When you invest in trust deeds, you're buying someone else's real estate loan, which is secured by a trust deed. Also known as private mortgages, trust deed investments typically offer healthy returns. However, you're taking the same risk as any other lender -- the risk that you won't get paid off. Investing in trust deeds exposes you to two broad market risks as well as the credit risk posed by your borrower.
Market Loss from Resale
One of the biggest risks that you take when you invest in trust deeds is the risk of having to resell your loan on the market. The underlying structure of trust deeds is essentially similar to bonds, so they are usually structured as investments that you can resell. However, the market for trust deeds is very specialized and is relatively limited. As such, there's a real risk that you could have to sell at a loss if you need to sell your trust deed before it gets paid off. One way to mitigate this problem is to only invest in a trust deed if you are sure that you can afford to hold it until you get paid off by the borrower.
Housing Market Loss
Buying a trust deed exposes you to the housing market. As long as the borrower can make his payments, you should get your expected return. However, if something goes wrong in the housing market, you take the risk that your borrower will lose the motivation or ability to make his payments. At that point, you would have to get your money back by foreclosing on the property and, hopefully, selling it for what you are owed. You can potentially avoid this problem by requiring a sizable down payment from the borrower. The more the borrower puts down, the more he'll lose if he doesn't pay you, and the more cushion you'll have if you have to sell the property. While down payment requirements can vary, a 35 percent down payment is nice to have and 40 percent or more is even better.
In addition to risks related to the trust deed and housing markets, you're also exposed to the risk that something will go wrong with your borrower and that he'll stop paying you. If this happens without a decline in the housing market, there should be value in the house to protect you. That value comes from the down payment that you received that lowered the loan amount below the home's value. The down side is that you'll have to foreclose and take the risk that he damages the property. Many private trust deeds are based on loans made to buyers that can't qualify for bank financing. That being said, you can still do due diligence on a buyer to determine the likelihood that he'll be able to pay you back. At the same time, having the house appraised to ensure that there is equity above and beyond your loan is also wise.
Insulation from Stock Market Losses
One of the benefits of investing in trust deeds is that they typically have a reliable, fixed payment. If you buy a trust deed that is based on a secure loan with a good borrower, you'll be able to enjoy regular income, month-in and month-out, even while other financial markets go up and down. As such, it can actually be a safe haven.
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