Estimated reading time: 8 minutes
Imagine earning passive income secured by real collateral. That’s exactly what thousands of investors have already attained by investing in mortgage notes.
Mortgage note investing is gaining traction as a steady, dependable alternative investment strategy. Investors often achieve predictable returns above those available with CDs or bonds, making mortgage notes an attractive option for those seeking higher yields compared to traditional investments.
In this article, we’ll explore the fundamentals of mortgage note investing, including examples, benefits, potential risks, and due diligence strategies to find the right investment for your portfolio.
Table of Contents
- What is a Mortgage Note?
- How Does Mortgage Note Investing Work?
- Types of Mortgage Notes
- Key Components of a Mortgage Note
- Benefits of Mortgage Note Investing
- Risks of Mortgage Note Investing
- Due Diligence Strategies
- Reduce Taxes on Mortgage Note Investing
- How to Set Up an SDIRA for Mortgage Note Investing
What is a Mortgage Note?
A mortgage note is a legal document that outlines the terms of a loan agreement between a borrower and a lender. It is a written promise to repay a specific amount of money, with interest, over a set period. The mortgage note includes details about the loan amount, interest rate, repayment schedule, and the rights and responsibilities of both parties.
How Does Mortgage Note Investing Work?
Mortgage note investing involves purchasing the debt and the associated promissory note from the original lender or current holder. As the note holder, you receive the monthly payments from the borrower, effectively becoming the lender. This can provide a steady income stream and the opportunity for significant returns.
Example of Investing in Mortgage Notes
Imagine you have $100,000 to invest. Instead of buying a rental property, you decide to invest in a performing mortgage note.
You find a performing mortgage note listed for sale on an online marketplace like Paperstac. The note is for a single-family home worth $150,000, with a remaining loan balance of $100,000. The borrower has been making regular monthly payments of $800, which includes principal and interest, at an interest rate of 5%.
You purchase the mortgage note for $95,000, slightly below the remaining loan balance. The seller receives instant liquidity, while the buyer gets a discount. This discount means that, over time, your investment will yield a higher return. As the new note holder, you start receiving the monthly payments of $800 from the borrower, totalling annual income of $9,600 per year.
Your initial investment is $95,000, and you receive $9,600 annually in payments. Therefore, your annual return is about 10.1%.
Throughout the duration of the loan, you continue to receive $800 each month without needing to manage the property. The property itself serves as collateral, so your investment is secured.
You monitor the borrower's payment history. If the borrower defaults, you have the option to foreclose on the property, potentially recouping your investment by selling the property.
Types of Mortgage Notes
Mortgage notes come in various forms, each with distinct characteristics and risk profiles:
- Performing Notes: These are mortgage notes where the borrower is current on payments and continues to make timely payments according to the loan terms. Performing notes provide steady income and are considered lower risk.
- Non-Performing Notes: These are notes where the borrower has defaulted on payments. Non-performing notes are higher risk but can be purchased at a greater discount, offering the potential for higher returns if the loan is brought back to performing status or the property is foreclosed and sold.
Key Components of a Mortgage Note
If you’ve ever purchased a home, you’re likely familiar with the main components of a mortgage note. As a refresher, here’s a brief over of the characteristics that mortgage notes share:
- Principal: The original loan amount that the borrower agrees to repay. This figure is the basis for all interest calculations and repayment schedules.
- Interest Rate: The percentage of the loan amount that the borrower pays as interest. This can be either fixed or adjustable.
- Term: The duration over which the loan is to be repaid, typically ranging from 15 to 30 years for residential mortgages.
- Repayment Schedule: The detailed plan for how and when the borrower will make payments, including the frequency (monthly, quarterly) and amount of each payment.
- Borrower and Lender Information: Identifying details of both the borrower and the lender, including names, addresses, and contact information.
- Default and Late Payment Terms: Conditions and penalties related to missed or late payments. These terms protect the lender by outlining the steps that will be taken if the borrower fails to meet their payment obligations.
