How to Invest in Mortgage Notes

Mortgage payments are expenses for borrowers and profit for lenders.

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When a homebuyer or a real estate investor borrows money for his purchase, there's an investor on the other side of that transaction collecting payments and earning interest. Sometimes, the loan is direct, where one investor makes a single loan to a single real estate purchaser. Other times, the mortgage and note are pooled with others to create a mortgage-backed security in which you can invest.

Direct Mortgage Lending

Private lending companies look for investors to provide them with money to lend. Typically, the company finds borrowers and handles the process of packaging the loan. You then decide whether you want to invest in the loan based on the value of the collateral and the strength of the borrower. Loans can be long-term traditional mortgages or short-term bridge loans. While interest rates vary, they are almost always higher than what a traditional bank would charge. Private mortgage lenders are typically small companies that you can find by talking to a financial advisor or someone in the real estate community. You may also want to consider looking for companies licensed in your state and members of major industry associations like the Mortgage Bankers Association or the American Association of Private Lenders.

Buying Existing Notes

Sometimes investors decide they want to sell their notes before maturity. Buying notes on the secondary market brings the opportunity to potentially get a mortgage at a discount. It also adds the benefit of seasoning. Seasoned notes have been around for a while and give you the comfort of being able to see that the borrower is actually making payments. The challenge in investing in these notes can be finding them to buy. Online marketplaces create some fluidity in the market, and most communities have note brokers, as well. A real estate attorney or investment advisor that is experienced in the field can help you find a reputable local broker.

Mortgage-Backed Securities

Instead of directly investing in the note, you can also buy a mortgage-backed security. Mortgage-backed securities are like bonds, but instead of being backed by a company or a government, they're backed by the income that comes from pools of homeowners paying their mortgages. Some of the best-regarded mortgage-backed securities come from government-sponsored entities like Fannie Mae, Freddie Mac or government-owned Ginnie Mae. The simplest types of MBS, pass-throughs, simply collect mortgage payments and send each investor her share. They're easy to buy, easy to sell and may offer good returns. However, there is the risk that you could get your money back sooner than you expect if homeowners pre-pay their loan. MBS are openly traded, so you can buy them through an investment broker, just like you would with any other bond or fixed-income investment.

Mortgage REITs

You can diversify your investment in mortgage notes while increasing your leverage by buying shares in a mortgage real state investment trust. Mortgage REITs are companies that borrow money and use it to buy mortgages. Since they're borrowing at short-term rates and buying long-term investments, the strategy can generate healthy profit. However, these investments carry real interest-rate risk because, in essence, they make the money they pass through to you based on the difference between what they pay to borrow and what they lend. Many mortgage REITs are publicly traded on major stock exchanges, making them easy to buy through a stock broker or investment company.