When most folks think about mortgage notes they think about industry giants such as Bank of America or Wells Fargo. According to Mortgage Bankers Association estimates, these institutions will originate $1.3 trillion in residential mortgages this year. But there is a subset of the mortgage market called private mortgages or seller financed mortgages.
“seller financing” — that’s when the seller agrees to lend his buyer all or a portion of the home’s purchase price. Often the principal and interest payments are structured to amortize over a 30-year period like traditional loans, but require a balloon payment — meaning the borrower must remit the entire outstanding principal — after five years.
The expectation is that the borrower will, during this five-year period, refinance into a conventional-type loan from an institutional lender. If the borrower is unable to pay the full amount after five years, the note holder can foreclose and take back the home. The main risk to the note investor is that the net sale proceeds of the foreclosure sale are insufficient to cover the note balance.
These seller-financed loans are generally used by borrowers who are unable to qualify for conventional institutional financing. This may not necessarily be a reflection of the borrower’s creditworthiness. For example, under existing institutional guidelines, many self-employed borrowers with high incomes and top credit scores still do not qualify for many institutional conventional loans.
Retirees face similar hurdles.
For these reasons, private mortgage loans generally carry a higher-than-market interest rate. It is this high interest rate that makes them attractive to real estate investors.
Private mortgages are also originated by private lenders who are willing to lend money to home buyers at above-market rates provided that the loan is secured by the borrower’s property as collateral. These investors will want to conduct due diligence not only on the borrower’s ability to repay, but also on the property’s market value and condition, should the investor have to foreclose.
Private mortgage notes are readily saleable in a robust secondary market. Although their higher-than-market interest rates make them attractive as buy and hold investments, private mortgage notes can be sold and thus converted into cash. The amount they sell for is based on the principal balance, the number of payments that have been made (referred to as “seasoning”), the number of remaining payments, the home’s appraised value and the borrower’s creditworthiness.
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