Mortgage notes are backed by real estate. That doesn't make them risk-free. Anyone who tells you there's no risk is someone you shouldn't lend to.
Here are the biggest risks I see, and how careful investors manage them.
1. The borrower stops paying
It happens. Jobs change, people get sick. How to manage it: look at payment history, keep a big cushion, and have a plan for workouts first. Here's what happens when a borrower stops paying.
2. The home is worth less than you think
A bad value estimate wipes out your cushion. How to manage it: use recent local sales, get eyes on the property, and keep your ITV low.
3. Back property taxes
Unpaid property taxes can get ahead of a mortgage. In some cases, the county can sell the home for taxes and wipe out the note. How to manage it: check taxes before you buy, and keep checking.
4. Title problems
A missing assignment, a lien you didn't know about, or a mortgage that isn't really in first position. How to manage it: get title work, and check the chain of assignments. Here's the difference between first and second liens.
Free lender guide: 5 questions to ask before you lend to anyone, plus a 12-item document checklist.
5. No insurance
If the house burns down and there's no insurance, the collateral is gone. How to manage it: confirm the policy, and make sure it names the note holder.
6. Time and legal costs
Foreclosure can take months or years, and it costs money the whole time. How to manage it: price the timeline into the deal, and know your state's foreclosure rules.
7. The person running the deal
For a lender, this is the big one. A great note doesn't help if the person handling your money is careless or dishonest. How to manage it: check out anyone you lend to, use a licensed servicer, and get a recorded collateral assignment.
8. Your money is tied up
Notes aren't like a savings account. You can't pull money out any day you want. How to manage it: only lend what you won't need for the full term. Here's how lenders get their money back.
The bottom line
Every one of these risks can be checked before money moves. That's what due diligence is for. Most deals I look at don't make it through.
Common questions
Can you lose money investing in mortgage notes?
Yes. Borrowers default, values drop, and legal steps take time and money. Careful due diligence and a big cushion lower the risk, but don't remove it.
What's the biggest risk for a private lender?
Usually the person running the deal. Check their track record, public records, and documents before you lend.
Are mortgage notes safer than stocks?
They're different. Notes are tied to a specific property and borrower, not the stock market. But they're harder to sell quickly and carry their own risks.
Written by Larry Hoffman
Managing Member of LJH Investments, LLC in Madison, Indiana. In real estate since 2006, with 300+ mortgage notes bought. Author of Mailbox Money Retirement.
General education, not legal, tax, or investment advice. Talk with your own attorney and tax adviser about your situation. All investing has risk, including loss of principal.