Follow one mortgage note from a seller-financed sale, through a note sale to an investor, to its final payoff.
5 min read · Lesson 1.6
Mortgage notes have given many investors steady cash flow that arrives every month. I think of notes as cash-flow machines that you build, plug in, and then let produce income for years, and you can build more than one.
Most people have some idea of what a mortgage note is, but few understand how it might work for them. Here we follow one mortgage note through its whole life, from the day it is created to the day it is paid off.
The note is born: John sells his house to Jane
John sold his home to Jane for $250,000. She put down $50,000. Instead of getting a $200,000 loan from a bank, she signed a 15-year note to John at 6% interest, secured by a mortgage on the house.
Jane pays John principal and interest of $1,687.71 a month.
John sells his house and gets $50,000 in cash plus monthly income of $1,687.71 from the note.
Worked example: should John sell the note to Bob?
Five years later, John needs cash. He can sell Jane’s note without changing her payment or terms. Bob offers John $128,000 for the note.
John’s side
Item
Amount
Payments received (60 × $1,687.71)
$101,262.60
Bob’s offer for the note
$128,000.00
Total John receives
$229,262.60
Original note amount
$200,000.00
Bob’s side
Item
Amount
Price paid
$128,000
Monthly payment
$1,687.71
Payments remaining
120 (10 years)
Yield
10%
Collateral
$250,000 house
John decides it’s a good deal: he collects more in total than his $200,000 note. Bob decides it’s a good deal too: Jane has paid reliably for five years, he earns 10% on his money, and in the unlikely event she defaults, he can foreclose on a house worth far more than his investment. John sells the note to Bob, and Jane keeps paying on time, now to Bob.
One note, two happy investors.
The note ends: Jane sells the house
Jane lives in the house for another three years, then takes advantage of rising home values and sells at a healthy profit. The new owner takes out their own loan and pays Bob in full.
Bob received three years of monthly payments of $1,687.71, plus a lump sum for the rest of the debt.
Jane no longer owes anything on the note and has money to buy another house, or anything else she likes.
Note investing is not always this simple, but this example shows how one note can serve a seller, a buyer and an investor.
How Bob’s yield changed when Jane paid early
Bob bought the note expecting 10% if Jane paid all 120 remaining payments. She paid it off after 36. That early payoff matters, because Bob bought at a discount to the balance.
Here is an illustrative calculation using the lesson’s own figures. When Bob bought the note, Jane’s balance was about $152,018, so his $128,000 price was roughly $24,000 below what she owed. Three years later, her payoff balance was about $115,529.
If Jane pays all 120 payments
Jane pays off after 36 payments
Price Bob paid
$128,000
$128,000
Monthly payments received
120 × $1,687.71
36 × $1,687.71
Lump-sum payoff
None
About $115,529
Bob’s yield
About 10%
About 13.2%
Bob collected the discount sooner, so his yield went up. This is why note buyers like early payoffs on notes they bought below the balance. In a real deal, the payoff amount comes from a payoff statement, not an estimate. You can test scenarios like this with the note calculator.
The three roles in a note’s life
Every note in this lesson involves the same three roles. Learning them now makes the rest of the course easier to follow.
The payor (Jane) owes the money and makes the payments. She’s the borrower, and her house secures the debt.
The note holder (first John, then Bob) is owed the money and receives the payments.
The buyer of the note (Bob) pays the holder a lump sum today in exchange for the payments still to come. The price he pays sets his yield.
The terms of Jane’s note never changed when it was sold. Only the person receiving the payments did. For definitions of these and other terms, see the note dictionary.
What could have gone differently
This note’s story has a happy ending, but a note investor plans for other endings too. Here are the common ones to think about before buying any note:
Late or missed payments. If Jane had fallen behind, Bob’s income would have stopped while he worked out a solution.
Default and foreclosure. Foreclosure takes time and money, and the rules vary by state and province. Strong equity, like Jane’s $50,000 down payment, is what protects the investor here.
A drop in property value. Less value means less protection behind the note.
Lapsed taxes or insurance. Unpaid property taxes or a lapsed policy can put the collateral at risk.
