A note is a promise to pay document. When homeowners have a mortgage there is someone who owners that mortgage/note. Originally its a large bank but that mortgage/note often gets traded.
Some of us homeowners or rental owners get annoyed when we have to send out mortgage and escrow checks to a different company when our note/mortgage changes hands. What typically has happened is that the owner of our note has traded it to another party. Majority of the times the company we (homeowner/landlord) are interacting with is just the servicer company. This servicer company is the intermediary who bugs us when we are late and manages our payments.
Some of the best note investment areas are where you don’t particularly want to own the actual real estate
Those nasty companies that harass people who are late on their mortgage payments are typically not the servicing company but another contractor who specialized in collections of bad debt.
There are two main sides of note investing:
- Performing notes – where the homeowner is being good and making payments. This is a little more stable and similar to a yield play deal.
- Non-Performing nates – where the homeowner had gone off the rails and behind on payments. This requires some sweat equity to get the person repaying or might even be a total loss. Once a Non-Performing note has gotten back on schedule it is made back into a Performing note.
Non-Performing notes allow you to buy a note at deep discount.
These numbers have the potential to grow at a much faster than expected rate especially with mortgage products with down payments as low as 3%.
We have started to see an uptick in defaulted newer originations coming to market, as well as increases in early payment default loans, where a borrower makes fewer than six payments before defaulting. This helps note investors get better deals.
Yield is the interest rate your money is earning on an annualized basis. Yield is the way we compare other investments and notes because it measures the rate the money is being returned to you (cashflow during hold) and the entire term of those payments. This is why when I compare MFH deals I ask what is the total pro-forma 5-6 year return because it compares the cashflow plus the appreciation at a certain time interval. Again this is the yield.
Yield is different from ROI, Cash-on-Cash, and Internal Rate of Return. When buying notes at a large discount the yield will automatically be high. This is incorrect. If the face value of the note the borrower is paying on is low (single digit %) you can have a relatively bad yield (less than 10%).
Just like getting 75% off at JCPenny on a crappy $80 sweater when buying notes a discount is good but don’t get hung up on the amount of the discount. Focus on the yield.
Yield on a note (and the price you pay for it as an investor) takes into account:
- interest rate
- payment amount
- number of payments remaining
- purchase price
- method of amortizing (fixed or balloon)
What if my note person goes into Bankruptcy?
Understanding notes and purchasing the mortgages of borrowers requires you to understand the progress of the borrower/lender life cycle.
This type of bankruptcy is known as a “liquidation” plan. In a Chapter 7, the bankruptcy trustee cancels or forgives most—or sometimes all—of the borrower’s debts. The trustee may also sell any assets the borrower has to repay creditors. The process takes about five to seven months to process complete. When complete, this is called “discharged.” This is, in essence, a new start for the borrower.
If for some reason a Chapter 7 is not completed successfully, it is referred to as “dismissed.” Being dismissed basically treats the bankruptcy proceeding like it never happened, therefore the borrower still owes all his/her debts. A dismissal can happen for a number of reasons, some of which have to do with the borrower not being able or willing to comply with the trustee requirements.
In a successfully discharged Chapter 7 bankruptcy, many creditors lose their claims. This means the borrower is no longer personally liable for the debts, and the lender can no longer pursue or contact the borrower for payment. This happens frequently with unsecured debt.
Unsecured debt includes things like credit cards, consumer loans, cellphone and cable bills, and other accounts that are not attached to collateral via a note. And this is why these rates are typically high because it is higher risk for the lender.
Items that are secured by a note, such as houses, property, and even car loans, are not forgiven. The borrower has the choice to surrender the items back to the lender. In private money lending for example it is important to be covered by a good Loan to Value (LTV) so when the house flipper screws up you can collect on a good portion of the value you lent on.
Another outcome of Chapter 7 is that the borrower can keep the house here is how…
In Chapter 7, borrowers can choose to retain the home and continue making mortgage payments. They can also sign an agreement called a “reaffirmation agreement.” This is essentially the borrower recommitting to the terms of the loan and promising to pay it. Since a note and mortgage are secured and attached to the property, it is not usually wiped away or made noncollectable in Chapter 7 filings.
