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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 About the author: 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.

{ 22 comments… add one }
  • The Financial Blogger November 1, 2007, 8:56 am

    Is there a possibility to pull out a credit bureau on the mortgagor and receive his employment information and a full balance sheet?

    It sounds very interesting but if you can not “qualify” the mortgagor yourself, it might become risky.

  • FrugalTrader November 1, 2007, 10:40 am

    FB, yes, I think it would be in your best interest to check the credit score of the people borrowing from you. As a banker, that should be easy for you. :)

  • Mike-TWA November 1, 2007, 10:56 am

    FT,

    I imagine the opportunity to purchase second mortgages has been limited somewhat by the sustained low mortgage interest rates and lower downpayment requirements. It would seem that the second mortgage seller would generally be a prior investor-owner of the real estate who then sold to an owner-occupant and carried a second mortgage to overcome downpayment requirements which might have a higher interest rate because, by necessity, the homebuyer’s need for the second mortgage would arise because the homebuyer would not be able to obtain the entire desired loan amount from the first mortgage (bank) lender. In such a case, where the 80% LTV criteria is met, it probably would arise only in the case where the second was longer term and the house appreciated to reduce the LTV percentage. It would seem that in most such cases the homebuyer would refinance the entire mortgage given lower interest rates or just the second through a more traditional home equity/bank second. But, since people don’t always do the sensible thing, it’s possible that the hypothetical second mortgages are out there.

    In answer to the Financial Blogger’s question, I don’t see any way that you could re-qualify the borrower. The seller may have information from the time of the loan albeit dated. The risk evaluation would almost certainly have to come from the LTV criteria, which would be dependent on the second mortgage buyer making sure he has made his own accurate valuation of the property.

    OK, sorry this is so long, but it’s an interesting topic.

  • FrugalTrader November 1, 2007, 11:05 am

    Mike-TWA: Is it possible to borrow the down payment through a VTB? I thought the rule of thumb is that the down payment cannot be borrowed in any way shape or form. I’ll have to ask my mortgage broker friends some questions. :)

  • Mike-TWA November 1, 2007, 11:42 am

    FT,

    You’re right. Generally, lenders won’t allow borrowing whatever they are requiring for the down payment. But, the second mortgage might nevertheless show up because 1. the second is not to meet down payment requirements of the lender but rather as a buyer-perceived easier way to buy the house from the investor (e.g. the lender might offer an 80/10 first/second mortgage combination of purchase loans. The only DP requirement is the 10%, which can’t be borrowed. Investor-seller carries the 10% second instead of the bank); 2. buyer just doesn’t tell and may be violating the mortgage terms (although lenders will probably do nothing about it, such as exercise a call on the first mortgage–I imagine this is the most frequent); 3. the second mortgage borrower himself may be an investor rather than owner-occupant. In the last category, the DP requirements are not necessarily going to follow the owner-occupant underwriting rules. This happens quite a bit with investment property (i.e. multi-families where there is not much of a retail owner-occupant market).

  • FourPillars November 1, 2007, 12:11 pm

    I think it sounds interesting but as Mike-TWA suggests I’m not sure how many of these mortgages are available.

    Other risks could be a lowering of the value of the house (it can happen) so your 80% LTV rule might not hold up.

    Another problem could be the owner getting more secured loans after you do your deal which would also invalidate the 80% rule.

    Seems like they are working out for Qcash.

    Mike

  • Canadian Capitalist November 1, 2007, 12:36 pm

    I’m good at finding risks, so here’s one: What happens when the mortgagee defaults on the second but not the first mortgage? Are you sure you can foreclose on the property?

  • Q Cash November 1, 2007, 12:42 pm

    CC

    If a mortgagee defaults on the second mortgage but is up to date on the first, you are entitled to pursue a Power of Sale. That is one of the rights the mortgagee has regardless of position.

    FP

    Not a 100% great experience, but working out so far (more details to come).

    FB

    Credit applications are a must.

    Q

  • ThickenMyWallet November 1, 2007, 2:46 pm

    I saw a couple of 2nd mortgages in my days as a lawyer in a slightly different context than described. The ones I saw were offered by mortgage brokers on behalf of their clients. Typically, the broker’s clients were investing in rental property so the security/collateral for the loan would be both a mortgage and an assignment of rents (albeit in a 2nd position for both) registered on title. To answer FB’s question, the broker would prepare a due diligence package including a formal appraisal of the property, notices of assessments of the purchaser from CRA, letter from employer on current income, potential cash flow generated by the property if rented out and other documents to assess the risk of the borrower and the property.

    If structured properly, the mortgage was also RSP eligible (but you have to have a self-directed RSP account in order to invest in mortgage directly).

    The really good 2nd mortgages can be found through mortgage brokers, experienced real estate lawyers or the 2nd mortgage circuit (try the Real Estate Investment Network). I would avoid the ads; on the “circuit” they give you everything you need to weigh your risk.

    To answer CC’s question in a different angle than Q Cash- it depends on the terms and conditions of the 1st mortgage. It may have “cross default” provisions which means the borrower defaulting on the 2nd is deemed to be a default on the first mortgage as well at which point the 1st mortgagee will take action.

    One downside of foreclosure- it takes a long time (think months and years and not days and weeks) to do even if it is a private action.

  • Anitra November 1, 2007, 3:37 pm

    I can’t say that I know much about these, but I know my mother (in retirement) buys second mortgages for exactly the reasons you’ve listed above. All of her bought mortgages have been pretty low-risk… the biggest problem she’s had so far is when the borrowers pay off their mortgage early, so she gets a smaller return!

  • FrugalTrader November 1, 2007, 3:55 pm

    Thanks for the info TMW, your legal background can really come in handy. How long were you a real estate lawyer?

    Anitra, how does your mother go about finding 2nd mortgages to buy?

  • Anitra November 1, 2007, 4:22 pm

    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.

  • Ed Rempel November 2, 2007, 2:25 am

    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

  • Y HAT November 3, 2007, 2:59 pm

    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?

  • Tommy May 2, 2009, 3:06 am

    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?

  • cannon_fodder May 2, 2009, 9:43 am

    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 May 3, 2009, 3:42 am

    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?

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