Why Buying Notes is a Great Way to Invest

Buying home mortgage notes could provide the smart investor with good returns without the risks of purchasing distressed assets, finding renters for the unit or having all the maintenance call that come with rentals.

For most people when they think about home loan notes they think of lending giants we hear about in the news like Bank of America or Wells Fargo. According to Mortgage Bankers Association estimates, these institutions will originate $1.3 trillion in residential mortgages this year.

There is a subset of the home mortgage market called private notes, which can be originated in a number of ways.

A typical private note is called a “seller financing note”. A seller financing note is created when the homeowner agrees to provide his customer a loan for all or a portion of the homes price. Generally, the principal and interest payments are structured to amortize over a 30-year duration like conventional loans, but they will call for a balloon payment meaning the debtor has to remit the entire outstanding principal after a predetermined number of years, common is 3 – 5 years.

The idea is the customer will, during this predetermined number of years, re-finance into a conventional-type loan from a bank or lending giant. The note holder could foreclose and take back the home if the debtor is not able to pay the full amount after the predetermined time frame. The biggest danger to the note holder is that the net sale profits of the foreclosure sale could be insufficient to cover the note balance.

These seller financing loans are normally made by borrowers that are not able to qualify for conventional institutional financing. This may not be a reflection of the debtor’s creditworthiness just their current situation. For example, under existing institutional guidelines, numerous self-employed borrowers with high incomes and good credit scores will not qualify for many traditional loans. Senior Citizens deal with similar difficulties.

For these reasons, seller financing notes normally carry a higher-than-market interest rate. This higher rate of interest makes them desirable to real estate investors.

Private mortgages come from personal lending institutions that are willing to lend cash to home buyers at above-market rates; lenders are protected by the debtor’s residential property as security. These investors will want to conduct due diligence not only on the debtor’s potential to pay back and on the home’s market price and condition should the investor need to foreclose.

Private home mortgages are sale easy in a strong secondary market. Their higher-than-market rate of interest make them desirable as “buy and hold” investments, private mortgage notes can be sold and then converted into cash. The amount they sell for is based on the principal balance, the number of payments that have actually been made, the number of remaining payments, the home’s market value and even the debtor’s creditworthiness.

The concept of “time value of money” determines just how much you would want to pay for a private mortgage note. The concept dictates that receiving a dollar today is worth more than receiving a dollar in the future. There are tools readily available online that will calculate the value of a future stream of income. What this means is that the seller of a private mortgage note cannot expect to market his note for the outstanding principal balance of that note. Rather, he can sell it just for the discounted “present value” of the sum of the future repayments.