Most new investors in active real estate start with a traditional method like rehabbing or buying and holding single-family rentals. They might invest in commercial real estate like apartments, storage, or strip malls, too.
In these examples, the investor buys the property and manages the asset by fixing it up or renting it to a tenant. In many cases, the investor does both. Depending on how you manage the assets, these methods of investing can be great ways to generate income, receive tax benefits, and build wealth -- but they aren’t the only ways.
Mortgage notes are an alternative asset class within active real estate investing. They have many benefits and present unique opportunities. They also earn higher-than-average returns for real estate investments.
Let’s dive into what it means to invest in mortgage notes by starting with the basics.
What's a mortgage note?
When a home buyer or investor wants to buy a house but isn’t able to pay cash at closing, they get a loan. They pay part of the purchase price as a down payment and borrow the remaining amount from a bank or lending institution. In exchange for the money, the lender has them sign a promissory note and a mortgage.
A promissory note, often just called a note, is signed by the borrower and is a promise to repay a debt. This document outlines:
- who borrowed money from whom,
- how much was borrowed,
- the interest rate of the loan,
- the timeline for loan repayment, and
- what happens in the event of default.
A note isn't typically recorded in public records, but it's a legally enforceable document.
A mortgage is a separate document that collateralizes the lender. In short, it says that the lender can take possession of the home if the borrower stops paying. It outlines
- the roles and responsibilities of the lender and the borrower,
- what would qualify as a breach in the agreement, and
- what property the mortgage is tied to.
These two documents do different jobs, but they go hand-in-hand. You would never create or buy a note without a mortgage and vice-versa.
The different types of mortgage notes
Mortgage notes can be categorized by type, lien position, performance, and asset class. Let's take a look at each.
Mortgage loans can be broken down into several sub-categories:
- Private loan.
- Institutional loan.
If a loan is secured (or "collateralized"), there's a tangible asset tied to the loan -- in the case of a mortgage, this asset is property. This means if the borrower stops paying, the lender can take legal action to gain title to the real estate or asset. If the loan is unsecured, there's nothing collateralizing the loan.
A mortgage note can also be classified by who created it, as in the case of institutional or private loans. An institutional loan means a bank or lending institution created the mortgage note. These loans have strict laws and guidelines for underwriting. They're held to a higher standard than private loans and must comply with the Dodd-Frank Act and Bureau of Consumer Financial Protection regulations.
A private loan means the mortgage note was created by a private individual. This could be a family member, friend, colleague, private lender, or even the seller of the home. In some instances, if the seller owns the property free and clear (with no mortgage), they can create and hold a mortgage for the buyer. These are called seller carry-back loans, seller-financed loans, or owner-financed loans.
A private loan still has a note and mortgage, but the underwriting process isn’t as heavily regulated. The language that goes into the documents is up to the lender. Some use attorneys or title companies to create the documents while others don’t.
The lien position categorizes the position of the lender’s claim on the asset. Ultimately, it determines which lenders get paid first if something goes wrong.
Mortgages that are in first position have the highest claim. Any loans created after the first are second-position, third-position, and downward from there. A second lien or junior lien is a subordinate mortgage note. The first position will always be paid before the second position gets paid.
Here's an example. Before the 2008 crisis, banks regularly let people buy properties with little or no money down. If someone wanted to buy a house for $200,000, they could get a first mortgage for $180,000 -- this was recorded in public records first. They could also get a second mortgage for $20,000, which was recorded later.
The buyer paid two separate mortgage payments each month. If they stopped paying and the bank foreclosed on the house, the first mortgage would get paid off before the second mortgage received any money. This practice isn’t as common since the Great Recession, but there are other forms of second mortgages. A home equity line of credit (HELOC) is one example.
That's why second-position or junior-lien mortgage notes are a riskier investment. There's typically a first lien in priority position, and if things go poorly, they'll get their money first.
You can also classify a note by the underlying asset class. There are mortgage notes on every type of real estate, including:
- single-family homes,
- small multi-unit homes,
- apartment complexes,
- commercial strip malls, and
- industrial buildings.
Most of the time, however, they're categorized as residential or commercial mortgage notes.
The last way to categorize a mortgage note is by its performance or payment history.
If a borrower has paid their mortgage on time and never missed a payment, the note is "performing." If the borrower has stopped paying their mortgage note, they're in default. The note can be categorized as 30 days late, 60 days late, 90 days late, or 180+ days late. Typically, if borrowers haven't paid in the past 90 days, their loans are categorized as “non-performing."
