What Is a Mortgage Note?
A note is a financial obligation between a borrow and a creditor or investor — usually in the form of a loan. Like an IOU, this document will detail the terms of the loan, such as the principal amount, any interest charged, and repayment details.
A mortgage note is specific to a home loan and is secured by real property. It will detail the home buyer’s required mortgage payments and assigned interest.
- Types of Notes
- Different types of notes include:
- Personal loans
- Treasury notes
- Structured notes
- Convertible notes
- Unsecured notes
- Bank notes
- Promissory notes.
Some of the most popular notes are Treasury notes (T-notes) and convertible notes. Investors can purchase T-notes, which obligate the U.S. government to pay a set interest payment every six months. On the note’s maturity date — when it becomes due in full — the government returns the principal investment to the investor.
A convertible note is a loan that can be converted to equity, and are commonly found in startups. When seed funds invest in the company, they might choose to have their investment convert into stock shares.
What Are Promissory Notes?
Perhaps the most popular note of all is the promissory note, which is a legal document that says Party A owes Party B. This agreement lays out the deal terms, such as the amount and interest rate, and is signed by both parties: the issuer and the borrower. Unlike secured notes, promissory notes are not typically backed by collateral, although promissory notes might be secured with a deed-of-trust or mortgage during a real estate deal.
Investing in Notes
Investing in notes, including mortgage loans, involves buying the debt or loaning money, thus becoming the creditor. There are a few ways to invest in notes.
Peer-to-peer lending involves investors offering an unsecured loan to another person, either for debt consolidation or purchases. Essentially, the investor acts as a bank or lender. The borrower agrees to pay them back over a certain length of time with a certain interest rate.
Hard money loans give people looking to invest in a higher-risk property, like a fix-and-flip, access to needed financing. Many banks are uninterested in these types of loan, so hard money lenders can charge a higher interest rate due to the risk.
Seed or startup capital for young or growing companies can serve as a convertible note, providing eventual shares in exchange for initial funding.
Investing in Mortgage Notes
Depending on the state, financed real estate is secured with either a mortgage or a deed-of-trust. These instruments outline the terms of the deal and explain the recourse if the debtor defaults. Investing in real estate notes is less hands-on than investing in physical properties. For example, note holders don’t deal with tenants or handle repair issues — you only own the debt, not the property. However, if you have to foreclose on the property, you could end up taking ownership, and you might be able to recoup late payments and attorney fees.
Notes can be purchased on the secondary market. Notes that have been around for a long time — say, the mortgage is on year 15 of 30 — are considered “seasoned,” or performing, and have a steady track record of on-time payments. Some aren’t in such good standing, and note buyers can purchase these at a discount. Real estate investors can purchase notes via online marketplaces or note brokers.
Performing vs. Nonperforming Notes
Investing in notes is buying debt, which can be either performing or nonperforming. If the notes are nonperforming, the borrower is likely behind on their monthly payments or in default, so you may have to pursue foreclosure or collections — and the borrower’s credit score is likely poor, so collecting the money owed may be difficult. Nonperforming notes are often sold at a discount. Investors that can navigate the collection or foreclosure process efficiently and effectively might target nonperforming loans.
A performing loan means the borrower is making their payments on time and the loan is not in default. With these, investors can purchase the notes and start receiving payments almost immediately.
Collateral vs. No-Collateral Notes
Notes can be backed by collateral (or “asset-backed”) or not. Ones that aren’t backed by collateral are considered unsecured. If an asset-backed loan like a mortgage goes into default, you can collect collateral — the real estate property. Unsecured notes, such as credit cards, have no recourse beyond collections.
Advantages and Disadvantages of Note Investing
With a note-based investment strategy, the investor enjoys the benefit of a steady stream of passive income — and notes can be sold or borrowed against. Unlike direct real estate investing, they do run the risk of default. Make sure to do your due diligence before purchasing nonperforming or no-collateral notes.
Mitigate this risk by investing in performing loans, which carry a track record of on-time payments. If it’s a mortgage, then the owner likely has a vested interest in the property, including built-up equity. The likelihood of the borrower continuing to make payments is positive.
Alternatives to Investing in Notes
Instead of investing in notes, investors can get similar benefits by investing in mortgage-backed securities, which provide investors access to a pool of mortgages. Investors collect the principal and interest payments. There are also real estate investment trusts, which borrow money at short-rate terms and use it to buy long-term mortgage investments.
Depreciation is how goods and assets lose value. But that’s not a bad thing—for savvy investors, it’s a tax strategy. Learn more about depreciation here.