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Good Notes and Mortgages

July 15, 2018

What is a mortgage or note? A mortgage is what you get when you borrow money from a person or bank or credit union to purchase a home. Some say you “take out a mortgage” or “get a mortgage”. A note is used interchangeably with mortgage. There are some technical differences, but for our purpose, we are using them as the same thing.

So when you get a loan from a bank for $150k the bank owns a $150k note. They pay out the money to the seller of the house and you get the house. Sometimes lenders want to get rid of some notes to raise money to originate more loans. What they do is sell these notes to other banks or even to individuals.

I like to purchase notes that were originated by individuals, not banks. That means that the loans were owner financed notes. More specifically, someone was selling their house and for whatever reason decided to owner finance the house.

An individual owner is collecting payments for 15, 20 or maybe even 30 years from the buyer of the house. Sometimes the note holder (or owner of the note) does not want to collect payments anymore. They want all their money NOW. This means that they will be selling the note.

Now lets say that the 150k loan was for 30 years at 6%. Five years has gone by and they have been collecting $899.33 all this time. They still have 25 years to go.

The balance on this loan after 5 years is $139.581.54 down from the original $150,000. So the owner of the house still owes $139,581.54 to the note holder after 60 payments or 5 years.

Hopefully the house is still in pretty good condition and the value has risen somewhat. Lets also say that the payments have been on time and there is no issue with the owner of the house. This would be a pretty solid loan to purchase. Solid loans with steady payment history are said to be performing loans.

The big question is always, “How much do I buy the loan for?”

A solid homeowner with a solid pay history is going to be an easy loan to deal with. It will be almost like a CD at the bank. You will probably not be able to get a big discount on one of these. You might be able to get slight discount, but dont count on buying it at half price.

The loan has a stated rate of 6%. To be able to get a 10% return on that note you will have to purchase it not for $139k, but for about $99,000. This is called buying notes at a discount. Your desired rate of return will dictate the price that you would be willing to pay for the note.

Lets say that you were ok with a 6% return, then you would buy the note for the actual loan balance. If you wanted an 8% return you would be willing to buy at about $116,500. OR if you could only settle for a 15% return on your money you would want to pay $70,300.

Most people will not even think about getting a 15% return on buying a note because interest rates are so low right now. If you could get an 8% or 9% return on your money, you are doing pretty good when CDs at the bank are 2%.

Of course money at the bank is 100% guaranteed when you dont exceed their limits. Buying notes is NOT guaranteed at all. There are plenty of ways to mitigate your risk though.

1. BTV balance to value. What is the balance of the loan to the now value of the property. I mentioned above that hopefully the value of the property went up and the balance of the loan went down. I like to buy when the btv is under 75%. This usually hits somewhere at about 5 to 7 years into a 30 year loan. This is not an exact science, but it is my quick rule of thumb so that if I have to foreclose I will still be in the money.
2. Interest rate. You have to decide what you need as a return on your money. With stated rates of 4% to 9%, this is the range that you will be seeing most commonly.
3. Discount. This is what you have to purchase the note at which is below the actual balance of the note. From the example above (6% note bought at 10% return) you have to purchase with about a $40,000 discount. You have to keep in mind there is a seller on the other end of the discount. Some folks dont mind taking a little discount, but too big will scare them away.
4. Payment History. You have to get payment history from the owner of the note. The better payment history that the homeowner has, the smaller the discount that you will be able to get.
5. Condition of the property. This kinda goes with #1. The property has to be in somewhat good condition so that you have a decent btv. But also, if the home is not in good condition, the homeowner will not be able to get or keep insurance.
6. Neighborhood. Where the property is makes a difference. If you have to take back the property, how hard will it be to sell it?

Take these items into consideration when thinking what kind of discount that you need. Remember great homeowners in great neighborhoods will not bring a big discount. Of course you will almost never have any problems collecting mortgage payments either.

These will be easy money. Easy money tends to pay a lower return. As you get more issues with the neighborhood, pay history, etc., the bigger discount that you are going to want. This will in turn mean that you need a bigger return on your money.

So how do you get a hold of $99,000 to buy a note?? You have to live a little more frugally. Dont spend so much money on your car, maybe not go out to eat so much. You might even start asking friends at work if they know anyone who needs to get out of their home.

Look more to your future and retirement instead of just getting fat and happy now.

I hope this gives you a little more insight into notes. You can always ask questions in the comments section at the bottom of the page.