However, there is some nuance to this. When a Chapter 7 is discharged, the borrower no longer owes the money personally for the note and mortgage. The property owes the money. This may sound a little strange, but the borrower has been forgiven of the personal liability for most of his debts. This includes a note and mortgage. That means you cannot pursue a judgment or sue the borrower personally for this debt—but his home still owes the debt outlined by the note and mortgage. With this protection in place, the noteholder still retains all rights to foreclose and sell the property if the note goes into default. So while this may seem a little strange, it is actually a great thing for a note holder.
Why do I say this is a great thing? Well, let’s think about it. After successfully completing a Chapter 7, the borrower is free of the crippling consumer debt that was draining his bank account each month. But the borrow may not care since people are emotional… Most people will choose to retain their home both during and after bankruptcy. If they don’t, you can simply exercise your right as a lender and foreclose, then dispose of the home to recover your money. A foreclosure is a rare occurrence, and a real pain but happens in the minority of cases.
Service Transfer Notice Requirements
Notices are required for mortgage service transfers and transfers of ownership of underlying collateral.
One separate notice is required for a change of ownership and another separate notice is required regarding a service transfer.
Any time a service transfer occurs, a transfer of servicing notice must be sent to cover both the new servicer, and the old servicer. A servicer can assist our servicing clients with meeting these regulatory requirements from the Real Estate Settlement and Procedures Act (“RESPA”).
For a loan purchaser or assignee, a notice of transfer of servicing letter may not be enough. Loan purchasers have a separate and distinct requirement to notify borrowers outside of and beyond regulatory requirements related to service transfer letters. These notices are often referred to as ‘404 notices,’ referencing the section of the bill that outlines the requirement. Implemented under 15 U.S. Code § 1641(g) of the Truth In Lending Act (“TILA”) and 12 CFR § 1026.39 of Regulation Z, these notice requirements ultimately amount to a trap for unwary loan purchasers or assignees.
Under the TILA requirements, any loan purchaser or assignee is obligated to notify a borrower of the loan purchase transaction within 30 days of the loan sale’s closing. The notice requirement also mandates the provision of basic information, including:
- identification of the new creditor,
- contact information, and
- providing the location of where an assignment of mortgage will be recorded.
Effective with the CFPB’s implementation of the TRID rules, 404 notices now also require disclosures and statements explaining the purchaser’s policy on partial payment processing.
Although the requirements are relatively straightforward, this obligation could easily slip through the cracks if not properly monitored. The 30-day deadline for this requirement will often have expired by the time the servicer is able to fully onboard a newly purchased loan. For that reason, our standard service does not include the mailing of the 404 notice. With that said, upon request the servicer is happy to help any our servicing clients meet this requirement in addition to the service transfer notice requirements.
As a note owner you like to have someone elsepay off your debts for you. Even better, what if that someone paid you extra money for the privilege which is cashflow for us.
Suppose you have a large outstanding student loan balance. This balance totals approximately $110,000.
Here’s the idea. Instead of making payments on these student loans from your own paycheck, what if you purchased a note and it paid the student loans for you?
Refer to the following loan amortization schedule. Let’s suppose you purchased a note similar to the one in the following table. It presumes that the borrower owes $40,000.
We can see that if the note pays as agreed over the term, the borrower will pay you a total of $86,335.28. This comprises both principal and interest on the loan.
Basically you purchase two notes similar to this example, at a discount. Let’s assume you purchase each for $20,000. This is a total cash outlay from you of $40,000. Every month, you will receive payments from the borrower. Use these payments to pay your student loans. Yes, it is that easy.
- Amount of your student loans: $110,000
- Cash outlay buying two (2) notes: $40,000
- Total monthly income from notes: $479.64
- Total income over term: $172,670.04
1. Pay off $110,000 student loan balance. You did this using only $40,000 of your own money.
2. Made an additional $62,670.56. You did this after paying your student loans in full. This additional money goes right in your pocket.
3. Recovered your initial investment of $40,000. In reality, the payments from two notes paid off your student loans, returned your initial $40,000 investment, and generated a profit of $22,670.56. (Profit is calculated by deducting the $40,000 from the $62,670.56.)