Keep in mind, a higher loan constant translates to a higher loan value.
4. Yield/IRR Variations: With lower balance loans, yield/IRR can be misleading due to its potential for large variations. Always consider the absolute profit - a difference of $1,000 can significantly change the yield.
5. 0% Loans: Avoid these at all costs. If the seller defaults, they have no incentive to pay since there's no accrued interest. Moreover, any fees you advance won't collect interest. Your only exit strategy would be to wait until the property is sold or you manage to sell the loan.
- Chris Seveney