Today we’re going to talk about how you can exponentially grow your real estate portfolio using notes. For those who have never heard about notes before, I’m going to go ahead and walk you through the definition, but rather than give you a definition itself, I’m going to draw a little nice diagram here, so you can get an idea of what the entire process of note investing is like.
To make sure, before you even attempt to make this, make sure you consult with a real estate attorney with a title agency to make sure that this exercise is legal in the state that you’re about to do this. I’m pretty sure it’s legal but always double-check just in case because they have different terminologies.
Each state calls it differently, so explain the practice itself to the real estate attorney, and they will be able to take care of you and make sure to drop a contract that’s going to have you legally protected. Also, make sure that you can still collect the money you’re about to do just right now.
Let’s assume that you found a house, and you want to invest in it, and you go through the traditional route of going to a bank. This is you, and then you go to the bank, and you get your loan approved for $100,000. You go on about your life, you’re very happy, bought your house, and you’re renting it out, great, but what happens if three more people were to come into the picture.
You got investors A, B, C who will also like to get access to money, but this bank gave the last $100,000 to you, the investor. Now, these three investors will not get access to any funding because they have to wait for you to pay back that loan every month for the next 30 years. Banks do because they go ahead and sell the mortgage note to investors.
Now, a very prominent one is Fannie Mae. I’m sure you’ve heard a lot about them in the news, there were all over the place because they had to be bailed out by the Federal Reserve Bank. That’s a topic for another episode, but this is what they do. Fannie Mae doesn’t own any mortgages, so they come here and buy the banks’ notes. In exchange, they provide cash, meaning liquidity into the banks to have money and lend to other people.
Let’s say, for example, the bank comes in and sells your mortgage for $100,000 to these investors at a discount, and they sell it to them at 75,000. After a month, or two, maybe even six months after the loan, they sell it at 75,000.
Now, you’re probably be wondering, “Well, that sounds kind of stupid. Why would I ever want to sell my note at such a big discount?” You have to think of it this way, one, and they already charge you a ton of money in mortgage originations. They already charge you a couple of months worth of interest rate for the mortgage they issue. They already made enough money more than you think they made, and what they’re doing is they want cash today.
They don’t want to have to chase you for the next 30 years. They don’t want to have to wait for every month so that you can give them something. Because a mortgage repays of like, let’s say $1000, it is not enough to make all three people happy. Instead, they sell books of mortgages to organizations like Fannie Mae, who come and they provide liquidity to these people.
Assuming we’re only talking about that $100,000 loan that you got, they sell it for 75,000, now that means that they get to borrow $25,000 for each of these people, and everybody is happy. Everyone is a happy camper. Everybody gets to invest in their real estate portfolio, buy more, and continue growing.
What happens to the mortgage payments now is that, instead of you and all of these three people having to pay the bank, what you’re going to do, you’re going to start sending your money to these people right here. The Fannie Mae people or whoever investor comes in, buy those mortgages. This is not only done in real estate. They also do this with medical bills, and they too do it with your student loans.
Some of you who have had to go on into the emergency room suddenly get a bill for $2,000 from the hospital. Then three months down the road, you receive another invoice saying, “Hey, don’t pay the hospital anymore. Now you’re going to send your payment to this person right here, or this company. Those who have already bought a couple of houses or their first home, and you get your mortgage bills for the first six months from the bank that issued the loan, then all of a sudden, and six months down the road, you got another letter saying, “You know what, don’t pay this company, go ahead and pay the other ones.”
In essence, this is what note investing is. If you want to get more creative than these people, they come in here, and they sell the loans again to other investors who are willing to buy this at a discount and give Fannie Mae money so that Fannie Mae can provide banks with any money. You have other investors, investor one, two, three, four, they all get a piece of the cake, and, what they do, this is an ongoing process that goes back and forth and back and forth.
The reason why the crisis happened, for those who are wondering, “Okay, I hear Fannie Mae, this is not good news. What’s going on here?” What happened is banks started lending money to people who were not supposed to be qualifying. Let’s say, for example. You have a family coming into the bank and asking for a loan. All they can afford was a thousand dollars. The bank’s what they did is that they started underwriting all of these loans for a minimum payment.
Let’s say you have $1,200, and how do you expect the family to pay an additional $1,200 out of their pocket? What happened is, these families here started defaulting on their payments because they just could not come up with the money. They didn’t know. They thought they were buying a house that they could afford because the banks told them that they could. Eventually, they cannot, or maybe there was a job loss, but everything happens simultaneously.