What does it mean to invest in mortgage notes?
Investing in real estate mortgage notes is a lot easier than you may think. When someone buys a property, whether it's a personal residence or an investment property, the buyer is put on the title. They're on the deed and are responsible for maintaining the property, having adequate insurance, and paying taxes.
The lender has a vested interest in the home but isn't responsible for property upkeep, taxes, or insurance. They simply collect a principal and interest (P&I) payment each month until the note is satisfied. If something goes wrong with the property, like the roof needing to be replaced or a plumbing issue, the owner has to take care of it -- not the bank.
When you buy a note and mortgage, you're buying the debt that remains to be paid on the note, secured by the asset outlined in the mortgage. You're not buying the property -- you're buying the debt and secured interest in the property.
Essentially, a note buyer steps into the shoes of the bank. You can now collect the remaining debt on the note and receive the monthly P&I payments. You can also take legal action to regain title in the event of default.
While many loans are bought and sold at full price, some can be bought at a discount. If the loan is non-performing, or the note holder needs to sell the note badly enough, they may be willing to part with it for less. In my experience, you can negotiate a discount of 5%–40% off the current market value or unpaid balance, whichever is less.
Non-performing notes may not seem like a worthwhile investment since the borrower isn’t paying anymore. They have a high risk of default, and that's bad for cash flow.
But investors often use these notes to acquire real estate at a discount. Once the tenant defaults, the investor can take possession of the property and create a long-term rental, fix and flip the house, or simply sell it.
There are significant risks to using mortgage notes in this way, but if you're smart about your investment strategies, it can pay off.
Investors can also modify the terms of the mortgage. For example, if you buy a non-performing note, you might lower the balance of the note, reduce the interest rate, decrease the monthly payment, or otherwise assist the borrower in making good on their loan. This can result in very high yields if you buy the note at a discount.
Over the past 10 years, the cost of non-performing notes has risen -- but you can still get them at 20%–40% off of the current market value or loan balance.
Where can I find mortgage notes to buy?
Banks create and sell mortgage notes as a part of their business model. They make their money from lending and receiving interest. The more they lend, the more they make.
There are guidelines for how much money a bank has to keep in reserve in order to lend -- this amount is called a reserve ratio. If a bank has low liquidity, they may sell some of their loans in a "pool," which is a group or package of mortgage notes. Other banks, hedge funds, and private individuals can buy these pools.
Hedge funds and banks are the largest buyers of mortgage notes direct from banks because you typically need millions of dollars to purchase them in bulk. For this reason, it can be difficult for individual investors to buy directly from banks, though it can be done.
Individual sellers that created a private mortgage note may also want to sell simply for the benefit of having cash now. Maybe they're experiencing hardship and need cash today rather than waiting for the remaining term of the note to pay off.
You can find private sellers of mortgage notes on online marketplaces like Notes Direct or Paperstac. You can also buy a list of private individuals who own or hold a note from a company like Listsource. You might send the noteholders a series of letters or postcards or get in touch with them another way to see if they're interested in selling.
If they need cash, banks and individual sellers will sell at a markdown. When you buy at a discount, your rate of return is higher than the nominal interest rate on the note.
Performing notes are typically more expensive. While you can buy them at a discount, it’s typically only a slight discount from the remaining balance of the note. Non-performing notes are often sold at steep discounts from the balance owed or the value of the property, whichever is less. Pricing is also higher on first-lien mortgage notes compared to junior liens. The more secure the position, the higher the price.
Let’s look at a few examples to see how this works.
Buying a performing mortgage note
Let’s say you find a private mortgage note that the seller needs to get rid of. The note is secured by a mortgage on a single-family home. The property originally sold for $150,000 and the borrower put down $15,000. That means the original loan was for $135,000. The note is a 5% fixed-rate 30-year loan, making the borrower’s payment each month $724.71.
The borrower has been paying the loan for seven years and is current. So, at the time you're evaluating the note, the unpaid balance is $118,725.68. There are still 276 months (23 years) left.
You decide you'll only buy this note if you can receive a 10% return on your money, or a 10% yield to maturity, so you offer $78,162. That’s $40,563 less than the current unpaid balance, or a 34% discount to the face value of the note.
This may seem like a big loss, but the seller gets $78,162 immediately and has already collected $60,875 in principal and interest to date. If the seller takes the cash now, he or she is essentially collecting $146.97 less per month from the borrower's P&I payment over the remaining 23 years.
