How is a promissory note used in real estate?
As mentioned above, mortgage notes are often used in scenarios where the buyer of the property is unable or unwilling to get real estate financing from a traditional lender. In this case, the seller would create a mortgage promissory note that spells out the terms of the loan agreement and collect on their investment over time.
However, beyond that, it's also important to note that it is possible to invest in mortgage notes themselves. Often, when the seller of the property gets tired of acting like a bank, they will sell their note on the secondary market. Often, investors can pick these notes up for less than their full value and then proceed to collect the remainder of loan amount from the borrower over time.
What are the pros and cons of using a mortgage promissory note as a borrower?
For the borrower, the biggest benefit of using a promissory note is flexibility. Again, this is a negotiable instrument, which means that you can set your own loan terms. It's not like getting an investment property loan from a traditional lender where they set the score.
The other benefit is simplicity. As long as the promissory note is signed by both parties, it is considered a legal document. In the case of a private loan, there is sometimes less need for a lengthy loan contract.
The biggest disadvantage of a promissory note is that, as the borrower, you're not afforded the same protections as you are with a traditional loan. For example, for the most part, balloon payments are not allowed on qualified mortgages. However, you may find yourself subject to one if you're working off a promissory note.
In this case, the loan terms are negotiated between both parties, so it's important to make sure you're able to negotiate in your own best interest.
The other disadvantage may be that a mortgage promissory note is legally binding, which means that if you default on the loan, there may be consequences. In particular, if you default on a secured promissory note, the lender is entitled to foreclose on the property.
What are the pros and cons of using a mortgage note as a lender?
As the lender, the biggest advantage to using a promissory note is also the flexibility. In this case, there are fewer limits set upon you, which means you may be able to get away with charging a higher-than-normal interest rate or asking for outside-of-the-box payment terms.
This method of financing also makes your pool of interested buyers larger. Here, if you are not limiting yourself to those who are able to receive financing from a large institution, you'll have more options. Owner financing can be a good alternative to consider in down markets where interested buyers are scarce.
In this instance, the biggest disadvantage is that all the due diligence falls on you. With that in mind, it's important to make sure you're specific about the terms of the loan and the repayment terms. You'll also want to ensure that you're willing to take your borrower through the foreclosure process if need be.
It's also worth noting that repayment could take longer. Instead of receiving the profits from your investment in a lump sum like you would in a traditional sale, it's likely that you'll receive them over time in the form of a recurring monthly payment.
The bottom line
At the end of the day, a promissory note can be a viable alternative to a traditional mortgage. However, like any other financial decision, this type of financial instrument does come with its own considerations. With that in mind, you're going to want to be sure that you understand the risks and benefits fully before moving forward with your decision. If you have questions about promissory notes or the mortgage note process, it's a good idea to get in touch with a financial advisor.