Wealth Strategy: Buying 2nd Mortgages II

In part 1, we discussed the bare bone basics of buying 2nd mortgages as an investment.  Today we'll get into an example along with the pros and cons of this strategy.

Here is an excerpt from Buying 2nd Mortgages I:

Here is the jist of the strategy:

  1. Investor advertises "We Buy Second Mortgages" in the local newspaper
  2. Investor receives calls and finds someone who is interested in selling their VTB mortgage.
  3. Investor makes an offer of 60-70% of the value of the mortgage.
  4. Offer is accepted and investors starts to collect payments.

Here's an example:

A vendor (mortgagee) agreed to take back a $12,000 mortgage on the sale of his home.  The terms of the $12,000 mortgage are interest only payments @ 12%/year paid monthly ($120/month) for 5 years. After a couple years, Mr. Investor gets a call from the mortgagee that he's interested in selling the VTB mortgage (needs cash now).  Mr. Investor offers $7,200 for the mortgage, after negotiating back and forth, they agree to $8,000. 

What kind of return is the investor looking at?  From the $8,000 investment, Mr. Investor is looking @ collecting $120 / month or $1,400/year which works out to be a 17.5% annual return.  This is not counting the $4,000 ($12,000 – $8000) capital profit he will make when the loan comes due in 3 years.  So the total profit on the deal would be: ($1,400 x 3) + $4,000 = $8,200 which equates to a return of 26.51%/yearNote that this is a hypothetical scenario.

What can go wrong?

  • The biggest issue with this type of investing is that mortgagors (borrowers) can stop making payments.  However, like any mortgage, the VTB should have a lien on the property and can foreclose. 
  • Another problem is that most of these types of mortgages are behind the first mortgage, thus if the borrowers run into financial trouble and are foreclosed on, the first mortgage gets paid back first.
  • The author suggests that if the mortgagor goes into foreclosure, make sure to make a bid on the house equal to the sum of all mortgage debt.  That way, if the investor gets outbid, the mortgage debts are covered.  If the investor ends up with the highest bid, then they can either rent it out on their own, or re sell it.  Since the investor never buys a mortgage on a property with greater than 80% LTV after all mortgages, even if they did end up buying it back, the investor would have 20% equity to work with.

Pros:

  • Passive income without having to deal with tenant/property issues.
  • If done right, there is a probability of extremely high returns.

Cons:

  • Chance of default, first mortgage gets priority.
  • Interest income is taxable as income (100% taxable under your marginal rate).
  • Liquidity issues?  How easy is it to sell the mortgage again in case the investor needs the cash?

Conclusions:

There you have it, a wealth strategy that provides passive income through real estate without having to deal with tenants.  Could this be the way to ultimate passive income without having to deal with tenants?

Perhaps a more lucrative solution would be to purchase the mortgages at a discount and resell them at a smaller discount.  But that might require a brokering license of some sort. 

I'll have to talk to a real estate lawyer before proceeding with this type of investing.  I have a feeling that there are a lot of caveats to this wealth strategy. 

What are your thoughts on this strategy? 

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FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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Tommy
11 years ago

