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Evaluating the Risks of Mortgage Note Investment

Updated: Nov 6, 2020

Homeowners should be a part of your investment portfolio


Risk is a part of every investment experience. There are no investments that are completely risk-free and few that combine low risk with a decent return that can beat inflation.


While we all interpret risks in different ways and we each have our own risk tolerance, I tend to categorize mortgage loan investments as one of the few investments that has minimal risks with great potential returns. Let’s take a look at some of those risks so you can see for yourself.


Borrower Default


When considering mortgage loan investment risks, it would seem as if borrower default is the biggest risk. After all, your income comes from the homeowners making their monthly mortgage payments and eventually paying off their loans.


But as it turns out, this risk might not be something that needs to strike fear in an investor’s heart for three reasons:

  1. Homeowner default is statistically rare.

  2. Mortgage loan investors can provide options for borrowers to help them get through short-term financial difficulties.

  3. If no agreement can be made, mortgage loan investors retain the right to foreclose on a defaulted loan’s collateral.

Now, let’s talk about each of these factors in more detail.


The Statistics of Mortgage Default


In a normal economic time, during a “normal” year, delinquency rates on single-family homes are low. In fact, the delinquency rate for mortgages ninety days or more past due fell from 4.9 percent in January 2010 to 0.8 percent in December 2019.[1]


Of course, as the Great Recession and the COVID-19 Recession have taught us, normal is a gift we don’t always get to enjoy. But a deeper look at actual delinquency and foreclosure rates during these events shows us that homes seem to be the last asset people are willing to lose.


It’s been estimated that between 2007 and 2010, there were just 3.8 million foreclosures in the United States.[2] In quarter one of 2010, the delinquency rate for single-family residential mortgages reached its highest point, 11.54 percent. At the time, the unemployment rate was around 10 percent.[3] In quarter two of 2020, after months of a pandemic and lockdown orders and with an unemployment rate of 11.1 percent, the delinquency rate for single-family residential mortgages was just 2.49 percent.[4]


In part, the drastic difference between delinquency rates today versus around the Great Recession is likely due to changes in loan underwriting standards and lending regulations, as well as government intervention in the form of automatic forbearance—factors that will continue to benefit mortgage loan investors throughout the future years and potential economic upheaval.


Modifying Payments


Chances are good you’ve heard about banks offering mortgage loan modifications to borrowers dealing with resolvable financial issues. With these modifications, they can reduce the borrower’s monthly payment and/or interest rate, extend the loan’s maturity date, and add past-due balances to the principal amount owed.


Banks do this because it works. Between 2007 and 2016, more than 24 million nonforeclosure solutions were offered by the mortgage industry, rescuing millions from foreclosure, keeping families in their homes and keeping payments rolling in.[5]


Our goal as lenders is simply to keep the loan payments coming in on a monthly basis, so common alternatives to foreclosure can include:

● short-term forbearance

● loan modification

● selling the house

● refinancing the house

● deed in lieu of foreclosure

These foreclosure alternatives are usually brought on by short-term financial hardships that prompt defaults. This can include difficult events such as:

death in the family

divorce

job loss

illness

overwhelming debt, frequently due to medical bills

The key here is short-term. Federal law prevents lenders from filing a foreclosure until a borrower is 120 days delinquent on their loan, so this usually gives a loan servicer time to reach out to the borrower, assess the borrower’s situation, and offer potential solutions.

Since loan servicers collect loan payments and communicate directly with the borrowers, investors should not get involved. In many states, calling borrowers directly can be considered debt collection, which would require a state license. Personally, as an investor, I want as large a distance between myself and the borrower as possible.

Why do these alternatives work so well with homeowners? If you’re used to dealing with tenants as a landlord and have had to evict—or threaten to evict—tenants, then you might not understand. As a landlord, I found that tenants generally viewed renting as a financial transaction. Their goal was to get the best unit for the lowest price, with the lowest amount down, and they were willing to move, even on short notice, for a better deal.


Also, the rental market was competitive. Many landlords would upgrade units and offer incentives like free rent to attract tenants; they’d even lower prices out of a need to fill units. Thus, many tenants weren’t concerned about an eviction, in my experience, because they could always move to another rental.


Homeowners, however, are a completely different breed. Just think about how the process of buying a home starts—usually with a big down payment. People save money for years, handing over more money than they may ever have before, to buy a home. Once they move in, homeowners personalize their home and yard, and they expand their families, get pets, and make memories.


