This guide covers eight factors to consider before investing in private mortgage notes to ensure you're choosing high-quality notes.
Investing in private mortgage notes can be a lucrative way to diversify your portfolio and earn passive income.
In simple terms, private mortgage notes are loans made to real estate borrowers secured by a property. As the investor, you act as the lender, holding the note — a promise to repay the loan — along with the right to collect interest and principal payments, rather than owning the property directly.
Here are a couple of reasons why investors turn to private mortgage notes:
That said, the main barrier to buying mortgage notes is the large capital requirement. For example, buying a 70% LTV loan on a $500K property will cost $350K.
Consequently, many investors turn to fractional note investing, that is, buying fractions of a loan originated by a private money lender, lowering the capital requirement. For example, Constitution Lending has a minimum investment requirement of only $1,000.
This guide outlines key factors to consider when investing fractionally in private mortgage notes to ensure you select high-quality loans. These due diligence strategies also apply to purchasing full notes.
We also cover how to start investing in private mortgage notes, including how to invest fractionally with Constitution Lending.
Constitution Lending has originated over $200 million in short-term hard money loans, with an investor reinvestment rate of 97% after the first year. You can learn more about our investment options by creating an investor account.
The first and most important factor you should consider when investing in notes is its LTV, which stands for loan-to-value — a ratio that looks at the loan amount compared to the value of the property.
For example, if a borrower used a $350K loan to buy a $500K investment property, the LTV on that loan would be 70%, 350/500=70%.
The lower a loan’s LTV, the more collateral backing the loan.
Low LTV private loans are typically safer because the property must lose a larger percentage of its value before it’s worth less than the loan amount, causing a principal loss. The borrower’s equity acts as a buffer for investors.
To safeguard your principal investment, we advise investing in notes with an LTV under 75%. This gives investors a 25% buffer. A 25% drop in the property’s value within the 6 to 18-month loan period — though exceptionally rare in the U.S. — would still allow investors to recover their full principal investment.
Constitution Lending exclusively originates loans with an LTV below 75%. As a result, our investors have never faced a principal loss.
Another factor you should consider in a mortgage note is the loan term since it dictates your interest rate risk.
Interest rate risk is the possibility that rates will rise after you purchase a note, reducing its appeal to potential buyers if you choose to sell.
The longer the loan term, the higher your interest rate risk because the longer you have to wait before the loan matures, and you can invest in the new, higher interest rate.
For example, if investors purchase a fixed-rate 30-year mortgage note and rates rise, they’ll be stuck in the lower-yield investment for the entire term. Selling the note at the original price will also be difficult, as potential buyers can invest in notes offering higher rates.
Instead, we recommend investing in short-term, 6 to 18-month loans (typically used to fix and flip investment properties). If interest rates rise, investors will receive their principal and interest payments quickly and can invest at a higher rate. There’s little risk of being tied to a lower-yield investment.
Borrower credit score is one of the main factors lenders evaluate when underwriting a loan, and rightly so. Credit scores are a reliable reflection of a borrower's ability and willingness to repay their loans.
We advise investing in private loans where the borrower has a credit score higher than 660.
It's also a good idea to look at the borrower's experience level because experienced commercial real estate investors are more likely to manage the fix and flip effectively, reducing the likelihood of default.
Understand the interest rate, repayment schedule, and term length of the note. For most short-term private mortgages, interest rates range from 10% to 14%.
Lien position refers to which loan is paid off first if a borrower defaults and the property is foreclosed on and sold.
Investors in the first-lien mortgage are paid before investors in the second-lien mortgage (i.e., a home equity loan or second mortgage).
We recommend investing in first-lien mortgages as they have less risk.
At Constitution Lending, all our private mortgage notes are first-lien, ensuring our investors are paid before any other creditors.
When buying fractional mortgage notes, consider whether the lender is investing alongside you — this is a strong measure of the lender's loan quality.
If a private money lending company doesn’t have their capital invested in the same private loans as you, they don’t have a financial incentive to exclusively offer high-quality loan options. With these “lenders,” you never know what you’re investing in.
With Constitution Lending, we originate all private money loans on our platform using our capital and hold a majority stake in them for the entire term. We are personally invested, and our financial success is directly tied to yours. This instills confidence in investors, knowing their money is in secure, high-quality loans.
The biggest worry for new investors is what happens if the borrower defaults.
When you invest in Constitution Lending notes, you’re protected by a payment guarantee — we pay you up to six months of interest payments out of our own pocket if borrowers don’t pay.
We use our foreclosure experience to foreclose on the rental property and sell it to our existing network of borrowers within these six months. Then, you receive your principal investment and returns.
Default rate refers to the percentage of borrowers who stop paying, making it a reliable way to determine the quality of private money loans a lender is originating.
The average default rate nationwide is 4%, with the best private lenders having a default rate of less than 4%. At Constitution Lending, we have a default rate of just 2%.
As we alluded to earlier, there are various ways you can invest in private mortgage notes:
Fractional note investing is the best way to start investing in mortgage notes because:
Most importantly, when you partner with a good private lending company like Constitution Lending, you access higher-quality notes than if you purchased them from a note marketplace.
This is because we originate all notes with our own capital and maintain a substantial share in them throughout the loan term. By co-investing with you, our success is linked to the performance of your investments.
On the other hand, note marketplaces are often filled with bad loans because they simply connect buyers and sellers — they allow almost any seller to list their loans with little quality oversight.
You can invest in private mortgage notes in less than five minutes with Constitution Lending:
Here’s what investors say about our loan options:
Experienced investors who know how to source, underwrite, and service loans may choose to originate loans themselves.
They have a pre-existing network of borrowers (likely real estate flippers) who need funding for their commercial real estate projects.
Investors can lend money directly to these borrowers and capitalize on higher returns. However, this isn’t an option for the average investor due to the expertise and time required to become a loan provider.
Traditional banks and other financial institutions often bundle multiple different types of loans into a pool and offer them to investors. These are known as portfolio sales and are a good option for those looking for an alternative to real estate investing.
The main drawback with purchasing promissory notes via portfolio sales is that it’s very capital intensive. Most portfolio sales require a minimum investment of $2 million.
Although we strongly advise against purchasing mortgage notes from marketplaces — since they mainly feature low-quality private loans — it remains a common strategy for many investors.
Note marketplaces allow sellers to list personal loans and notes for a fee, while buyers can browse a wide selection of hard money lending investment opportunities and choose one to purchase.
However, as we mentioned above, because these lending platforms only connect buyers and sellers and don’t have any skin in the game, we don’t recommend choosing this route.
Fractionally investing with a private money lender like Constitution Lending is much safer because they are invested in the same loans as you.
You can purchase portions of the loans we originate by signing up for an investor account.
Read more:
| Qualification | Requirement |
|---|---|
| Minimum and maximum loan amount | $150,000 to $3,000,000 |
| Type of property | Non-owner occupied single-family, multi-family, and 5-8 unit properties |