- Security: The property used as collateral to secure the loan.
Benefits of Mortgage Note Investing
Mortgage note investing offers several advantages that make it an attractive option for investors seeking a consistent source of passive income:
Regular, Passive Income
Investors receive monthly payments of principal and interest from borrowers, providing a steady stream of passive income without the need for active property management.
Potential for Higher Returns
Mortgage notes often boast returns ranging from 8% to 12%. These returns could prove significantly higher than those from traditional investment vehicles like CDs and bonds.
Diversification
Adding mortgage notes to an investment portfolio can help diversify risk. By investing in various notes secured by different types of properties and borrowers, investors can reduce their reliance on the stock market and other traditional investments.
Collateral Security Borrower Default Risk
Mortgage notes are secured by real estate, providing a level of security. If the borrower defaults, the investor can foreclose on the property to recoup the investment.
Risks of Mortgage Note Investing
While mortgage note investing can offer attractive returns and diversification benefits, it also comes with certain risks. Here are some key risks to consider:
Borrower Default Risk
If a borrower defaults, the investor may face significant losses, especially if the property securing the note is worth less than the outstanding loan amount.
Real Estate Downturn
A decline in property values can reduce the collateral value, making it harder to recover the full investment in case of default.
Rising Inflation/Interest Rates
Rising interest rates can decrease the market value of existing notes with lower rates, while falling rates can reduce returns on new investments.
Illiquidity
Mortgage notes can be less liquid than other investments, making it difficult to exit the investment promptly if needed.
Where to Buy Mortgage Notes
Investors looking to buy mortgage notes have several options, ranging from banks and brokers to online marketplaces. Here are some of the primary sources for purchasing mortgage notes:
Banks and Financial Institutions
Banks often sell mortgage notes to manage their portfolios and liquidity. They typically sell large bundles of notes to other financial institutions or large investors. However, these notes typically have large minimum purchase requirements.
Note Brokers
Note brokers act as intermediaries between sellers and buyers of mortgage notes. They purchase notes in bulk from banks and other institutions, then sell individual notes or smaller packages to investors.
Online Marketplaces
Online platforms such as Paperstac and NotesDirect have made it easier for investors to buy mortgage notes. These marketplaces provide detailed information about each note, including the loan amount, interest rate, borrower payment history, and property details.
Private Lenders
Individual lenders or private lending companies often sell mortgage notes. These sellers might be more flexible and willing to negotiate terms compared to larger institutions. Finding private lenders can be more time-consuming, but they may offer unique opportunities and better terms.
Real Estate Crowdfunding Platforms
Lastly, some crowdfunding platforms such as Fundrise and PeerStreet allow investors to pool their money to purchase mortgage notes. This can be a more accessible option for smaller investors looking to diversify their portfolios. Crowdfunding platforms may offer fractional ownership in notes, providing a lower entry point for investors.
Due Diligence and Evaluating Mortgage Notes
Before you invest in mortgage notes, it’s crucial to conduct thorough due diligence. Here are some strategies to maximize your odds of making informed and profitable investment decisions:
Assess Borrower Creditworthiness
Check the borrower's credit score to gauge their ability to repay the loan. Higher credit scores typically indicate lower risk. Review the borrower's payment history for any missed or late payments and confirm the borrower’s current income to ensure they can meet their payment obligations.
Evaluate Property Value and Condition
Obtain a current appraisal to determine the property's market value. This ensures that the property provides adequate collateral for the loan. If possible, conduct a property inspection to assess its physical condition. Look for any signs of significant wear, damage, or required repairs.
Review Loan Terms and Documentation
Understand whether the interest rate is fixed or adjustable, and evaluate its impact on your returns. Check the remaining term of the loan. Shorter terms may offer quicker returns, while longer terms provide extended income streams.
Analyze the Note’s Performance
Calculate the loan-to-value (LTV) ratio by dividing the loan amount by the property’s appraised value. Lower LTV ratios indicate less risk as the loan is better secured by the property. Check the borrower’s DTI ratio, which shows their debt load relative to their income. In general, lower DTI ratios indicate better financial health.
