Buying Loans from Other Lenders

Buying existing loans is a popular way to invest in loans without all the paperwork and screening that comes with loan origination. Many lenders work closely with a business that originates loans, cherry picking their favorite loans from the loans the business is looking to sell. Most commonly, I’ve seen this with car dealerships, but it’s also very common with mortgages, personal loans, construction loans, and many other types of loans. If you are considering purchasing existing loans here is some information to help you get started.

Purchase price isn’t necessarily the principal balance on the loan.

The loan may have a face value of $4000, but you might buy the loan for $3000 or $4500, depending on various circumstances.  Most commonly, a loan will be priced higher if the rate on the loan is higher than the current industry rates.  You might pay $4500 for that $4000 loan if it’s at an interest rate of 12% where currently, an equivalent borrower would be able to get a loan at 8%.  You pay a premium for the extra profitability.  If the borrower is very well qualified, stable, and pays exactly as scheduled you might pay a little more than the principal balance for the loan.  Paying more than the balance is common in the mortgage loan market.  Prepayment penalties are frequently written into loan agreements to ensure mortgage buyers will recover the premium paid for the higher interest rate even if the borrower repays the loan suddenly – for example, by refinancing.

Loans at a discount often come from businesses with internal financing available.  A car dealer might only have $3000 “invested” in a car that the borrower borrowers $4000 against when they buy it.  The dealer only needs $3000 to make that sale profitable, and might sell the loan for $3000 even though the principal balance is for $4000.  Also, if a loan has a rate below the prevailing market it may sell for less than the principal balance.  A loan at 6% will cost less if you could make a new loan at 10% with your funds instead.

Purchase price affects the amount of taxable income you have from the loan.  (Discount Earned)

If you make the loan and service it to maturity, your taxable income is the interest plus any fees you charge.  If you buy a $4000 loan for $3000, the extra $1000 in payments you receive that are labeled “principal” must be reported as taxable income.  This taxable income is called the “discount earned”.  As the payments arrive on the discounted note, the extra profit is taxable income.  Loan servicing programs like Moneylender Professional will be able to track the discount earned on a loan and help you report your income accurately.  In this example, by the time the borrower has paid the balance down to $2000, you’ll have earned $500 against the discounted purchase price.  The discount earned must be tracked and added to taxable revenue for the entire period of ownership, whether resold or paid off in months or years.

Loans can be traded like commodities, but require consistent servicing to retain their value.

When investing in loans, unless your strategy is very short term, like many originating banks that sell mortgages before the first payment is actually due, you’ll need a mechanism to service the loans and keep them productive to retain their value.  A loan with late payments or problematic payment histories is worth less than one with all payments on time.

Purchasing a loan and subsequently servicing it poorly will deteriorate the resale value of your investment.  On the other hand, purchasing troubled loans and rehabilitating them into good standing and consistent payment can drastically improve the resale value of the note, just like buying and fixing houses.

Loans can be sold individually or in bundles.

For many private lenders, loans are bought individually.  Deals are often made between acquaintances or friends, and negotiated one loan at a time.  The majority of the users of Moneylender that buy loans rarely buy more than a few loans at a time.  Very well funded investors, however, might purchase loans in bundles.  It’s a good way to transfer many loans at once, hundreds or thousands of loans might be bundled into a single sale.  Similar to group health insurance, there may be a majority of healthy loans with a few sub-par notes peppered in.

Hopefully this brief orientation to loan resale and marketability has helped clarify a little bit about the resale value and tax implications of purchasing loans.  While researching this article, I found these easy-to-read articles on ehow.com about mortgage resale.  Check them out if you want more information.

When is it Profitable to Sell Mortgage Loans?

How Do Mortgage Companies Buy & Sell Loans?

How to Buy & Sell Mortgage Notes

(I disagree slightly with how they suggest doing business in this last one, but that’s probably because I’d prefer to service the notes directly.)