Buying mortgage notes can give the savvy investor steady returns without the hassles of flipping a fixer-upper, finding tenants for a rental condo or unclogging toilets.
When most people think about mortgage notes, they think of industry giants such as Bank of America or Wells Fargo. But there is a smaller part of the mortgage market called private mortgages, and they come in several forms.
How seller-financed notes work
A common form is seller financing: the seller agrees to lend the buyer all or part of the home’s purchase price. Often the principal and interest payments amortize over 30 years like a traditional loan, but a balloon payment is due after five years. That means the borrower must pay the entire remaining principal at that point.
The expectation is that during those five years, the borrower will refinance into a conventional loan from an institutional lender. If the borrower can’t pay the balloon, the note holder can foreclose and take back the home. The main risk to the note investor is that the net proceeds of a foreclosure sale won’t cover the note balance.
Why private notes pay higher rates
Seller-financed loans are generally used by borrowers who can’t qualify for conventional financing. That isn’t necessarily a reflection of their creditworthiness. Under institutional guidelines, many self-employed borrowers with high incomes and top credit scores still don’t qualify for conventional loans. Retirees face similar hurdles.
For these reasons, private mortgage loans generally carry a higher-than-market interest rate. That higher rate is what makes them attractive to real estate investors.
Private mortgages are also made by private lenders willing to lend to home buyers at above-market rates, as long as the loan is secured by the property. These investors will want to check not only the borrower’s ability to repay, but also the property’s market value and condition in case they have to foreclose.
What sets a note’s price
Private mortgage notes can be sold in a robust secondary market. Their higher rates make them attractive to buy and hold, but they can also be converted to cash. The price depends on:
- The principal balance
- The number of payments already made (called seasoning)
- The number of payments remaining
- The home’s appraised value
- The borrower’s creditworthiness
The time value of money also controls how much you should pay. A dollar received today is worth more than a dollar received in the future. Online calculators will figure the present value of a future stream of payments.
This means a note seller can’t expect to sell for the outstanding principal balance. He can sell only for the discounted present value of the future payments.
