Most people obtain mortgages from major lenders, such as the local branch of a national bank, or another financial institution such as a savings and loan association or credit union. However, there is a considerable subset of homeowners who purchased their properties via owner financing. The home’s former owner sells the property to the new owner and finances the loan so the buyer can purchase the dwelling. These loans are known as mortgage notes, promissory notes or real estate notes.
Basics of Mortgage Notes
Seller financing became common during the Great Recession when it was often the only way a borrower could obtain a mortgage for a home. Because borrowers can’t qualify for conventional mortgages, a mortgage note often carries a higher interest rate.
When an owner finances a mortgage for the buyer, it’s seldom for a 15-year or 30-year period, as with a conventional mortgage. Generally, the mortgage note is set up as to require a balloon payment after five years, at which time the borrower refinances the seller-financed mortgage to a conventional loan from a financial institution. If the buyer cannot qualify for a conventional mortgage and cannot make the balloon payment, the seller can foreclose, and the property is theirs.
How to Buy Mortgage Notes
One of the simplest ways to purchase mortgage notes is through a mortgage note brokerage. Real estate investment trusts (REITs) may sell shares of mortgage notes, and that is another easy way to buy these notes.
The mortgage note will contain the loan terms, such as a five-year adjustable rate mortgage (ARM), the interest rate, when payments are due and fees and penalties if the loan terms are not met. When purchasing a mortgage note, you automatically turn into the borrower’s lender. If the borrower stops paying the mortgage, as the lender you can contact the borrower and try to modify the loan terms or start foreclosure proceedings.
Selling Mortgage Notes
The private mortgage note holder may decide to sell their mortgage note before the balloon payment or refinancing occurs. Because the mortgage notes are backed by the property as collateral, companies purchasing these securities are willing to take on the risk. There are several options available when selling private mortgage notes. These include:
- Selling the entire note for a lump sum – no more mortgage payments are received from the buyer.
- Selling a certain dollar amount of the note – receive a cash payment, but not receiving a specific number of mortgage payments.
- Selling a percentage of the mortgage payment – receive a lump sum and lesser mortgage payments.
Mortgage notes usually reach peak value when they are due in just a few years. The price depends on the principal balance, the number of prior mortgage payments, the property’s appraised value and the borrower’s credit history. However, do not expect to sell a mortgage note for the remaining principal balance. Mortgage note buyers look for the number of future payments remaining on the note when determining value.
Mortgage Note Investment Benefits
For years, CDs, savings and money market account returns have suffered from very low interest rates. While safe, these investments aren’t going to give you much in the way of returns for the foreseeable future. Investors want decent returns with relatively little risk, and passive investments such as mortgage notes can fill the bill.
Many people want to invest in real estate but have no desire to get involved with the messy realities of tenants; investing in mortgage notes is another way to go. Mortgage note investors can earn good returns on mortgage note investments, but if the borrower stops paying the mortgage, all is not lost. You can foreclose on the property and then decide whether you do want to deal with tenants or sell the house. You can also create another mortgage note opportunity if you offer seller financing to the new buyer.
Another advantage of purchasing mortgage notes is that there are no, or very low, fees and sales commissions involved. That is the case when purchasing private mortgage notes directly, not when investing in a REIT.
Mortgage Note Investment Risks
As with any investment, there are potential risks with mortgage notes. Performing your due diligence can help you avoid many issues. While mortgage notes are primarily used for the purchase of single-family homes and these receive the best prices, mortgage notes may pertain to any real estate transaction.
Risk factors include litigation involving the property or title problems. These issues could turn a relatively safe investment into one requiring legal fees to defend your interests.
The biggest risk is borrower default, which allows the mortgage note investor to foreclose on the property, but also involves a great deal of time and legal expense. Keep in mind that when a property is foreclosed, there is no guarantee that its sale will recover the amount of the mortgage note. A property’s appraised value is supposed to exceed the amount of the mortgage note, but the current housing market and the property’s condition could mean the mortgage note investor loses money in these circumstances.
More Risks to Consider
An investor who is not experienced enough to perform the type of due diligence necessary when investing in mortgage notes is better off committing funds to a REIT, where professionals have already done the necessary investigative work. When you purchase REIT mortgage note shares, your investment is more liquid, unlike a privately owned mortgage note. However, even with REIT shares, there is the possibility that no one will want to buy your mortgage note shares at the time you wish to sell.
One risk factor you cannot do much about when investing in mortgage notes is the homebuyer’s prepayment options. Most mortgages allow prepayments, and if the homebuyer comes into an inheritance or other windfall and pays off their mortgage, you no longer receive the monthly income stream a mortgage note provides.
If you do have to foreclose on the property for non-payment, it is critical that you have the mortgage note showing you are the lender. Depending on the foreclosure laws of the state in which the property is located, the borrower can force the lender to produce the mortgage note in court to prove they are the debt owner.
Self-Directed IRAs and Mortgage Notes
Many mortgage note buyers defer taxes on mortgage notes, or avoid them entirely, by purchasing notes through a self-directed IRA. A self-directed IRA is an IRA in which the IRA makes the investment decisions, rather than a mutual fund manager or manager of other types of IRA investments. Self-directed IRAs are either traditional IRAs, in which taxes on growth and earnings are deferred until the IRA owner begins making withdrawals in retirement, or Roth IRAs. With a self-directed Roth IRA, all withdrawals are tax-free in retirement as long as the owner has held the Roth IRA for at least five years.
If you want to open a self-directed IRA to purchase mortgage notes or for any other kind of non-traditional investment, you can’t do so through your brokerage, bank or financial entities providing traditional or Roth IRAs. You must find a company specializing in self-directed IRAs. The IRS does not permit the holding of real estate for personal use in a self-directed IRA, but that’s not the case with a mortgage note. It does mean that if you foreclose on your mortgage note, you cannot live in the foreclosed home.