The goal of investing in real estate is to make money. It’s clear how you earn money rehabbing a property or buying rental properties, but how do you make money investing in notes?
Learn how note investors make money investing in notes and how the profit or return an investor can earn will greatly differ depending on the type of note they’ve purchased.
How mortgage loans make money
In general, profit is earned on a mortgage note because of interest. Interest is the rate a borrower pays the lender in order to borrow the funds for the purchase of the house. The higher the interest, the higher the cost to borrow, and the more the lender makes overtime. The lower the interest, the cheaper the cost to borrow, and the less the lender makes on the principal amount borrowed
If a bank or private individual creates a mortgage note for $100,000 charging 6% interest for 30 years, they would receive all $100,000 back (principal) plus $115,838.44 in interest at the end of the 30 years.
Each time a mortgage payment (P&I) is made to the loan, a portion is paid to the principal and interest as outlined in the amortization chart, with the largest portion of the monthly P&I going to the interest at the beginning of the loan, and the largest portion paying down principal toward the end of the loan. This allows lender to earn the majority of their interest before the principal balance is paid down.
When you create a mortgage note or a buy a performing loan at face value, you are earning a profit from the interest you receive while you hold the loan. The interest rate that is specified on the loan is the rate of return you will receive if you hold the loan to maturity. However, if you buy a note at a discount from how much principal is owed, then your return increases.
For example, using the same terms as the note example above, let’s say you buy the note after 10 years. The principal balance on the loan is now $83,685.78. You negotiate a slight discount of 12% buying the loan for $73,643.52 allowing you to collect the remaining 240 payments (or 20 years of monthly payments of $599.55). Even though the mortgage’s interest rate is 6%, the discount increases your return to 7.64% if you hold the loan to maturity.
How to make money if the loan isn’t paying
In the examples above, we talked about how to earn money buying or creating performing mortgage loans, where the borrower pays on time every month for the life of the loan. In an ideal world, all we would have are performing loans, but unfortunately some borrowers stop paying. In the note investing world, these loans are titled as a non-performing loan (NPL) or non-performing note (NPN).
If you create or buy a mortgage note that isn’t paying, you can try to recoup your investment in one of two ways:
- By gaining title to the property.
- By modifying or adjustment of terms to get them repaying.
Some real estate investors choose to solely focus on investing in non-performing notes (NPN) because of the discount they offer. As the example above illustrates, the greater the discount, the higher the return. Non-performing loans are often sold at a large discount, which can range from 30% to 50% or more from face value. This discount provides the note investor with the flexibility to work with the borrower while still earning a high return.
Recouping your investment through the property
Note investors and lenders have two ways to try and recoup their investment through the property, with foreclosure or a deed in lieu of foreclosure (DIL). Both result in the lender gaining title to the property and having the ability to sell the property, if desired, as a way to recoup the investment.
When a lender creates a mortgage loan they are secured by the property. They have the right to pursue legal action, called foreclosure, to gain title to the property and recoup the money that was owed to them. Eventually, the property will go to foreclosure sale at a public auction where third party bidders can bid on the property. If it sells at auction, the lender is paid their portion of the proceeds from the sale. If it does not sell to a third party bidder at auction it becomes a real estate owned (REO) property and the lender is responsible for selling and maintaining the property as a means to recoup their investment.
The foreclosure process varies from state to state and can last anywhere from a few months to several years. Because foreclosures can be timely and costly, most lenders and note investors use this as a last resort only after trying all other available options.
Deed in lieu of foreclosure
An alternative option to a foreclosure where the lender still gains title to the property is a deed in lieu (DIL), where the borrower signs the deed to the lender in lieu of foreclosure. This can be a great option for borrowers who have no interest in keeping the home and possibly owe more than the home is worth, as it keeps a foreclosure off their credit history and allows them to move on from their delinquency. Once a DIL is executed, the borrower’s debt is absolved, and the lender is placed on title subject to any liens or encumbrances. For this reason, lender’s usually only implement this option when the property’s title is clear of any other liens or encumbrances that would hinder the lender’s ability to resell the property.
Example of how to make money with a DIL or foreclosure
Let’s say there was a borrower how owed $182,916 on their mortgage and were 10 months behind on their mortgage. The note investor bought the loan at a 40% discount, for $109,750. The property is worth around $175,000 in the current market, so rather than try to sell with a realtor as a short sale or make up the difference themselves, they request a deed in lieu from the lender. After reviewing title on the property, the lender agrees. The borrower signs a deed in lieu and the lender releases the borrower’s mortgage, removing any debt obligations they had to the property or mortgage. The lender is now on title and lists the property for sale at $170,000 with a realtor. After closing costs, property maintenance and holding costs, the lender nets $155,200 providing them with a profit of $45,450 or a 41% return on investment (ROI).
If the borrower didn’t want a deed in lieu, or there were other liens on title that would prohibit the deed in lieu from being a viable option, the lender could foreclose. If it sold at auction for 25% of the current value, or $140,000 the lender would still walk away with roughly $23,750 in profit (accounting for $6,500 in legal fees and holding costs).
Modifying or adjustment of terms to get them repaying
Another way investors can make money investing in non-performing notes is by adjusting the terms of the loan to get the borrower repaying. This is by far the most advantageous option for both the borrower and lender because it allows the homeowner to stay in their home and the lender can passively earn money without the hassle or cost of maintaining or selling the home and is especially viable if the note was purchased at a discount because the lender has more room to be flexible with the terms of the loan.
The investor can work with the borrower to achieve a monthly payment that is achievable by lowering the interest rate, amortizing the loan back to 30 years based on the current balance, forgiving a portion of the balance (especially helpful if the borrower owes more than the house is worth), or changing the type of loan (such as adjustable rate to a fixed rate loan). If agreeable terms are reached and the loan can be modified. The lender can then hold the loan, collecting the monthly P&I until it is satisfied or paid in full, or they can sell the loan to another investor as a re-performing loan.
Example of how to make money by modifying the terms of the loan
Let’s say you buy a loan where the borrower is 7 months behind. With interest and fees, they owe a total of $124,261. You buy this NPL at a 35% discount for $80,770. After the sale is complete, it’s discovered that borrower had temporarily lost their job, but has secured a new job and would like to start paying again. The original mortgage charged 5% for 30 years, with a monthly P&I payment of $805.23. You decide to roll their arrears and balance to the end of the mortgage, keeping the interest rate the same but amortizing it to 25 years (300 months). This brings their payment to $726.42, and nets you a return of 9.87% if you hold it to maturity. The borrower has a more affordable payment, and you as the investor collect $726.42 of passive income for the next 25 years.
Investing in notes can be a profitable venture in most scenarios, but in almost all cases the bigger the discount you negotiate when you buy, the higher your chances of making more money on the investment. There are definitely ways you can loose money investing in notes, but if you are educated on the process of investing in notes and understand how to analyze and price mortgage notes properly you reduce your chances for a deal going south.
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