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Most people think of a mortgage as a vehicle for buying a home, not an investment. Often times, someone selling a home actually ends up financing the buyer’s purchase and “takes back” a note. They serve the same function as a bank and are called the “note holder”. After several years they may decide to sell their note and use the proceeds for another purpose like paying for a child’s college tuition or buying a new car. They can sell the note on one of several exchanges where note brokers purchase and hold them for their own portfolio or resale. When you invest in a note you become “the bank”.
Buying notes offers a lot of security. If you invest in stock, you’re subject to the market’s variability with no safety net. When the market drops, your investment may lose value. While the stock market occasionally offers higher yields than can be achieved by investing in notes over all, notes out-perform the market. The stock markets 20 average yield is 7%. Performing notes often yield 8 to 10%. It’s also important to know that the stock market’s quoted performance is a gross yield. Most mutual funds or investment managers charge 1½ to 2% management fees so the actual yield investors receive is 5 to 5 ½%. If you invest in notes using a self-directed IRA, the management fees are usually less than 1/4 of 1%. If you buy using your savings or other funds, there are no management fees.
By investing in notes wisely you can further mitigate potential losses. Here are some things to consider:
- Invest in notes with a broker you trust
- A broker’s primary interest should be in the quality of the note and whether it fits your investments objectives. They should also be willing to assist you with any issues that may arise until the note matures or is repaid.
- Make sure the borrower has made a substantial down payment or has equity in the property
- By having a large down payment or long-term ownership the borrower has more to lose if they default. This means that they will likely work harder to keep the payments current and thus protect your investment.
- Buy notes with low loan to value ratios
- Let’s say the borrower has done everything they can to make their payments, but they’ve had a major life occurrence like an unexpected medical expense or death of a spouse and they default. If the loan to value ratio is 60% or less there is a better chance that the house could be quickly sold at a discount, so you can be repaid your remaining investment.
- Insure that area rents are higher than the borrower’s mortgage payments
- If the mortgage payment is say $400 per month, your broker should survey the local market to determine that the rents are significantly higher. Thus, if the borrower defaults the house could be rented for more than the mortgage payment, which would insure that you receive your return.
Additionally, most people work hard to make their mortgage payments because, like you, they are proud homeowners and will protect the equity in their homes. This is another factor decreasing the risk of investing in notes.
11 frequently asked questions about Mortgage Notes
1. Who sells notes and why do they want to sell them?
The two sources of notes are Individuals and large investment companies. In each case the property seller has acted as the bank for a home buyer. Many individual sellers want the long-term income provided when they originate a note but then change their mind. They may have found another investment with a higher return or need the money for a personal reason. Investment companies usually sell their notes because they need to return investors capital.
2. Where are the properties?
Most of the properties we buy are located in clean, safe, working class neighborhoods in the Midwest and Southeast.
3. What are the demographics of the areas where the homes are located?
We buy notes in areas that have diverse sources of employment, low home prices, and high rents. Buying notes in these areas increases the likelihood that borrowers will be able to continually make their mortgage payments.
4. Who are the borrowers?
They are working class people like millions of Americans. They work in factories, stores, warehouses, schools and many other places.
5. How much do people usually invest?
Most investments range from $20,000 to $50,000 for each note purchased.
6. How long does the investment last?
These are long term investments lasting 10 to 28 years. Most loans will be paid off early but some run for the entire term.
7. What yield should I expect?
Most performing notes have yields in the 8 to 10% range.
8. What happens if the borrower sells the house or refinances?
If the borrower sells the house, refinances or retires the loan for any other reason before the maturity date you will be paid the remaining balance of your investment.
9. How is the loan serviced during my investment period?
There are a number of companies that specialize in servicing investor loans. We use several servicers that are well known in the industry.
10. Do I have to work with the borrower if he doesn’t make his payments?
The mortgage servicer sends notices for overdue payments and other notifications to the borrower. We also assist our clients in these situations. If necessary, we will connect you with a lawyer in the state where the property is located to foreclose on the loan. If you’ve only bought a portion of a loan we will take care of this.
11. How do I make sure the borrower is making his payments?
The mortgage servicer will monitor the loan, collect the payments, and deposit the funds into your account. However, it’s always a good idea to occasionally check your account to ensure that payments are being properly deposited.
Notes are a good alternative to stocks and provide diversity in a portfolio. While no investment is risk free, they have factors that mitigate risks and provide higher returns than are found in stocks which have no insurance against loss. If you want to create long term, stable income that’s not affected by an unpredictable market to supplement either your monthly income or improve your retirement earnings, then you should consider investing in notes.
Written by: Richard G. Thornton, Principal, American Note Capital.
About the Author
Richard Thornton has been in the mortgage lending and real estate investment arena for over 30 years. Having been a principal in several firms, originated over $1.5BB of loans, invested in Senior’s housing projects and “flipped” 18 properties he is currently buying and selling home mortgages for his own portfolio and others. For more information visit www.amnotecap.com.
This is a contribution article, written by a third-party. These are not the views of The Entrust Group nor do we endorse any of the information contained.