What Makes a Marketable Mortgage Note?

The value of a note depends, in the end, on the economic conditions that support the value of the property. Everything else on this list builds on that.

Rank the collateral

An owner-occupied single-family house in a good neighborhood, in an area with a long-term stable economy, is the best collateral possible. It is even better with a payor who has an excellent credit record and an unblemished payment history.

Less desirable collateral, in descending order (some buyers use a slightly different order):

1. Owner-occupied duplexes and triplexes (owner lives in one unit)
2. Non-owner-occupied single-family houses
3. Non-owner-occupied duplexes and triplexes
4. Other non-owner-occupied multi-family units
5. Improved land
6. Commercial (non-industrial) properties
7. Resort properties
8. Subdivided but unimproved lots
9. Raw land

Collateral to avoid

Because of the regulatory environment in the U.S., industrial properties, gas stations and even properties with underground oil tanks carry many hidden liabilities. Avoid notes secured by them.

Cooperatives, time-shares, mobile homes and personal property are not real estate. On their own, they are not adequate security for a note.

Equity and the down payment

The higher the investment-to-value ratio, the riskier the note. ITV = (amount paid for the note + senior lien balance) ÷ market value of the property.

If the property is appreciating little or not at all, the loan-to-value ratio is a barometer of how likely the note is to default. Notes on property bought with $1,000 down or less often default. The higher the down payment, the better.

Payment terms and lien position

• Amortized beats balloon. An amortized note is worth more than one with a balloon, because the payor may not be able to make the balloon payment.
• The monthly payment matters most. It is the single most powerful financial factor in a note’s value. All else equal, a 10-year note with a large monthly payment and no balloon is worth more than a 10-year note with a smaller payment and a balloon.
• First beats second. A note in first lien position is worth more than one in second position. Third-lien or lower notes are worth very little.
• Watch the senior lien. Avoid a second-lien note behind a huge first lien. In a foreclosure, the owner of the second would have to make the payments on the first.
• Assumable firsts are better. A second behind an assumable first is always preferable to one behind a non-assumable first.

Seasoning and the payor’s credit

A seasoned note, one with a payment history of several years or more, is better than a green note with little or no payment history.

The payor’s credit history helps show their character and how likely they are to default, but it isn’t infallible. Anyone, even someone with the best credit, can lose their income, face a medical emergency or suffer some other unforeseen catastrophe. The best use of a credit report is to spot a potential bankruptcy candidate.

These are some of the factors to weigh when you consider a note. And again: the value of a note depends ultimately on the economic conditions that support the value of the property.