Real Estate Investing

How to Generate Passive Income by Investing in Mortgage Notes

November 25, 2023

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A Guide To Mortgage Notes

What does it mean to invest in debt? 

Mortgage notes are an often-overlooked method of real estate investing, as they are anchored in debt rather than equity. Mortgages notes are secured by real estate collateral but avoid the uncertainty traditionally associated with real estate, such as vacancies and property damage.  

In this article, we’ll talk more about what a mortgage note is, what their benefits are, and how to invest in one yourself to start generating passive income. 

What is a Mortgage Note? 

First things first: What is a mortgage note? 

Also known as a promissory or mortgage promissory note (read more about these here), a mortgage note is a legal agreement between a buyer and a lender describing the terms and conditions of a mortgage loan. It’s the legal document that specifies the loan agreement, including the monthly mortgage payments, the interest rate, and any other terms of the agreement. 

Mortgage notes are said to be “collateralized” by real property since if the borrower defaults on payments, the lender can foreclose on the property and sell it to recover costs. In very simple terms, a mortgage note serves to represent the debt owed by the borrower to a mortgage lender on their loan.

How Do Mortgage Notes Work? 

Mortgage notes can be classified in many different ways, including: 

  • Asset class (e.g., single family vs. multifamily) 
  • Risk factor (e.g., distressed or non-distressed, how well the borrower is currently paying off the loan, etc.) 
  • Lien position (the loan priority in the event of the borrower defaults) 

Each type of note has different pros and cons for the person who holds the mortgage note.

Investors typically obtain mortgage notes by purchasing them from banks or a traditional mortgage lender, who want to exchange the note for cash. This is typically done at a discount to incentivize the sale, such that, for instance, an investor could purchase a $70,000 note for $65,000 and see a return of $5,000. After the note is transferred to the investor, they receive monthly payments for the principal and interest from the borrower instead of the original lender. If the borrower defaults, the investor can foreclose on the home and either sell it or rent it out themselves. 

Example of a Mortgage Note Investment 

Let’s look at a simple example of a mortgage note investment. 

Buyer Bob and Seller Sam have just agreed on a seller financing arrangement. Instead of going through the process of approval at the bank or for a private loan note through private mortgage lenders, Bob will pay off his debt to Sam directly, in monthly installments of $1,100. The home, worth $150,000, is the collateral while Bob finishes paying off the 30-year fixed loan with 8% interest. 

This arrangement works well for Bob and Sam, and after five years, Bob has paid off about $60,000 of the principal. But now Sam is looking to buy another property himself, and his priorities have changed. He’s in need of fifty grand for his new investment, so he’d rather have the remaining $90,000 owed to him now, in cash. What can he do? 

One solution is for Sam to sell the mortgage note for Bob’s loan to another investor on the secondary mortgage market. Let’s imagine that you are the mortgage note investor. You’re in essence purchasing the loan so that you’ll receive Bob’s monthly payment amounts instead of Sam. But it won’t be profitable for you to do so unless you can get the note at a discount. Sam agrees to give you a 20% discount on the loan balance, meaning you’ll pay him $72,000 instead of the full $90,000. 

Bob is still responsible for paying you the full amount that he borrowed, however. So you paid $72,000 for a mortgage note with a remaining balance of $90,000, and therefore you could profit $18,000 off the investment. 

Benefits and Risks of Becoming a Mortgage Note Investor 

Becoming a mortgage note investor comes with its share of pros and cons. Here are a few: 

Benefits: 

  • Purchase notes at a discounted rate. Mortgage notes for sale are often discounted to incentivize buyers. 
  • Avoid the risks of vacancies, property damage, or market fluctuations. Since you haven’t invested directly in the property, you don’t need to worry about its appreciation or the demand for rentals in the market. The mortgage holder still owes you the money, and they are responsible for navigating the various stressors of property management. 
  • Generate passive income. This is the biggest reason to purchase mortgage notes, as you can create money via interest without the work and dedication required to maintain a property. 

Risks: 

  • Potential default. Mortgage notes are not insured by the FDIC (Federal Deposit Insurance Corporation), meaning the note holder is required to cover the costs of foreclosure proceedings in the event of a default in either the mortgage interest rate or principal.
  • Fixed interest rates. If market interest rates increase after you purchase a note with a fixed rate, the investment value will decrease. 
  • Lack of liquidity. Mortgage notes are not very liquid assets, and they may be difficult to get rid of mid-term. 

How to Invest in Mortgage Notes 

If you’re interested and wondering how to invest in mortgage notes, here are a few simple steps. 

  1. Locate a mortgage marketplace. Large lenders like banks and credit unions tend to sell notes in bulk, so you might have better luck purchasing a note individually through a private seller. Check online marketplaces like Notes Direct or Fundrise. These mortgage marketplaces sell notes individually at more affordable prices 
  1. Find an experienced mortgage broker to walk you through this process. A mortgage broker will have the expertise and experience necessary to guide you through this process smoothly. Note brokers also buy and sell mortgage notes, so you could potentially find a note for sale through them.  
  1. Choose a performing (non-defaulting) mortgage note and collect payments. Try to buy the debt at a discount so that you can generate a worthwhile return on your investment. 

Conclusion 

There’s no one strategy that’s best for investing, and that includes mortgage notes. It might seem counterintuitive, but buying debt is a great way to invest in real estate without involving many of the risks typically associated with real estate investments. 

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