mortgage note investing explained

Mortgage note investing can be a great investment strategy for real estate investors seeking diversification for their portfolio especially in a competitive market without many of the hassles traditional real estate investing may bring.

Over the past decade mortgage note investing has grown in popularity for obvious reasons — it’s one of the only ways to invest in real estate without having to physically own and manage the real property yourself while still benefiting from earning passive income remotely.

If you’re interested in learning more about note investing and how it works, this article explains learning what note investing is as well as how to buy and earn a profit investing in real estate notes.

What is a mortgage note?

A mortgage note is a set of documents that is used to secure a borrower and a lender when a loan is acquired in order to purchase a property. The note outlines the borrower’s terms to repay the lender including how much was borrowed, what interest rate the borrower will pay to the lender, and for how long. The mortgage outlines the responsibilities, rights, and protections granted to both parties including what happens if the borrower defaults, or stops paying the note.

Types of mortgage notes

There are many different types of mortgage notes in real estate, but in most cases, notes are classified into four categories.

  1. Type of real estate or “collateral”.
  2. Origination type.
  3. Lien position.
  4. Performance or pay history.

Real estate mortgage notes are used for residential properties, like a single-family home or rental property, as well as commercial real estate like an apartment complex, industrial complex, office space, or retail store. The type of real estate that secures the loan is called the collateral. It is the tangible asset the lender can pursue in the event the borrower stops paying making mortgage notes a secured loan.

Most mortgage notes are created by an institutional lender, like a bank, credit union, or formal lending institution although private individuals can also create a mortgage note — which is called owner financing or seller financing. Who creates or originates the loan classifies the mortgage note as a private mortgage note or institutional mortgage note.

Mortgage notes can also have different lien positions, which relates to the level of security a lender has in the collection of debt. If a borrower buys a property getting a 30 year loan from Bank X, but then takes out a home equity line of credit (HELOC) five years later from Bank Y, there are now two separate mortgage notes created at two separate times.

The mortgage note to Bank X is considered a first lien, because the mortgage note was originated first. This means Bank X’s debt will be repaid first in the event the borrower stopped paying. Bank Y is still secured, but as a second lien that is subordinate to the repayment of Bank X’s debt first. First lien notes are more secure than second lien mortgage notes, and because of this, are typically more expensive than second lien notes.

The last way mortgage notes are typically classified is through performance or pay history. Loans can be:

  • Performing, where the borrower has never missed a payment. 
  • Non-performing, where the borrower is currently 60 – 90 days past due. Loans beyond 90 days can also be referred to as non-accrual.
  • Re-performing, where the borrower was previously delinquent but is now paying on time again. 

How does mortgage note investing work?

In the real estate and financial world, mortgage loans are created and sold all the time. Financial institutions in particular create loans, package them together, then sell them to investors or government sponsored entities (GSEs) like Freddie Mac or Fannie Mae. It’s a part of their business model and the only way they are able to continuously create more loans.

Private note holders from time to time may also have a need for cash now rather than collecting the mortgage payment back over time. Investors can purchase the mortgage note, often at a discount having all rights and interest to collect the mortgage note assigned to them from the original lender.

The borrower still owes the same amount with the same terms, their payment is just made to a new investor or company.

When you invest in a mortgage note, you are the bank. You do not own the real estate itself, the borrower does. You simply own the mortgage note and have the right to collect the principal and interest (P&I) payment until the loan is paid in full. If the borrower fails to repay the loan as agreed, you are secured by real estate.

Buying real estate mortgage notes

How you buy mortgage notes will depend on what type of loan you are buying. For example, institutional loans or those created by banks or formal lenders are typically sold in bulk as a package. For this reason, small investors are rarely able to go directly to a bank or credit union to purchase mortgage loans. Most buyers are larger investors or hedge funds that have millions of dollars at a given time to purchase a pool or large group of loans.

Private lenders, like a note holder who offered owner financing can sell their individual note to a large company or an individual note investor. For this reason, many smaller or new note investors will target Hedge Funds or individual note holders to purchase one or two notes at a time.

The due diligence process is similar for both transaction types, with the investor reviewing the borrower’s pay history, the loan documents, and verify the condition and value of the collateral or real estate securing the loan among other factors.

Pricing varies when buying real estate mortgage notes and is directly impacted by the health of the market, the note’s position, and its pay history. If a loan is non-performing, it has less value than a note that is paying on time. Many non-performing loans (NPLs) are sold at a discount of the unpaid balance or the property’s value, which ever is less. Discount amounts will vary depending on location, condition, and quality of the asset. Performing loans are often sold “at par” or at face value, although there are times that the note investor may be able to negotiate a slight discount, especially if the note seller is a private individual.

