Discounted Mortgage Notes

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If you’re like most people cruising through a real estate investment site, you no doubt saw an article titled “mortgage notes” and wondered what this means.  Well fear not, you hungry minded, you actually already know what they are. You just may not know that you know it

A “mortgage note” is a note secured by real estate.  Usually it is a house. When someone talks about “taking out a mortgage” or “making a mortgage payment”, all they are really saying is taking out a loan, or note, on a home.

Many people assume banks are the only people who can make these loans. While it is true that banks make the majority of these loans and are often insured by the federal government for them, anybody can make a loan secured by a piece of real estate.  Sometime’s these loans are sold to other investors who collect the mortgage payments on them.  Sometimes these loans go bad and the borrower stops paying them.

When a borrower stops paying, the note becomes what we call “non-performing”. Non-performing notes are worth much less than performing notes because the holder of the note is not getting money back.  This is usually when the foreclosure process begins and the note holder starts the process of taking title to the home securing the note in order to recoup their investment.

Now, as you may have guessed, not everybody enjoys the paperwork, time, and headache involved with the foreclosure process.  These people may prefer to sell the note for a discount rather than take on the challenge of completing the foreclosure process.  This, my friends, is one way to find “discounted mortgage notes”. Hence the title to the article.

Now when we call the note “discounted”, what we are saying is that the note is being purchased for less than the amount owed on the note.  So if the note still has a balance of $100,000, and you are able to buy it for $70,000, you’ve received a discount on the note.  This can be a great investment strategy for building passive income as well as increasing your net worth.

One common strategy when buying discounted mortgage notes is to buy a non performing note for a steep discount, then contact the borrower and restructure the mortgage so they begin paying again.  People stop paying their mortgages for several reasons, and if you are able to purchase the note at a steep enough discount, you can lower the principal amount they owe and get them paying again.

Another strategy is to buy the note, complete the foreclosure process yourself (or with the help of attorneys) and take title to the property.  If you are buying the note for $60,000, and the house is worth $100,000, you would have successfully purchased the home for .60 cents on the dollar.  Not a bad deal.  You can now either sell the house, keep it as a rental, or let the home owner purchase it from you under new note terms.  Flexibility is the key to protecting your assets and this strategy affords the note holder a lot of it.

Sound good? Well we haven’t even got to the icing on the cake. A very powerful way notes can build your net worth is when they pay off early.  Now in the above example, we purchased a note with a balance of $100,000 for $60,000.  Well, what happens when the borrower moves? Or refinances? Or inherits money and wants to pay off their mortgage balance?

In these cases, you would receive the full $100,000 (minus whatever part of the principal they have already paid off). Now if this happens when the homeowner still owes $90,000, you will receive that full balance.  A $90,000 pay off for a $60,000 investment isn’t a bad return now is it?  Now just think about what would happen if you took that extra money and bought more notes…An interesting topic, but we will save that for another post.

(To read more about investing in multiple discounted mortgage notes, click here)

IN SUMMARY

Pros:

  • Typically less work to manage and own than rental properties.
  • Able to buy at a discount.
  • Early note pay off can mean big profits.
  • Simple. Mortgage collectors can be hired to collect payments on your behalf and deposit them into your account for you.
  • Steady source of income. No repairs, maintenance, or unexpected costs associated with notes like with a rental property.

Cons:

  • Not easily leveraged. Very tough to take out a loan to buy a note.
  • No tax shelter on the income. Depreciation is not allowed on note income.
  • Difficult to liquidate. Not as big of a market for note buyers as home buyers.
  • Less control. You don’t choose when you want to inherit the property. The borrowers actions dictate that.

 

As you can see, discounted mortgage notes can function very similar to rental property in the sense they can be bought at under market value prices, rehabbed, and then held onto or resold.  They also typically involve much less work than owning rental property and take less time to manage.  If you love the idea of passive income with a big upside, but don’t want to be a landlord or own a business, purchasing discounted mortgage notes can be a great proposition for you.  For more information regarding investing in mortgage notes, I highly recommend researching anything written by Dave Van Horn of PPR Note co.  I was very impressed with his work and have invested in his funds myself.  For articles written by Dave, check out www.BiggerPockets.com.

 

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David is a real estate investor/agent/author/entrepreneur/police officer in the CA SF Bay Area. David's goal is to achieve total financial independence through real estate and to help as many others do so as possible. When not hunting bad guys, he hunts deals and loves talking real estate. To learn more about David, visit his website where you can also sign into his free investor's newsletter and follow along as he walks you through his deals and shares his latest projects.

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