Creativity is rewarded in the lending business. Secondary mortgage notes, made to home buyers who can’t get traditional bank financing, became a much larger market after the housing crash. This lesson explains where these notes come from, who the borrowers are, and three ways to invest in them.
How the housing crash grew the secondary note market
Back in 2005, it was clear to anyone who looked closely that the housing market was on unstable ground. Lenders were freely lending to borrowers with credit scores in the 500s, at combined loan-to-value ratios of 103%, on stated income with no proof of income and no money invested in the property. They were lending to people who could not afford the houses they were buying.
The housing market took a dive, the financial markets melted down, and the Great Recession followed. Those events led to rapid growth in the secondary note space, and they permanently changed how lenders treat borrowers with “imperfect” loan applications.
Who borrows through secondary notes
Secondary mortgage notes are made to home buyers who don’t qualify for traditional financing, however the current market defines it. They may have a credit issue (a score that is too low) or a down payment issue (not enough cash). Whatever the issue, they have a big toe outside the bank’s lending box, and the bank won’t make an exception.
People who buy with seller financing understand that their financing may be temporary. If they become institutional-quality buyers, they can refinance into a conventional mortgage, which costs them less. They accept the secondary loan terms as the price of owning a home while they repair their credit.
In my experience, these borrowers are very often excellent people who pay their home loans on time and in full. Under the right loan terms, they make great borrowers because they sincerely want to be homeowners and value the opportunity. They also tend to be willing to pay above-market interest rates, make larger down payments and pay higher prices for the properties themselves.
Most investors don’t know how to work with these buyers. They miss out on premium sale prices, well-collateralized investments, and the chance to help more families own homes.
Three ways to invest in secondary notes
- Create notes yourself. When you are willing to create notes through seller financing or other creative lending structures, you attract your own pool of eager buyers who are willing to pay above-market prices on both the loan and the property. You also bring speed to the deal, since secondary financing can usually be arranged faster than a bank loan.
- Buy performing notes and collect the monthly income. Buy seasoned mortgage notes with a history of on-time payments, then collect the payments. Over time, the payments can add up to well more than you paid.
- Buy non-performing notes, “rehab” them, and then keep or sell them. Note investors often buy non-performing notes at a discount, then work with the borrower so the payments start again. Once a note is back to performing status, it may sell for much more than you paid.
