Are you thinking about investing in notes? If you are, there’s a lot to consider before you do so. While note investing is great, it’s in your best interest to learn exactly how it works.
That way, you can make smart investment decisions. With that in mind, if you’re curious to learn more about investing in notes, just keep reading.
What Is a Note?
A note—also known as a promissory note— is essentially a promise to pay. When you borrow money and document that you’ll pay the money back, that’s considered a note.
Here are a few examples of notes:
- Mortgage loans
- Treasury notes
- Student loans
- Business loans
- Personal loans
- Credit card contracts
The note holder is the bank or lender. But in some cases, if you borrow money from a person, that individual is the note holder. The borrower promises to pay back the amount over a particular length of time with an agreed interest rate.
Real Estate Notes
A real estate note defines debt that’s sold as an investment. When an individual wants to borrow money from a bank for a home mortgage loan, they’ll sign an original promissory note. It’s also known as the mortgage note or the real estate note.
In the note, it includes information regarding the purchase price, interest rate, monthly payments, and other details. The property is what secures the note. That way, if the homeowner doesn’t make the loan payments, the note holder can reclaim the property.
Collateral and Non-Collateral Agreements
There are two categories in which notes fall: asset-backed and non-asset-backed. Below are examples of each category:
Asset-backed means that if a person defaults on their loan, the lender gets something in return. In other words, the note is collateralized.
For example, in the instance of a mortgage, the loan is collateralized against the house. As stated above, if the individual defaults on their mortgage payment, the bank can reclaim the property. Basically, the home will go into foreclosure.
However, non-asset-backed notes work a little differently. Notes that fall under this category are credit cards and student loans.
There is no way for the lender to retrieve any physical property if the payments aren’t met. However, the card issuer can report the default to the credit bureaus and ruin the borrower’s credit score.
As far as student loans go, if a borrower defaults on the loan, the government is allowed to garnish wages, deduct from tax refunds, and withhold social security checks.
Investing in Notes
There are several ways in which you can invest in notes, including the following:
Loans to Small Businesses
When small business owners are trying to get their company off of the ground, they generally need capital to get started. In most cases, they’ll get a loan from the bank via a promissory note. When they can’t get a loan from the bank, then they’ll use private investors. These investors include family and friends or other business owners.
In cases such as this, business professionals and even loved ones take an interest in investing in a startup business. The ultimate goal is to get a return on their investment.
Hard Money Lending
This type of note investing includes getting a loan that’s backed by an asset—generally a property. For instance, if a builder wants to repair and flip a home, they’ll look for a loan in order to purchase the property and provide construction.
However, banks don’t usually loan money for these types of projects. Therefore, the investor might look to get a loan from a hard money lender that’s willing to provide the cash.
The caveat in this situation is that the lender would be first in line to get the lien on the home in case the borrower defaults.
If the borrower doesn’t pay their loan, then the lender has legal rights to take the property. Hard money loans are provided by private individuals and big companies.
Peer-to-peer lending is offered on different platforms, and it creates notes for individuals looking for money to consolidate debt and make purchases. They collaborate with investors who are expecting a return per the agreement detailed within the note.
However, these types of loans are not asset-backed. Therefore, The borrowers don’t face many repercussions if they default. They’ll get a negative hit towards their credit, but that’s about it.
Investing in Notes: Is it a Good Idea?
If you’re looking for a way to earn passive income, investing in notes can definitely be a way to do so. As a note holder, you will get returns from the borrowers’ payments. Therefore, the checks will roll in effortlessly.
On the flip side, there is a downside to note investing. Before you start, it’s best to decide which note lending avenue is best for you. Again, there are asset-backed and non-asset-backed notes.
If you choose to go for non-asset-backed notes, just know that borrowers have a larger incentive to default.
If you understand anything about this type of investing, then you know that it provides a nice passive income—more than any other type of investing. If you want to even things out a bit, just make sure that note investing isn’t your primary form of investment in your portfolio.
That way, you’ll have an investment avenue that builds over time and another that provides income, but with a few risks.
Speaking of risks, follow the highlighted link to learn more about the high interest investment risk factors to consider.
The Upside of Note Investing
As detailed above, investing in notes has its perks. If you are careful with the types of notes that you invest in, you’re guaranteed to make a nice income from it.
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