Real estate mortgage notes are classified in several different ways, but all of those classifications fall into two main categories: Performing and Non-Performing. An investor considering adding mortgage note investing to their portfolio needs to understand the difference between these two types of mortgagee notes, and the pros and cons for each.
What Are Performing and Non-Performing Notes
A mortgage note is classified as “performing” when payments are being made as laid out in the terms of the note. The payments have consistently been made on time, and no payments have been missed.
A mortgage note classified as “non-performing” is one where payments are not being made according to the terms of the note. If payments are 30 – 89 days late they are considered to be in default. Loans with payments 90 or more days late are considered to be non-performing.
Performing Notes Investment: Pros & Cons
· Low-risk – Performing notes are, by definition, “performing,” payments have been, and are being, made on time. The terms of the loan are being met. There is an established pattern of return.
· Dependable Income – Because there is an established pattern of return, an investor can count on that pattern to continue, providing consistent, reliable, dependable passive monthly income.
· Little to no discount – Performing mortgage notes usually sell for 75%-100% of the unpaid balance (UPB). So, even though you can count on dependable monthly income, your profit margin is almost entirely based on the interest paid by the borrower.
· Fewer Available – As an individual investor, or even a small investment group, it will be more difficult to purchase performing notes from a lending institution unless you have a considerable amount of capital available. Lending institutions, especially large ones, prefer to sell performing notes in larger bundles -thereby regaining larger amounts of working capital for themselves.
Investing in performing notes is a low-risk avenue to passive income. Performing notes are frequently purchased by investors who want low-risk, dependable monthly income. Investors who want to broaden their investment methods also tend to invest in performing notes.
With the low level of risk associated with investing in performing notes, you may wonder why banks and other lending companies would even consider selling them. But selling notes is a regular part of their business. Many loans are approved and issued with the decision having already been made beforehand to sell them soon after. There are even Government-Sponsored Enterprises (GSE) that exist specifically and solely for purchasing these loans.
While mortgage-related Government Sponsored Enterprises (GSE) like Freddie Mac and Fannie Mae do not lend money directly to the public, they help provide liquidity in the housing market by purchasing performing notes from lending institutions. The original lender takes their profit, then sells these notes to a GSE or similar entity, which returns their original capital to them. This makes the funds available again for the lender to loan to another borrower. This process keeps the housing market flowing.
While it may be possible for an individual investor or small investor group to purchase performing notes from a large bank or another large mortgage lender, your success rate will be higher with smaller banks and credit unions. You may also find success with purchasing from hedge funds, although your rate of return will likely be lower. They will have purchased the mortgage note from the original lender and will be looking to profit as well. Performing mortgage notes usually sell for 75%-100% of the unpaid balance (UPB), so your Return On Investment (ROI) will be significantly lower if you are purchasing through a hedge fund or other third-party seller.
Non-Performing Notes Investment: Pros & Cons
· Significant Discount – Because a non-performing note is a distressed asset and can drag down the value of their portfolio, lenders are willing to sell these notes at a discounted rate, on average for 20% – 60% of the lesser of the current market value or the Unpaid Balance (UPB).
· Higher Availability – Again, because these are distressed assets and negatively affect their portfolio, a lender is usually eager to sell non-performing notes, and at a steep discount.
· Higher Risk – By definition, non-performing notes are not functioning according to the terms of the original loan. Payments are not being made on time and have not been for 90 days at least. A pattern of non-compliance has already been laid so an investor can expect the same pattern to continue. If a solution cannot be worked out with the borrower for resuming timely payments, the investor is then faced with having to begin foreclosure proceedings on the property.
· Potential Expense – Again, if arrangements cannot be agreed upon between the investor who has purchased the mortgage note and the borrower, the investor can begin foreclosure proceedings to assume complete ownership of the physical property. This brings with it additional expenses. Plus, once the investor assumes ownership, he is likely to be faced with maintenance and repair issues and possibly back taxes, too.
Banks sell non-performing mortgage notes for a variety of reasons, all of which produce an end result that protects their portfolio and working capital. Besides selling the note to regain their original capital, they also sell to avoid potential liabilities – including possible environmental issues (most often seen involving commercial properties).
Another reasons for selling non-performing mortgage notes is to avoiding the time and expense of a drawn-out foreclosure process.
Looking for a New Approach to Passive Income?
If you are looking for a new approach to passive income, sign up now with Melanin Homes to become a preferred buyer or schedule a FREE consultation to learn more. https://www.melaninhomes.com/mortgage-notes/ Watch for more details and information on both commercial and residential mortgage note investing in our future blogs posts.