If the real estate market is healthy, there will be less of a need to sell mortgage notes, especially at a discount. However, if a market is in a recession, banks and other note holders will likely have a large need for cash now and will have more inventory to sell at a larger discount. After the 2008 financial crisis, banks were selling mortgage loans at huge discounts in hopes to avoid closing down.

Making money in mortgage note investing

You make money in mortgage note investing differently depending on the type of loan you purchased.

Making money with a performing note

If a loan is performing, once you buy the note you simply collect the monthly mortgage payment over time until the loan is paid in full. Since mortgage loans are repaid with interest, the note holder will be paid more than the original loan amount. If the note is purchased at a discount, the return on investment (ROI) will only increase.

For example, let’s say a borrower purchase a property for $120,000 putting $20,000. A loan was created with an interest rate of 5% for 15 year term. The monthly payment is $790.79. After five years, the note holder decides they want to sell to get cash now. The unpaid balance (UPB) after 5 years is $74,557.34. If you purchased it at face value, you would earn a 5% ROI for the 10 remaining years on the note. However, if you purchased it at a 10% discount from the unpaid balance or $67,101.61, your return would increase to 7.34% for the 10 remaining years on the note.

Making money with a non-performing note

Earning money with a non-performing can be more complicated because there are a number of possible outcomes. Non-performing note investors are active investors, who are actively working to get the loan to either pay or to recoup the money owed to them through legal action. If the borrower is interested and able to repay the loan, you as the lender can modify the terms of the original loan to be more favorable to the borrower while still achieving your desired return.

If the borrower has no desire to repay or to keep the property, you as the lender have the right to pursue legal action through foreclosure. The property can be sold to a third party at foreclosure auction or you as the lender can regain title to the property. You can then sell the property as is, fix it up and sell it, turn it into a rental, or create a new mortgage note by offering owner financing. Since you purchased the mortgage note at a discount from what is owed or what the property is worth, you there is equity that will repay any money owed to you. When you buy a non-performing loan, it’s extremely important to build in a room for added expenses like legal fees, property maintenance, and selling costs.

How much you can make greatly relates to how large of a discount you are able to get when you buy the note.

Let’s use the same 15 year mortgage example above but this time, the borrower stopped paying around year 4. The balance of the loan with accrued interest and fees, is now $84,700 and the property is worth around $100,000 in the current market. You purchase the note at a 45% discount, or $46,585 which is 55% of the total balance and 47% of the current property value. In scenario 1 the borrower wants to stay, and after getting a new job is able to start paying again. They make a payment of $4,000 which is applied to accrued interest and fees and start making their payment of $790.79 again, which nets you a 17.29% return on your investment.

In scenario B, the borrower does not want to pay or has already vacated the home. So instead of adjusting the mortgage note terms, you pursue foreclosure. After legal fees, paying for insurance to protect your interest in the property, and property preservation, you spend a total of $9,800 in additional fees on top of your $46,585 purchase price. 10 months later the property goes to foreclosure sale, and sells to a third party bidder at the auction for $75,000. The county sends you a check three days later for $75,000 netting you $18,615 profit, or a 33% return on investment ($18,615 profit / $56,385 investment = 33%).

The risks of mortgage note investing

As with any type of investing mortgage note investing does have risk. The largest of which is the risk of a borrower defaulting. If you purchase a performing note close to face value, there is very little room for added cost to pursue legal action if needed. This can greatly lower the rate of return or become an unnecessary burden for the note investor.

Another risk note investors face when buying mortgage notes is the unknown condition of the property. Since you as a note holder do not own the property, in most note transactions you are unable to confirm the interior condition of the property. If you end up taking the property back because they stopped paying, the property could be in a bad condition, lowering the value of your collateral. Large changes in market values will also affect note investors because the collateral value will drop, leaving many homeowners underwater (where the owe more than the home is worth). Recessions can lead to an increase in defaults, very similar to what we see in the Great Recession. 

Investors can mitigate their risk by doing thorough due diligence in addition to negotiating a substantial discount. The greater the discount, the more wiggle room the investor has and more room for positive returns even in a changing market.

Want to learn more about note investing?

Even as the economy heads into rough waters, note investors are positioned to do very well during these uncertain economic times.

If you're interested in learning how we are able to invest and profit by creating, buying, and selling mortgage notes regardless of the economic climate, visit our website, where we show you how you can become a note investor through our online note investing education program, Note Investing Academy.