You want to make money buying notes. They go by several names, including notes, trust deeds and paper, but whatever you call them, making money is the point.
You’ll see many opportunities to buy notes. You might not see the pitfalls. And if you don’t, buying notes can be a good way to go broke instead of a good way to build wealth.
What a seller-financed note is
A good place to start: a note is a debt. When you buy a note, you buy a debt. A note is always written, never just an oral agreement, and it is signed by the payor, the party who owes the money.
When you buy notes, you’re buying a particular kind: a seller-financed note. It starts when a real estate owner sells property and extends credit to the buyer for whatever is left owing after the down payment, plus interest.
The debt is between the seller of the property and the buyer. The buyer becomes the payor on the note, and the seller receives the payor’s payments.
How the note market works
Sometimes the seller later needs cash and finds someone to buy the note, which is a valuable asset. This happens often enough to create a market in seller-financed notes.
You step in and offer cash for the seller’s note, at a discount. You pay less than the full amount owing and receive payments over time for the full amount. That’s your profit. You give up cash now in hopes of greater rewards over time. The discount is based on the time value of money.
When you buy at a discount, you’re buying a pre-existing debt between two other people. You become the new owner of the note, and the payor makes the payments to you instead of to the seller.
Like any market, the note market rises and falls. Sometimes there are more notes than you can buy. Other times there are none to be found. When notes are scarce, there’s great urgency to find any deal that looks profitable, and that’s where the first major pitfall of note buying shows up.
The pitfall: a note that is really a loan
Say the market has dried up. Someone offers to sell you a note that pays high interest and looks like any other note you’ve bought. When notes are scarce, be on guard: as you look at the details, it may turn out to have one major difference.
Here’s the situation to watch for. A person offers to sign a note to you, secured by real estate they own, in exchange for your cash. You think you have bought a note. You haven’t. You have made a loan.
Loans have two problems:
- The note on a loan is inherently higher risk and more likely to end up in default.
- Loans must comply with all the legal requirements of lending laws, which can be demanding and complicated.
The test: who gets my money?
How can this be a loan? You have a note and you paid cash for it. Isn’t that note buying? It’s a note, all right, but it’s not a seller-financed note. The easiest way to tell the difference is to ask yourself: Who gets my money?
If the seller gets your money, you bought a note
If the person who gets your money isn’t the one who has to pay you back, you bought a seller-financed note. There was a pre-existing note: a seller financed the sale for a buyer, and the buyer became the payor.
The payor doesn’t get your money. The seller does. The person who sells you the note is not the person who pays you back. It’s a three-cornered relationship: you, the seller and the payor.
If the payor gets your money, you made a loan
If the person who gets your money is the person paying it back, that’s a loan. Yes, you have a note, but it’s a note between just you and the person paying you back.
There was no pre-existing note, and no pre-existing debt between two other parties for you to buy. You created a new note. Without that third party, it’s simply a loan from you to a real estate owner who has promised to pay you back. It doesn’t matter if they give you discount points or pay higher than usual interest. It’s still a loan.
What to know before you make a loan
There’s nothing wrong with making loans, as long as you realize that’s what you’re doing. The pitfall is making a loan and thinking you bought an ordinary seller-financed note.
First, the note you receive on a loan is more likely to default than a similar seller-financed note. In a loan, your entire profit comes from one person, the payor. In a seller-financed note, it comes from two people: the seller, who gives you a discount, and the payor, who pays the interest. The burden of a loan rests on one person, and the greater the burden, the more likely a default.
Second, a loan must comply with lending laws. There are two major requirements: you must provide substantial disclosure, and you must not charge more than the legal interest rate limit. Buying a seller-financed note carries minimal risk of usury and minimal disclosure requirements.
Remember the rule: buying a seller-financed note is a three-cornered relationship, while making a loan is a two-party transaction.
