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:
- Investor advertises "We Buy Second Mortgages" in the local newspaper
- Investor receives calls and finds someone who is interested in selling their VTB mortgage.
- Investor makes an offer of 60-70% of the value of the mortgage.
- 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%/year. Note 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.
- Passive income without having to deal with tenant/property issues.
- If done right, there is a probability of extremely high returns.
- 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?
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?