If the seller needs the cash, they may accept that offer. In that case, you receive a nice 10% internal rate of return (IRR) and a passive $724.71 of cash flow each month, provided that note keeps performing for the remaining 23 years.
Buying a non-performing mortgage note
Let’s look at a different example. A hedge fund finds a bank with a low reserve ratio and a high proportion of non-accrual loans (180+ days past due). The bank sells a pool of non-performing loans to the hedge fund. The hedge fund keeps some of the notes that meet its criteria but decides to sell the notes that don’t fit its investment model.
The hedge fund sends you a list of non-performing loans for sale and you look through the list to determine which assets you want to buy.
A non-performing note where the borrower has not made a payment in over two years piques your interest. The current unpaid balance is $128,934 with 214 payments remaining. The note is secured by a nice single-family home in Georgia that you believe is worth $140,000 as-is. The original note had a 5.5% interest rate for 360 months (a 30-year loan) with a monthly payment of $794.90. Because it’s non-performing, you're able to pick this up for a steep discount -- just 58% of the unpaid balance, or $74,781.
Now that you own the note, you can reach out to the homeowner and see why they stopped paying. Then you can find out if they want to keep the property and work out a plan to get them paying again if they're interested.
Because of the discounted purchase price, you have flexibility in the terms of the loan. You could lower the interest rate, re-amortize the loan, decrease the balance, or offer other conditions to make the home more affordable. If you simply get the borrowers to start paying their monthly mortgage of $794.90 again without adjusting any of the terms of the original loan, you'd get a 10.92% yield to maturity.
There are several other scenarios where you could increase the overall yield to maturity by adjusting the terms of the loan. You might increase the interest rate, re-amortize the loan, or shorten the length of the loan to meet your desired rate of return.
In many cases, these adjustments are temporary. A borrower might agree to pay you a lump sum upfront to show good faith, then pay a lower amount each month until they can get back on their feet. There are many situations you might encounter when buying non-performing notes, and you'll have to assess each one individually.
If the borrower isn’t interested in keeping the home or can't pay, there are other options. You can work out a deal where the homeowner signs the deed over to you and you eliminate the mortgage and their obligation to pay the debt. This is often called a deed in lieu of foreclosure. It’s not always the best solution, but it's an option for many lenders and homeowners.
If they aren’t interested in either option, you can start the legal process of foreclosure. Foreclosure varies from state to state in cost, length, and procedure. It’s important to know the relevant state foreclosure laws before you buy a note. After you foreclose, the home goes to public auction. If an investor buys the property at the auction, you get paid. If it doesn’t sell, you're put on the title and own the physical real estate.
Once you gain title to the property, you can:
- sell it as-is, like an REO sale;
- fix it up and sell it;
- keep it as a rental (you may have to do repairs); or
- sell it by creating a new mortgage note.
It’s important to note that this strategy of active real estate investment has inherent risk. The borrower could trash the home before they leave. Or they could contest the foreclosure and cause delays and legal expenses. They could even file bankruptcy, which can halt your collection efforts completely.
Non-performing notes can be a lucrative way to create passive income by working with the borrower to create a performing note. They're also a great way to gain title to the physical real estate at a discount. But they can also be very risky.
The best strategy with mortgage notes is the one we’re going to talk about next.
Creating a mortgage note from your own real estate
When I first started investing, a wealthier and more experienced colleague told me to buy real estate, rent it, and create a note when I'm ready to retire. It’s great advice.
With this method, you can take advantage of the tax benefits of owning physical real estate, make money through the cash flow of a rental, and enjoy the appreciation of the property. Then, when you’re ready to sell, you create a seller-financed note in which you hold the mortgage, receiving passive income in the form a P&I payment. Pretty genius, right?
An added benefit of this model is that you break up the tax hit from capital gains over the life of the loan rather than paying it in one tax year. From a tax perspective, it’s one of the best things you can do once your depreciation calendar runs out on a property.
Let’s say you own a single-family home that you kept as a rental for 30 years. You had a mortgage on the property, but using the additional cash flow from the rental, you paid off the 30-year fixed-rate mortgage in just 15 years. You now own the property free and clear. It’s performing well, but your depreciation calendar has run out. You no longer have the tax advantages of holding this physical property and would rather buy a new rental to take advantage of the tax deductions. But if you sell, you'll be hit with capital gains tax. So instead, you create a mortgage note.