YOU WOULD GO TO THE FORECLOSURE AUCTION AT THE COURT HOUSE STEPS.
YOU HAVE TO DO YOUR OWN RESEARCH TO FIND IF THEY HAVE ANY CODE VIOLATION LIENS ON THE CITY THE PROPERTY IS LOCATED.
IM PRETTY SURE THE OWNERS WILL STILL BE AT THE HOUSE; SO YOU WILL HAVE A HARDTIME HAVING ACCESS; BUT THEN AGAIN YOU COULD JUST LOOK FOR OUT STATE OWNERS, WITH A 1ST AND A 2ND; SO THEY HAVE A BETTER CHANCE TO BE EMPTY. BUT JUST DRIVING BY THE HOUSE WILL GIVE YOU A IDEA OF THE CONDITION OF THE HOUSE.
YOU WILL THEN HAVE TO FIND THE OWNER OF THE SECOND MORTGAGE AND OFFER HIM NO MORE THAN 10 CENTS ON THE DOLLARS FOR HI’S 2ND MORTGAGE 3 WEEKS BEFORE THE AUCTION.
IF HE DOES NOT LIKE IT; TO BAD; HE WILL BE BACK IF HI’S BRAIN STILL WORKS PROPERLY.
MAKE SURE YOU CAN FIND COMPS BY EITHER DRIVING THE NEIGHBORHOODS AND FINDING WHAT FSBO ARE LISTING THEIR HOUSES FOR; THEY ARE THE BEST WAY TO KNOW WHAT THE FMV IS AT THE PRESENT TIME ; BECAUSE IT IS YOUR COMPETITION AT THE TIME OF THE AUCTION; ON WHAT INVESTOR ARE GOING TO BE WILLING TO PAY.
LOOK FOR AT LEAST 70% CLTV; MEANING; THE 1ST AND 2ND IS NO MORE THAN 70% OF THE FMV. THIS WAY YOU HAVE A BETTER CHANCE TO HAVE A BID AT THE AUCTION THAT WILL COVER THE 1ST AND MOST PART OF THE 2ND. THEN ALL YOU DO IS COLLECT THE BALANCE ABOVE YOUR INVESTMENT. PRETTY SICK AHHH?

cannon_fodder
11 years ago

Tommy,

Where would we go for these auctions? Does a person have the chance to view the property before the auction? Do they get the equivalent of a “carfax” for the property, showing who were the previous owners, what they paid, etc.? Does one also have access to recent listings in the area for comparison to determine current value?

Does the equity remaining in the property need to be above a certain level to make this worthwhile, eg. above the total value of the 1st and 2nd mortgages?

Tommy
11 years ago

Ok people wake up; all you have to do is buy a second mortgage that is already about to be foreclosure by the first mortgage and it still has equity in the property. That way you go to the auction and wait for the investor to buy out the first and cover you investment for the second and the rest is free money. The key here is free equity still available in the property. Oh, I forgot; the balance of the face value of your second mortage; now becomes a credit in your taxes as a loss.
Sweet ahhhhh?

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Y HAT
13 years ago

This sounds like an extremely risky investment strategy. First, you’re lending money to someone who is already having cashlow problems. Second, foreclosing on a second mortgage is tricky. Finance companies that give 2nd mortgages will usually have to buyout the first mortgage holder to ensure that the house sells for enough to cover the 2nd lien, not to mention the costs incurred in the foreclosure process: legal fees, costs to fix up the porperty to make it look habitable (people tend to trash houses before banks take them over), broker fees, etc…

Why not short google stock if you’re really looking for a risky investment strategy?

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Ed Rempel
13 years ago

They can be quite profitable, but the risks are usually higher than people think. CC is right about the risk of foreclosure. Remember that gnerally only people with questionable credit take 2nd mortgages at high rates. Often these people are 1 or 2 paycheques away from financial crisis.

I’m not a lawyer, but my understanding is that if you want to foreclose, you need to assume the 1st mortgage first. Even with a “cross default”, the 1st mortgagee gets priority and doesn’t usually care about the 2nd, so you have to be prepared to buy the property yourself.

In other words, you may need quite a bit of money and time to be able to protect yourself in case of a default.

Often, people buy 2nd mortgages to get higher income, but don’t have money to back it up. When the borrower defaults, they cannot assume the 1st, so they have little or no recourse and just take the 100% loss. If they force the 1st to foreclose but cannot afford to put in a reserve offer, the 1st mortgagee can sell it off for just enough to pay off the 1st.

I have also heard stories of scams involving faked or exaggerated appraisals. An investor bought a mortgage believing it was only up to 80% of the home value, but it was actually more than the home value. In this case, foreclosure cannot protect you at all.

You need to do your due diligence and know what the property is really worth, who the borrower actually is, and understand the 2nd mortgage market. You should usually only invest in them if you have the financial strength to enforce a foreclosure or buy the property yourself.

Tax consequences are generally unfavourable, since all the interest is of course fully taxable, plus a capital gain on the sale is generally also considered interest income and therefore fully taxable.

Ed

Anitra
13 years ago

FrugalTrader: I’m pretty sure my grandfather originally set it up for her. He was a very savvy investor – I think she now finds new mortgages through a broker of some sort.