There are two kinds of real estate notes: Performing & Non-performing.
When the note is performing the homeowner is usually up-to-date on the payments. In essence when the note is purchased, it is the remaining payments till the note is paid off that is purchased. Generally, with a performing note the potential profit is less than that of a non-performing note, but it is safer because the homeowner has been making the payments on the loan.
That’s the biggest difference between performing and non-performing notes, the payment history.
Thus, non-performing notes are typically sold with a greater discount. Usually the goal of the note-holder is to get the note to be performing again. Of course, to do that the borrower must start making payments again. There are a number of scenarios, but they generally involve some form of refinancing and reduced payments for the borrower.
When the note becomes performing (you) the note-holder can either continue collecting the monthly payments or can resell the note as a performing note.
If the note cannot be made performing then the note holder has a number of options.
- In some instances the non-performing note can be resold at a small profit.
- Sometimes the borrower will vacate the house rather than go through foreclosure and have that on his/her credit record. Sometimes the borrower will have already vacated the house. In either case the borrower might cooperate and give it to you as a deed-in-lieu of foreclosure. When that happens the house can be sold or rented.
- Finally, if none of the above is a possibility then the note holder (you) will have to foreclose on the property, which sometimes is a lengthy process that results in a smaller profit.
I’ll run through a simplified example.
You find a residence valued at $60,000. The borrower purchased the house for $100,000 and owes $95,000. You buy the note for $30,000. If you reduce his/her debt by refinancing the house for $50,000 and she makes the payments, you could then make a nice profit by reselling the note as performing or you can hold it and collect the payments to increase your cash flow. Then as the value increases you might consider selling it to make an even greater profit.
If that doesn’t work out you can offer the option of walking away to the borrower and you then will have a $60,000 house that cost you $30,000.
I’ve simplified the process here quite a bit. There is more to it than merely an exchange of money. For instance, any taxes owed will have to be taken into account as well as the condition of the house. Very often the properties are in another state, so that state’s regulations, codes, etc. need to be taken into account.
In the end, a well-researched note can earn a profit greater than a savings account, CD, or IRA.