A non-performing note has no income until you resolve it. The exits fall into two families: keep the borrower in the property and get the loan paying again, or end the loan and recover through the property or a sale of the note. Decide which exits are realistic before you bid.
A non-performing note is one where the borrower has stopped paying as agreed, which makes buying one a different job from buying a loan that pays, as our comparison of performing and non-performing notes for investors makes plain. The price you can justify depends on which exit you expect, how long it will take and what it will cost.
What to find out before choosing an exit
Start with who is in the property: an owner living there, a tenant or nobody. An occupant who wants to stay opens exits that a vacant house does not. Next is equity, meaning the property’s value minus everything owed against it, including back taxes and any liens ahead of yours. Last is why the payments stopped, since a lost job that has since been replaced is a different case from a borrower who has left town.
The state counts as much as the borrower, because every exit below runs on local law and needs local counsel. If non-performing notes are part of what you buy, say so when you join the buyer list and name the states you are set up to work in, so that the notes you are shown are ones you could resolve.
The exits at a glance
| Exit | Borrower keeps the property | What you end up with | Main cost to you |
|---|---|---|---|
| Reinstatement | Yes | The original loan, current again | Little, if the borrower has the cash |
| Repayment plan | Yes | The original loan plus catch-up payments | Time and follow-up |
| Loan modification | Yes | A new set of terms on the same loan | You may give up rate, term or arrears |
| Discounted payoff | Yes | Cash, less than the full balance | The part of the balance you forgive |
| Short sale | No | Cash from the sale to a third party | The shortfall against your balance |
| Deed in lieu | No | The property | Holding, repair and resale costs |
| Foreclosure | No | Sale proceeds or the property | Legal fees, time, then property costs |
| Selling the note | Not your decision | Cash from another note buyer | The discount that buyer requires |
Exits that keep the borrower in place
Reinstatement
The borrower pays everything that is past due, with the late charges and costs the note allows, and the loan carries on as written. It needs a borrower who can find a lump sum, so it is more likely when the default is recent and the amount is small.
Repayment plan or forbearance
The borrower resumes the regular payment and adds an extra amount each month until the arrears are cleared. Under forbearance, a related arrangement, you hold off on enforcement for a period while the borrower recovers. Put either one in writing, signed by both sides, with a clear statement of what happens if a plan payment is missed.
Loan modification
You change the loan so the borrower can afford it: a lower rate, a longer term, or the missed payments moved to the end of the loan. You give up something on paper in exchange for a loan that pays. Changing the terms of a consumer’s home loan is regulated, and the rules depend on the state and on who you are as a lender, so have a professional servicer and an attorney handle the documents.
Discounted payoff
You agree to accept less than the full balance as payment in full, funded for example by a refinance or by the borrower’s family. It ends the loan and returns your capital in one step, and whether the figure is a good one depends on what you paid for the note. Forgiven debt can have tax consequences for the borrower, which is a subject for their CPA and one you should stay out of.
Exits that end the loan through the property
Short sale
The borrower sells the property to a third party for less than is owed, and you agree to release your lien for the net proceeds. You avoid the cost of foreclosure and never take title, but you need a cooperative borrower and a realistic listing price.
Deed in lieu of foreclosure
In a deed in lieu of foreclosure, the borrower signs the property over to you and you release them from the debt, or from part of it. When it works it is quicker than a foreclosure. The risk is that a deed in lieu generally does not clear other liens the way a foreclosure can, so you take the property with whatever else is recorded against it, which is why the title search comes before the signature.
Foreclosure
Foreclosure is the legal process that enforces the lien. Some states use a court process and some allow a sale outside court under a deed of trust, and the cost and duration differ a great deal between them. At the sale a third party may bid enough to pay you off, or you may end up owning the property and selling it yourself. Budget for attorney fees, property taxes, insurance, securing the property and the cost of selling it. Before any of that, confirm that you can foreclose as the owner of the note, which rests on the documents you hold.
Selling the note instead
Nothing obliges you to see a note through. Sold as it stands, it may suit a buyer with an exit you are not equipped for, such as a foreclosure in a state where they already have counsel, and that buyer will price in the same uncertainty you did.
The other sale comes later. A loan that has been brought current and has then paid on time for a stretch is called re-performing, and buyers of performing notes will look at it once there is a fresh record of payments. How long a record they want differs from one buyer to the next, so ask before you plan around a resale.
What can interrupt any of these
A bankruptcy filing by the borrower generally puts collection and foreclosure on hold until the court allows them to continue or the case ends. If that happens, stop contact about the debt and speak to a bankruptcy attorney before doing anything else. Unpaid property taxes can also overtake your plan, since a tax sale can threaten your lien, so keep checking them for as long as you hold the note.
Price the note against a second exit as well as the first
Work out what you would recover, after costs and time, under the exit you think is most likely and again under the one you would fall back on. A note that only makes sense if the best case arrives is priced too high. An example of the sum, with invented round figures: you expect a payoff of $50,000 and would spend $4,000 getting there, so you net $46,000. Your fallback is a foreclosure that brings in $45,000 and costs $12,000 in legal and holding expenses, a net of $33,000. The bid has to work at $33,000 as well as at $46,000.
Check your own readiness in the same sitting. Without a servicer, an attorney in the state and cash set aside for legal fees and taxes, the exits above stay out of reach whatever the spreadsheet says. If any of the three is missing, put it in place before you bid, starting from the groundwork in the investor guide.
Related questions
Which exit is the most common?
We publish no figures on that, and it depends on the borrower, the equity and the state. An exit that keeps the borrower in the property avoids legal costs and the work of owning and selling real estate, which is why buyers look at those first.
Do I have to foreclose if the borrower will not pay?
No. You can negotiate a payoff, agree a short sale, accept a deed in lieu, or sell the note to another buyer. Foreclosure is the enforcement route when the others are not available or do not make sense.
Can I sell a non-performing note I no longer want?
Yes. Other buyers purchase non-performing notes, and they will price in the same uncertainty you face. A note that has been brought current and has a fresh record of payments can also be offered to buyers of performing notes.