You list the property for sale at $200,000 and offer owner financing. A nice couple wants to buy the property at your full asking price and has $30,000 to put down. Their credit is good, but they're unable to get traditional financing because they're self-employed. You offer them a 20-year fixed-rate mortgage at 6.5% interest. They’re happy to find a dream home they can finance and you’ve just created an additional passive income stream with tax benefits.
You now get to collect $1,267.47 every month and have zero responsibility in maintaining the home, paying taxes, or insurance -- the new homeowner does that.
Because you collect interest, you won’t only get your $170,000 back, but you’ll also make an additional $134,194.71 in interest over the entire 20 years!
To keep you compliant with the Dodd-Frank Act, it's best to use a licensed mortgage loan originator (LMLO) to underwrite and create your mortgage note. LMLOs charge nominal fees for their services. They'll prepare the loan paperwork and confirm that the potential buyer qualifies and can afford the home.
There's always a risk that the borrower stops paying, which turns this from a passive investment strategy to a very active one. You'll have a lot of work to do if you want to get them paying again or resolve the situation another way. This is especially true if you lend to someone who can't qualify for bank financing because of financial problems. Consider this risk before determining if creating a mortgage note is the right investment option.
What are the expenses of owning a mortgage note?
Expenses are rather low with mortgage notes, especially compared to rental property.
Most people hire a third-party servicing company to handle the loan. The servicing company keeps records of the payment history, can collect payments on your behalf, provides the borrower with their balance and statements, and separates the interest and principal received in each payment.
While you can service a loan yourself, this industry is heavily regulated. To keep your risk mitigated, we suggest paying the low monthly cost, which can range from $20–$40. The servicer can deduct the fee from the buyer's mortgage payment, making it even easier.
Non-performing loans have more costs associated with them. There are legal fees involved with regaining the title, as well as securing and maintaining the property.
Additionally, the borrowers may not have paid their taxes or insurance in several months or years -- those payments become the responsibility of the bank or noteholder.
Experienced note buyers factor these costs into their offer price and know exactly how much they expect to spend.
How do I know a good note from a bad one?
There's a saying in this industry: If you wouldn’t want to own the property that the mortgage note secures, don’t buy it. While you’re actually buying the paperwork relating to the loan, the property is the collateral and what secures you. Make sure the collateral is a quality asset. Due diligence on a mortgage note often includes finding out:
- the value of the property in its as-is condition;
- if there are any liens or encumbrances on the property that might affect or jeopardize your position;
- if there are any unpaid taxes, potential tax liens or tax deed sales;
- the annual tax rate;
- if all required paperwork (the original note, mortgage, and other documents) is in possession of the current lender;
- the payment history on the note; and
- the borrower’s credit score.
What’s the risk of investing in mortgage notes?
A common concern when an investor buys a performing note or creates a mortgage is the risk of default. If the goal of the investment is to receive cash flow as passively as possible, the last thing you want is for the borrower to stop paying.
For this reason, it’s important to thoroughly review the borrower, including their income, credit history, down payment contribution, and if applicable, pay history. According to the Federal Reserve Bank of St. Louis, the residential mortgage default rate nationwide was below 3% in Q2 2019, but was over 11% in 2010. Economic and financial conditions can change a borrower’s ability to pay at any moment. Weigh the risk of default before buying a note.
One of the greatest concerns when buying non-performing mortgage notes is not being able to talk to the borrower or see the interior condition of the property before buying the note. To help alleviate some risk, assume the property is in terrible condition. If you gain title to the property, you'll have a welcome surprise if it's in better condition than you anticipated.
Another way to minimize risk is to get the largest possible discount when purchasing the property. The lower your investment, the more your risk is mitigated.
Where can I learn more about investing in mortgage notes?
If you’re interested in learning more about this method of real estate investing, read as much as possible. Invest in Debt by Jimmy Napier is one of my personal favorites on this topic.
There are many educators who specifically teach the ins and outs of investing in mortgage notes, as there are many laws, rules, regulations, and steps you must know before making this a successful business. Some of these educators charge a few thousand dollars for classes, while others charge tens of thousands.
If you're interested in formal education, do your research on the educator. Read reviews, talk to current students, and weigh the cost of the course. Rarely does the experience and knowledge of one person justify a cost of tens of thousands of dollars, but that's up to you to determine.
Mortgage notes can be an incredible vehicle for building wealth and are one of the more passive streams of income you can get as an active real estate investor. If you do your research and carefully weigh the risks involved, it can be a great way to invest in real estate without becoming a landlord.