In some 15 years in business as a national note investment firm, we have bought thousands of notes. This is the story of the worst investment we ever made. When the mortgage first came to us it seemed simple enough. Little did we know that you should never buy a contractor note. Read on and find out why.
A simple-looking second mortgage
An agent called in for a quote. The property’s value was estimated at $235,000, with a first mortgage of $130,000 and a second mortgage of $39,500, put on for an addition to the home. The second was for sale.
We assumed (and you know what they say about assuming) that as long as we got an Affidavit of Satisfaction and Completion, everything would be fine.
The mortgage had been in place for 5 months, and 4 payments had been made. The note was amortized over 3 years at 7.5% interest, with a monthly payment of $1,228.70. By the time it came to us, the balance had been paid down to $35,535.73.
| Item | Amount |
|---|---|
| Estimated property value | $235,000 |
| Appraised value | $220,000 |
| First mortgage | $130,000 |
| Second mortgage (original) | $39,500 |
| Second mortgage balance when bought | $35,535.73 |
| Terms | 7.5%, 3 years, $1,228.70 a month |
| Price paid | $31,836 plus closing costs |
Our due diligence and two mistakes
We started our due diligence. The payors’ credit was good. We received an Affidavit of Satisfaction and Completion on the work, plus an estoppel letter stating that the payors had no offsets or claims against the note. Both were signed by the payors and notarized.
The appraisal came in slightly low, at $220,000, but it was only $500 short of what we needed, so we made an exception. That was our first mistake.
Our second mistake was not noticing that the estoppel letter and the affidavit had been notarized by the contractor. (Ever since, we have always checked this.) At the time we didn’t know about either mistake, so we bought the mortgage for $31,836 plus closing costs.
When the payments stopped
After closing, we sent out the payment coupon book along with a letter signed by the note seller, notifying the payors that the mortgage had been sold. For 5 months the payments came in on time. Then came October 1994, and no payment.
We sent our standard late letter. Still no payment. We called the payors, and they never once mentioned why they weren’t paying. For the next 3 months they kept promising payments, but none came.
Our policy is that when a note has been in default for 3 months, it goes to an attorney for foreclosure. We did that, but before the attorney could start, we were served as a co-defendant in a lawsuit against the contractor for unfinished work. What a surprise that was.
We had bought the note 5 months after it was written. We had an affidavit that the contracted work was completed satisfactorily. The payors paid us for 5 months, and we spoke with them on the phone many times, and not once did they mention a problem. You could have knocked me over with a feather. Instead of foreclosing, we were defending ourselves in a lawsuit. And of course, the contractor was nowhere to be found.
How the case ended
We thought, “No problem. We did our due diligence. We have proof the payors had no complaints 5 months into the note. How can they possibly win?” Wrong again.
After $15,789 in legal fees and almost 4 years, we finally had a court date. Gwen from our office was rehearsed and ready, with her facts straight and the documents to back them up.
A week before the court date, our attorney called. The payors had offered $10,000 to settle the whole thing. Ten thousand dollars didn’t even cover the legal fees, let alone what we had paid for the note. Our attorney tried to get more, but their first offer was their final offer.
We asked our attorney what to do. He said you never know what a jury will come back with (meaning we might actually end up paying these people), so he suggested we take the offer.
That was November 1996. We accepted, completed all the paperwork and waited for the check. We accepted that it had been a bad investment and made it our policy not to buy contractor notes anymore.
We waited and waited for that check. Finally, on April 18, 1997, it arrived. It wasn’t for the expected $10,000. It was for $7,400. The attorneys had charged another $2,600 in fees for collecting the promised settlement.
I wonder if we can sue them now for late payment?
What this deal teaches
Looking back at this deal, three lessons stand out:
- Check who notarized the documents. An affidavit of completion and an estoppel letter notarized by the contractor, the party with the most to gain, protect you far less than they appear to.
- Be careful with exceptions. Making an exception on a slightly low appraisal was the first mistake in this deal.
- A note for home improvement work carries the contractor’s risk. If the work is disputed, the note holder can be pulled into the lawsuit, even after months of on-time payments. That’s why this firm stopped buying contractor notes.
