The Difference Between a Mortgage and a Note?
Investing in mortgage notes can be a great way to add much-needed income to your self-directed IRA, 401(k) or retirement account. But it is important to understand the basics, and a note and a mortgage are two different things. In this article you will learn the difference between a mortgage (or trust deed) and a note.
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Mortgage notes go by many names, including promissory notes, real estate notes, mortgage notes, or just notes. They are written agreements between a borrower and lender – effectively an IOU. Whereby, the borrower promises to pay the lender some money at a later date. The two parties agree to the terms of the agreement during the lending process, and the promissory note legally binds the borrower to repay the lender with set conditions.
What are Notes Used For?
Notes are used for a variety of purposes. This includes banks and credit unions providing mortgages to their customers, owners financed real estate transactions, and private lending.
In the case of owner financed notes, a buyer will pay the seller of a house a deposit, and the seller will carry a note for the balance. So, the seller takes the position of the bank and collects monthly payments from the buyer under the terms of a note. I have used owner financing many times to help low-income families become homeowners in our Pathway to Home ownership affordable housing program.
Notes are also used in private lending transactions. This is where a passive investor loans money to an active real estate investor to purchase and rehab a property. The RE investor will usually pay interest payments to the private lender under the term of a notes and will then refinance the property with a traditional bank or sell it to pay back the private lender.
Related: What Are Real Estate Notes Used For?
What Terms Does a Note Contain?
The note contains the terms of the agreement between the borrower and lender. Every note is different, but as a bare minimum it should contain:
- Amount of the loan
- Borrowers’ names
- Property address
- Interest rate
- Late charge penalty amount
- Term to maturity (number of years)
- Any balloon payments
The note is not recorded in the county records. Instead, it is held by the lender, and returned to the borrower marked ‘paid in full’ when the loan has been repaid.
Related: What is a Promissory Note and What Terms Should It Contain?
Mortgages and Deeds of Trust
A mortgage deed or deed of trust (I will use the term mortgage here) provides security for the loan that is evidenced by the promissory note. A mortgage provides the lender with the right to take ownership of a property should the borrower fail to pay under the terms of the note. In this respect, the title of the real estate is used as collateral for the loan.
What Happens if a Borrower Defaults?
A mortgage allows a lender to require immediate repayment of the loan in full under certain circumstances, such as the borrower defaulting and missing payments. This is known as an acceleration clause.
As a rule, the lender must provide the borrower with sufficient notice before accelerating the loan. Usually, the borrower will have a period in which to cure the default. If they fail to do so, the lender can begin foreclosing the loan.
A foreclosure is the legal process in which real estate secured by a mortgage is sold to satisfy the underlying debt. Lender’s often have other remedies to avoid costly foreclosure, such as taking the deed in lieu of foreclosure. Lender’s often also sell their defaulted loans to other investors who seek to work out a solution with the borrower or foreclose the loan.
What Does a Mortgage Contain?
The mortgage or deed of trust should contain at least the following:
- Borrowers’ names
- Real Estate address
- Legal description of the Real Estate
The mortgage or deed of trust is recorded in the county land records, usually shortly after the borrowers sign it.
If the loan is fully repaid, the lender will record a release (or satisfaction) of mortgage or a reconveyance of deed (used in conjunction with deeds of trust) in the county land records.
1st Position vs 2nd Position Mortgages
A mortgage or trust deed can be recorded in 1st or second position. A 1st position mortgage takes priority over most other liens in a foreclosure – although there are some types of lien that can get in the way of even a 1st position mortgage such as a property tax lien.
A mortgage recorded in 2nd position is settled only after the 1st position lien has been settled in full. This means lenders in 2nd position could lose some or all their money if there is not enough cash from the sale of a property to satisfy the lender in 1st position. This higher risk is why mortgage loans with a 2nd position lien tend to attract higher interest rates.
Related: A Guide to Understanding Lien Position and Priority
Buying and Selling Notes
Mortgage notes can be a great investment. They generate reliable, consistent income, and they are backed with physical collateral. Notes can be bought and sold freely on the open market, so anyone can buy a note using cash, or even their retirement account.
An assignment is the document of legal record of the transfer of the mortgage or deed of trust from one owner to another. The assignment is usually recorded in the county land records.
The assignment should display the legal descriptions of the real estate to avoid any confusion as to which piece of real estate it refers to. It should also contain name of the original lender, along with the name of the party buying the mortgage, and the date of the assignment.
When a lender sells a mortgage, they do not need to notify the borrower. The new lender must send the borrower a notification advising the sale took place and how the borrower should make their payments to the new lender.
The endorsement shows the transfer of the promissory note from owner of the loan to another. When an investor buys a loan, the previous owner will endorse the note. This provides formal recognition that the note is being transferred to a new owner. Just like a check, a note can be endorsed in blank. This makes the note a bearer instrument, so whoever holds the note owns it and can enforce it.
Performing vs Non Performing Notes
There are two types of notes that you can purchase as an investment. A note is performing when the borrower is fully up to date on all payments. If the borrower defaults – usually by 90 days or more – the note becomes non performing.
Performing notes with a good borrower, good collateral and good terms command high prices because they are seen a as safe, stable income investments that pay great returns. Non performing notes are usually sold by lenders at big discounts to their face value. This discount provides a profit opportunity for investors that have the time, money and knowledge to modify the loan or offer forbearance to the borrower to get them paying again, or to take a deed in lieu or foreclose the loan.
Related: Performing vs Non-Performing Notes – Which is the Better Investment?
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