Besides that, over time, their equity in the property can grow to hundreds of thousands of dollars, making their home the most important investment many of them have. Homeowners have both a financial and emotional connection to their homes (even when they are underwater on value) and almost never walk away.


Foreclosure


While it doesn’t happen often, there are borrowers who become so behind on mortgage payments that their lender files foreclosure. But, as I mentioned, this is infrequent, even during times of financial stress such as the Great Recession, when about 25 percent of homeowners were underwater, yet only 3.8 million ended up in foreclosure.[6],[7]


Because we are secured lien holders, mortgage loan investors retain the right to foreclose on a property to reclaim the balance of the loan. As a lender, I am willing to provide alternatives to foreclosure if I see a clear resolution in sight. I don’t want to displace borrowers unless absolutely necessary and all alternatives have been exhausted. But if no solution can be found, then sometimes foreclosure is the only answer. Just because a foreclosure case is filed doesn’t mean that it will be completed; among the statistically small percentage of cases that are filed, even fewer actually make it to a foreclosure sale.

This is yet another reason I suggest that investors stick with owner-occupied, primary residences; homeowners are much less likely to allow them to go into foreclosure than they might a vacation or investment property.


Lending is a business. One of the biggest lessons I learned during thirteen years of real estate investing is that decisions should always be made based on the numbers, not on how I feel about a situation or my desire to shape an outcome. I strongly believe that I have a responsibility to the portfolio of loans I manage, and that means making sure timely payments continue to come in during the life of each loan.


While I want to help borrowers whenever possible, it’s unreasonable for anyone to think they can stay in a home for a year or longer without paying a mortgage, taxes, or insurance. Sooner or later, everyone needs to face the reality of their situation, and delaying the inevitable just makes situations worse for everyone involved.


The key in mortgage loan investing is to have a large portfolio diversified over many borrowers in many markets in order to withstand any financial storm.


Falling Property Values


When you invest in real estate as a landlord or flipper, falling property values can be a great concern. After all, selling the property or leveraging the equity can be an important means of accessing capital and gaining profits. Falling property values threaten to undermine that completely.


From that perspective, mortgage loan investors don’t need to be as concerned about falling property values. While I always look for equity in my purchases, since I don’t own the property or need to use its equity as leverage or liquidity, the value of the property itself plays little role in my overall business model.


Instead, mortgage loan investors need to be concerned with how homeowners will react to falling property values. During the Great Recession, a common concern was that borrowers would abandon their homes as property values plummeted, and by March 2011, almost 30 percent of them were underwater or very close to it.[8] The term strategic default was coined by lenders to identify borrowers with negative equity who decided to just lock the doors of their home and walk away. Financial institutions were concerned that millions of homeowners would strategically default since there was no financial incentive for them to stay.


As it turns out, the concern over strategic default was overblown, which should give today’s mortgage loan investors some additional confidence. J.P. Morgan Chase conducted a study in 2017 to learn about borrower behaviors and motivations during the financial crisis, and what they found was astounding.

Strategic default never happened.[9]

The study followed almost a half-million homeowners who received a home loan modification and found that in virtually every single case, the only borrowers who lost their homes were borrowers who had no financial ability whatsoever, either through themselves, a spouse, or family members, to continue to pay. In other words, default was tied to a fundamental drop in income, rather than a drop in property values or size of payments. Underwater borrowers stayed in their homes, continued to pay, and just waited for the housing market to rebound.

Why would they do this? Overwhelmingly because they loved their homes and wanted to stay in them! In 2018, when almost two million homeowners still had negative equity, The New York Fed found that the primary reason underwater homeowners hadn’t even considered strategic default was simple: they liked their homes and didn’t want to lose them.[10]


When you think about it, everyone needs a place to live. Whether you’re paying a mortgage or rent, you’re paying living expenses. The extensive research done after the Great Recession shows us that homeowners would far prefer to keep paying for their homes rather than give them up to pay rent on a temporary dwelling they have no stake in, control of, or emotional tie to.


This data perfectly illustrates the importance of emotional equity in home ownership, which has proven to be even more powerful than financial equity. The mindset of a homeowner is completely different, because it involves ownership. Homeowners do not make rational, data-driven decisions about their homes. Their decisions are overwhelmingly emotional.

