Note Buying – “What is the difference between Note & Mortgage?”

I received the following question:

“Hello Dean, I have only been doing real estate for the last three years.
Can you please tell me, what is the difference, pros and cons of investing in the note vs investing in trust deeds/mortgages?”

My reply:

George, thanks for your question, let me address this one for you:

First, let’s get down to the basics:

A Note is a promise to pay signed by 1 person to another person. A Note can be unsecured – it is merely a promise to pay, and has no “collateral” connected to it like a car or a house or a boat. A Note can also be secured – usually to a house or a vehicle or boat, for example.

The “instrument” that “secures” that Note to the house (let’s just use the house example here) is the Mortgage or Deed of Trust (or Security Deed if you live in Georgia). I’ll refer to all of these generically as security instruments, by the way.

So that Trust Deed, as it’s also called, specifies what you as the beneficiary of the Trust Deed, can do if the borrower defaults, or breaks any commitments, specified in the Note. That’s where you’ll find references to foreclosure, for example. That won’t be in the Note.

So what happens when you buy a real estate Note, you ask?

You buy BOTH, the Note and the Deed of Trust or Mortgage. They’re part and parcel of the same transaction. Don’t think of them as separate.
Think of them as a pair – like a pair of socks. Whenever you buy a sock, you’ll always get 2. (I won’t go into unsecured liens here – we’ll save that for an advanced topic since I wouldn’t advise you to go out and pursue deficiency judgments Day 1!).

So don’t worry about whether you’re buying a Note or a Trust Deed – you’re getting both. Even if you’re an investor and you’re investing in partial Trust Deeds that are originated by some hard money lender, you should ALWAYS get a copy of the borrower’s Note and the Trust Deed or Mortgage securing that Note.

And just to round this out so that you see what happens as you “work out” your Note and make money from it. I’ll give you two situations:

a) If you end up foreclosing on the Borrower because they default on the terms of your Note (the terms of repayment are always defined in the Note rather than in the security instrument) and you take the property to foreclosure sale, the Note goes away at the point of sale.
Now there’s no more obligation to pay since you took the house. But so too does the Deed of Trust. Instead, you end up with a Deed – title to the house. But there’s no more Deed of Trust since that was just a piece of paper that tied your Note to the House. Now that you own the house that Deed of Trust is gone. So do all Junior (e.g. a 2nd Deed of Trust, a 3rd Deed of Trust, or junior judgments and liens – federal liens and county/city taxes excluded – topic for another post)

So in simple terms here’s what happened: the borrower defaulted on their Note. Since they weren’t paying you on your Note, you said – “well, I’m going to recover my loss on this Note by collecting on the collateral that is tied to that Note – the house.” The word “collecting” just means going through the process of filing a foreclosure action in order to force a transfer of the house from the Borrower to you.

b) if you end up, let’s say, buying a 2nd Trust Deed behind a 1st that is foreclosing, and that 1st takes the property to foreclosure sale, here’s what happens. The day of the sale, your Deed of Trust disappears. It’s gone. Worth nothing more than the paper it’s written on. BUT you still have your Note (in most cases – however there are exceptions to this in certain states with certain types of mortgages, e.g. a note secured by a California purchase money mortgage on an owner-occupied home in 2nd position does not survive post foreclosure on the 1st, but I’m getting off topic here …. !) And some investors just collect on those Notes through the courts, by filing a judgment against someone personally, and then working to collect on that judgment by calling/writing/garnishing wages, etc.

Maybe more than you wanted, but I wanted to make sure that you understood that when you’re buying Notes and when I or most other people online and in the real estate field are referring to buying Notes – we AUTOMATICALLY assume the associated security instrument.

Nothing ventured, nothing gained.

Dean