Consult Professionals
It’s often a good idea to seek out licensed professionals. Hire a real estate attorney to review legal documents and ensure the transaction is legally sound. Consult with financial advisors to align mortgage note investments with your overall investment strategy and risk tolerance.
To bolster your own due diligence skill, download our Due Diligence Guide. Inside, we’ve included a due diligence checklist for all investments. This includes how to ensure legal and regulatory compliance, and tips for reviewing the investment structure and terms.
Self-Directed IRA Due Diligence Guide
Reduce Taxes on Mortgage Notes with a Self-Directed IRA
Mortgage note investing can generate various types of income, each subject to different tax treatments.
Most income earned from mortgage note payments is interest, considered ordinary income. Just like your W-2 income, these earnings are subject to federal and state income taxes at your marginal tax rate.
However, if you sell a mortgage note for more than you paid for it, the profit is considered a capital gain. If you hold the note for one year or less, the gain is taxed at your ordinary income tax rate.
If you hold the note for more than one year, the gain is taxed at the lower long-term capital gains tax rate. At the federal level, this ranges from 0% to 20%, depending on your income level. States generally tax long-term capital gains at their ordinary income tax rate, which can reach as high as 14%.
As you can tell, taxes can significantly cut into your profits in mortgage note investing. That is, unless you’re investing through a self-directed IRA (SDIRA).
These accounts are essentially identical to any other IRA, with one crucial distinction – rather than being limited to stocks, bonds, and mutual funds, an SDIRA allows you to invest in any asset the IRS allows, including real estate private equity, and mortgage notes.
Income and gains from investments within an SDIRA grow tax-deferred or tax-free, depending on whether you have a traditional or Roth SDIRA. Plus, if you’re able to pick out a high-performing mortgage note, you may be able to achieve higher returns than with a target-date retirement fund.
How to Set Up an SDIRA and Invest in Mortgage Notes
Interested in opening an SDIRA and investing in mortgage notes with your retirement funds? Here’s a step-by-step guide to get started.
- Choose a Reliable SDIRA Provider: Find a reliable SDIRA provider like The Entrust Group that specializes in SDIRAs and allows investments in mortgage notes. Look for those with good reputations, reasonable fees, and excellent customer service.
- Open and Fund Your SDIRA: Complete the application process with your chosen provider. At The Entrust Group, all you need is 10 minutes of your time and a copy of a government-issued ID. Then, you can fund your SDIRA by transferring funds from an existing IRA, rolling over funds from a previous employer’s 401(k), or making a direct contribution.
- Research Mortgage Notes: Investigate and select notes that align with your investment goals and risk tolerance. Evaluate the borrower's creditworthiness, property value, loan terms, and payment history. Consider working with real estate attorneys, note brokers, and financial advisors to ensure you make informed decisions.
- Direct the Investment: Once you’ve selected a mortgage note, submit a Real Estate Note Buy Direction Letter, or similar form provided by your custodian, to authorize the purchase. This form details the investment and instructs the custodian to execute the transaction. Entrust will complete the purchase on behalf of your SDIRA.
- Manage Your Investment: Regularly review the performance of your mortgage note investment. Keep track of payments, borrower communications, and any changes in property value or market conditions. Ensure all income and expenses flow through the SDIRA to maintain the tax-advantaged status of your account.
By understanding and implementing these strategies, you can successfully invest in mortgage notes and leverage the benefits of an SDIRA to enhance your retirement savings. For further assistance, consider consulting with financial advisors and professionals who specialize in mortgage note investing.
Or, if you’re interested in learning more about real estate note investing, check out our recent webinar, What You Should Know About Real-Estate Backed Lending. In the session, Dave Goldberg, President at the Investor’s Source, covered a 101 education on trust deeds, including potential benefits and risks, and how market forces affect trust deed investments.
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