What to Know Before Buying a Mortgage Note

Before you buy a mortgage note, you need to know three things: what the note is worth given its terms and risk, whether the paperwork actually gives you the right to collect, and what you would do if the borrower stopped paying. Most private mortgage notes are created through seller financing or private lending, carry higher interest rates than bank loans and trade at a discount. That higher rate is paying you for real risk.

This guide covers where these notes come from, how they are priced and what to check before you commit money.

What you are buying

A mortgage note is a borrower’s written promise to repay a loan, backed by a mortgage or deed of trust that gives the lender a claim on the property. When you buy the note, you step into the lender’s shoes: you receive the payments and you hold the right to enforce the note if the borrower defaults.

The notes most individual investors buy are not bank loans. They are private mortgages, usually from:

• Seller financing. A property owner sells and lends the buyer some or all of the price.
• Private lenders. Individuals who lend to buyers or investors at higher-than-bank rates, secured by the property.

Our guide to private mortgages explains how they differ from bank loans.

Why the rates are higher

Private notes usually carry higher rates because the borrowers could not or did not use a bank. That is not always a sign of poor credit. Self-employed people with good income, retirees, and buyers of unusual properties often fall outside bank guidelines. But some private borrowers are simply higher risk. The higher rate is compensation for that uncertainty, and part of your job is working out which kind of borrower you are looking at.

How the price is set

You will almost always buy a private note for less than its unpaid balance. That gap is the discount, and it is how buyers reach their target yield, the annual return on the price paid. The main factors that move price:

• Seasoning: how long the borrower has been paying on time.
• Equity: how much the property is worth compared with what is owed.
• Borrower credit and payment behavior.
• Rate and remaining term.
• Lien position: first lien or second.
• Paperwork quality.

A worked example

Say a note has a $120,000 balance at 7% with 25 years (300 payments) left, about $848 a month. If you price it to a 10% yield, you would pay roughly $93,300. The numbers are illustrative.

ITV, investment-to-value, is your purchase price divided by the property value. At 55% here, the property would need to fall a long way before a foreclosure sale failed to cover what you paid. A buyer pricing this note would also adjust for the borrower and the paperwork, covered below.

Watch for balloon payments

Many seller-financed notes are written with payments as if the loan ran 30 years, but with the whole remaining balance due after a shorter period, often five or seven years. That lump sum is a balloon payment. The plan is usually for the borrower to refinance with a bank before it comes due.

If the borrower cannot refinance, the note holder faces a choice: extend the loan, renegotiate or foreclose. A balloon can raise your yield if it is paid, because you get your money back early, but it is also a point where many private notes run into trouble. See balloon payments and note value.

Due diligence before you commit

The price only matters if you can actually collect. Before funding, check:

• The collateral file. The original signed note, the recorded mortgage or deed of trust, every assignment and allonge in the chain, and proof that the seller owns the note. Our guide to what is in a collateral file lists each item.
• Title. An ownership and encumbrance report or title search confirms who owns the property and what other liens exist.
• Property value and condition. A broker price opinion or appraisal, plus photos.
• Payment history. Bank records or a servicer’s statement, not just the seller’s word.
• Taxes and insurance. Confirm property taxes are current and the property is insured.
• Compliance. Seller-financed loans to owner-occupants are subject to federal and state lending rules. A note created outside those rules can be harder to enforce.

A full list is in our due diligence checklist for note buyers.

If the borrower stops paying

The main risk is that the borrower defaults and a foreclosure sale does not cover what you paid plus your costs. Foreclosure timelines and costs vary a great deal by state. In some states it can take a few months; in others, much longer. Before buying, know whether the state uses judicial or non-judicial foreclosure and roughly what it costs. Often a workout with the borrower, such as a modification, is a better outcome than foreclosing.

Notes can be sold again

Private mortgage notes trade in an active secondary market, so a note you buy is not locked up forever. You can sell it later, or sell a partial, meaning only part of the remaining payments. Notes with good seasoning, solid equity and clean paperwork sell most easily.

Bottom line

A private mortgage note can pay a steady, above-bank rate, but only because it carries more risk than a bank loan. Price it based on equity, seasoning and the borrower, verify every document in the chain, and know your plan if payments stop. If you are new to this, our guide to buying your first note is the next place to go.