What happens is, Fannie Mae went ahead and sold the loan to all of these people, and then whoever was on this side of the picture was not getting any money from all of these four people right here into their bank accounts. That means they can no longer afford to buy Fannie Mae’s loans. Because Fannie Mae didn’t have enough money from these investors right here, Fannie Mae cannot afford to buy anything from this bank right here that issue you the loan for the first place. It’s a whole ripple effect.
You might wonder what does this has to do with me? It has a lot to do with you, and this is where the fun part starts. I just wanted to get you the overall concept of what note investing is. Now, we’re going to dive into the creative aspect and how you can expand.
First things first, where do you think you can find all of these note investors. You can find them in local Ria. You can find them in For Sale by owner signs, or you will probably see some of those in Zillow saying make me move kind of signs. These are all engagements that you can deal with the seller directly, and this is how you’re going to structure the deal so that it works out to your advantage, and you don’t have to put any money down on that purchase.
Let’s say you come in and you see this house. You met this person in a local area, and he or she is saying, “Okay, I have this house for a hundred thousand, are you interested in buying?” You go, you check it out, and you love it. The asking price is a hundred thousand, but what’s the problem? You don’t have $20,000 to put down, and you already have an FHA loan that you’ve used to buy another rental. Even if you have the 5,000, you can afford to put $25,000 down.
What you’re going to do is that you’re going to talk to the owner or the seller in this case, and you’re going to ask them, “Hey, are you willing to finance the down payment?” Meaning, I can go to the bank and ask for 80,000 and finance it. You’re asking them to put the $20,000 on your behalf. They can go ahead and put this down on your behalf, and what you’re going to do, you’re going to create a promissory note saying, “Okay, now, for the next five years I’m going to pay you monthly payments, or whatever is it the arrangement that you guys have. You can pay the monthly fees for the next 30 years, or you can get monthly payments for the next five years and then give them a balloon payment at the end of the term.
Those who don’t know what a balloon payment is are a structure where you start paying small monthly fees. Usually, interest only to the owner until you paid off the loan. Then in the last month, you just paid out whatever balance you have left. You come in here, and the owner is paying $20,000 down, and then you go to the bank, and you finance the remaining 80,000, and voila, that’s how you got the house.
Guess what the owner’s going to do? He’ll probably be going to charge you for the first six months, 12 months. This person has collected enough interest off of you, guess what they’re going to do? They’re going to go to another local Ria. From this 20,000 that they lent you, let’s say you pay down $3,000, which means this promissory note still has 17,000 dollars left. What they’re going to do, they’re going to take $17,000, and they’re going to sell the note to another investor. That way, they can get cash today, usually at a discount.
Let’s say from this $17,000, this seller decides to sell the note for $15,000.
They sell it for $15,000, and they will prevent themselves from having to go after you ever again or deal with you ever again so you can pay them back the monthly payments. You’re going to go ahead and start sending those payments to this new investor that purchased the note for $15,000, and this seller gets his or her cash today. They can get those $15,000, go on a trip, buy another property. It’s all about what you can get with the money today. That overall is the concept of note investing.
You can do this the same way for your investments.
Let’s say you have a house and you want to sell it. They can come to you, and they’ll say, “You know what, I would love to buy this house from you, but I don’t have the $20,000 to use as a down payment. Can you deal with seller finance? Can you help me with the down payment? You do the same thing. You come in. Then now, instead of the buyer, this will be you. You put down the $20,000 to this person. He or she will go to the bank and get the finance for the remaining 80,000. Then, every month you’re going to receive cash flow. You’re going to accept whatever payment you two agreed on, whether it’s 500, a thousand dollars, until this load is paid up. If you want to keep the note with you because all you want is just the monthly cash flow.
You can take the same approach and sell this promissory note to someone else at a discount. You collect the same thing, $3,000 already worth of note payments, and you sell it at a discount for 15,000 here. You don’t have to deal with this buyer ever again. You’ve got $15,000 in your pocket, and then you move on and do whatever you want with that money, whether it’s a nice family trip or whether it’s another purchase in another neighborhood that you were planning to move into anyways. The opportunities are endless.
It’s all about how creative you can get with it, and that’s it. That’s all about note investing, how it can work for you, how can it work for the banks, or the buyers or the sellers. It’s a win-win for everybody. Just remember, real estate, it’s all about making money in the buy using other people’s money and how to create a win-win situation for everybody.