Furthermore, humans are essentially creatures of habit and familiarity who don’t like change. Moving is difficult and expensive, and most people try to do it as rarely as possible. How could you find an investment that is better than this, with borrowers who are motivated to keep their mortgage current and in good standing, regardless of what happens in the economy and markets around them?

Interest Rate Changes


Interest rate risk is inherent with many investments. It describes the risk that when a fixed investment, such as a bond or CD matures, an investor may not be able to reinvest their principal at a similar rate if rates have fallen.


Real estate investors face a different type of interest rate risk, as their expenses are driven up when they invest in properties by taking out mortgages during a high, or rising, interest rate environment.


Most commercial loans are balloons of about five years, meaning that investors are required to refinance their debt (and pay bank fees) upon the balloon’s maturity, at the bank’s discretion. If rates are increasing, investors could find themselves with a nasty surprise: increasing leverage costs that they cannot absorb by raising the rents. If banks sense systemic risk, they could decide not to refinance the loan at all, forcing the investor to either find a new bank or sell the property in the current market conditions. In a declining market with a neglected property, an investor could find themselves—pardon my language here—totally screwed.


For mortgage investors, interest rates, whether high or low, play no role in our ability to profit, even if we’re reinvesting our principal when loans are paid off early and interest rates are extremely low. The reason we don’t need to be concerned about interest rates is that we generally buy loans based on yield, not interest rate.


When mortgage loan investors calculate investment yield, we don’t pay attention to the borrower’s interest rate. Our only concern is our yield, which is based on the amount of each payment, the number of payments remaining, and the purchase price. Discount allows us to increase our desired yield to meet our investment requirement.

In addition, when rates fall, homeowners are more likely to refinance their loans, meaning we get paid back early. Depending on our purchase discount, an early payoff can drastically increase our investment ROI.

Out of the hundreds of billions of dollars of mortgage loans originated each year, there are wide varieties in the interest rates.[11] I review countless loans every year originated by smaller lending institutions or credit unions as far back as 1995, at or above 10 percent interest. Higher interest rates don’t necessarily mean a higher-risk borrower, and they don’t equal a higher yield. When a mortgage loan investor looks for a specific minimum yield, the calculation revolves around the cost of the loan and the remaining payments.


As you can see below, the yield of the investment changes not because of interest rate, which isn’t even a factor in the calculation, but based on the purchase price of the loan itself.

Number of payments 132

Monthly payment $494.12

Yield 8%

Purchase price $43,285.21

Number of payments 132

Monthly payment $494.12

Yield 12%

Purchase price $36,125.48


No matter what interest rate homebuyers are paying, you can maintain the same yield with every new investment.


Risk may be an unavoidable reality of any investment worth having. Understanding the true nature of the risks associated with mortgage loan investing gives you the power to create hedges against them, such as diversifying the locations for your mortgage loans. Often, however, the very nature of this type of investment and its focus on yield create a far more hospitable environment for investors seeking low-risk and comfortable returns for a portion of their portfolio.

[1]https://www.consumerfinance.gov/data-research/mortgage-performance-trends/mortgages-90-or-more-days-delinquent/#mp-line-chart-container [2]https://www.chicagofed.org/publications/chicago-fed-letter/2016/370#:~:text=As%20a%20result%20of%20the,were%20approximately%203.8%20million%20foreclosures. [3]https://tradingeconomics.com/united-states/unemployment-rate [4]https://fredblog.stlouisfed.org/2018/11/the-lowdown-on-loan-delinquencies/ [5]https://www.housingwire.com/articles/36455-hope-now-145-million-solutions-available-to-homeowners-in-2015/ [6]https://cnsmaryland.org/2020/05/19/a-decade-after-great-recession-home-values-in-some-communities-remain-underwater/ [7]https://www.chicagofed.org/publications/chicago-fed-letter/2016/370#:~:text=As%20a%20result%20of%20the,were%20approximately%203.8%20million%20foreclosures. [8]https://www.corelogic.com/news/new-corelogic-data-shows-23-percent-of-borrowers-underwater-with-750-billion-dollars-of-negative-equity.aspx [9]https://institute.jpmorganchase.com/content/dam/jpmc/jpmorgan-chase-and-co/institute/pdf/institute-mortgage-debt-reduction.pdf [10]https://www.marketwatch.com/story/why-do-underwater-homeowners-keep-paying-the-mortgage-2018-04-19 [11]https://www.consumerfinance.gov/data-research/consumer-credit-trends/mortgages/origination-activity/

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