In the first article of this series we examined the concept and the mathematics that support and explain the wealth building process. We learned who the players are and what roles they play in the promissory note industry. Additionally, we reviewed the types of promissory notes available to private party investors.
RISKS
To be a winning investor, you must know the risks. Now, moving forward, this article will focus on examining and explaining the risks related to promissory note investing. Essentially, the fundamental characteristics of the risks are universal and could apply to other types of investments in varying degrees and in varying ways. In the real world of investing, all investments carry risk of some type. To the uniformed person, many of the risks that actually exist are not obvious-they tend to be overlooked. But, whether they are recognized or not, they still exist and they will impact investor decisions over time.
RISKS OF A GENERAL TYPE
Let's start by reviewing some of the less obvious risks that are often overlooked by the beginning investor or by the uninformed investor.
Purchasing power risk is the possibility that we experience inflation that reduces the purchasing power of the dollar. Often, people refuse to invest because they fear loosing money. In many instances they keep their savings in low yielding bank accounts that are insured by the FDIC. These accounts presently are paying about.8 % to 1.8% interest annually. If the inflation rate, which has historically averaged about 2.5%, continues in the future as it has in the past, these bank deposit savers/investors will loose an average of about 1% of their investment annually. The loss of purchasing power over time is actually a hidden tax on the investor.
Interest rate risk is the possibility that by chasing the highest interest rates available, the investor takes on higher and higher risks of loss--unknowingly. In the world of investing it is usually true that a high interest rate paying investment also will carry a high risk of loss. Ignoring, or being unaware, of this proven fact can cause the untrained investor to venture into a "mine field" of risk and not realize it until the investment "blows up".
Shortfall risk is the possibility that the investor, because of poor planning and/or poor execution, discovers that they do not have the funds necessary to accomplish their planned objective. That objective may have been to provide funds for their children's education, to provide funds for some special event, or to provide funds for their own retirement at a specified standard of living level. Planning and monitoring progress over time are necessary steps that will avoid investor disappointment in the future.
RISKS SPECIFICALLY RELATED TO PROMISSORY NOTES
Now that we have reviewed some of the general risks that impact all types of investing, let's shift are focus to some of the risks that are specific to promissory note investing.
Unenforceability risk is the possibility that the promissory note and the loan documents have not been drafted properly and cannot be enforced in court to collect what is owed. An experienced, properly trained attorney should draft all loan documents. But, the problem facing the promissory note investor is that the attorney's skill with promissory notes is unknown. Many attorneys think they understand how to properly draft loan documents, but, in fact they do not know all of the recent laws and regulations-they do not know what they do not know. To avoid this risk, locate an attorney through references from an experienced, successful investor. Don't expect the ordinary attorney to volunteer to you that they are not qualified to do your legal work.
Borrower default risk is always a possibility. The borrower may have been of good character, had a good job, and was in good health when the promissory note was created. Subsequently, the borrower may have suffered a set-back. Examples of typical set-backs include loss of employment, reduction of hours worked, personal illness, family illness, a bad investment decision, etc. Any of these set-backs can cause your note payments to not arrive on time, or not to arrive at all. This risk is in integral part of promissory note investing. When this happens it is your collateral security that becomes your next line of defense. Your collateral security can avoid the risk of loss upon default.
Collateral security risk Normally, the borrower repays the amount borrowed. But, if the borrower cannot repay, then the collateral security must be sold to repay the debt.
The risk of loss is created if the value of the collateral security is inadequate to cover the amount owed on the note. To avoid this risk, have a qualified, experienced real estate appraiser value the collateral security and provide a written repost. The appraiser should be familiar with the real estate market (activity, typical values, financing available) in the subject neighborhood. Ideally, the amount loaned should not exceed 75% of the value of the collateral security.
Priority of the lien risk Normally, the promissory note should be secured by a first position lien-mortgage or deed of trust-on the collateral security. In order to know for certain that the mortgage line is in first position, a Lender's Title Insurance Policy should be purchased from a reputable title insurance company. Without a Lender's Title Insurance Policy in your file that states that your collateral security is a first position lien, you have a risk of loss; at the time of enforcing your mortgage lien you may discover that you actually have a "junior" position mortgage; your mortgage may actually be in second or third position. There may not be enough collateral security available to you to repay what is owed. The rule: Don't assume that you have a first mortgage-buy a Lender's Title Insurance policy to avoid the risk of loss.
RISKS
To be a winning investor, you must know the risks. Now, moving forward, this article will focus on examining and explaining the risks related to promissory note investing. Essentially, the fundamental characteristics of the risks are universal and could apply to other types of investments in varying degrees and in varying ways. In the real world of investing, all investments carry risk of some type. To the uniformed person, many of the risks that actually exist are not obvious-they tend to be overlooked. But, whether they are recognized or not, they still exist and they will impact investor decisions over time.
RISKS OF A GENERAL TYPE
Let's start by reviewing some of the less obvious risks that are often overlooked by the beginning investor or by the uninformed investor.
Purchasing power risk is the possibility that we experience inflation that reduces the purchasing power of the dollar. Often, people refuse to invest because they fear loosing money. In many instances they keep their savings in low yielding bank accounts that are insured by the FDIC. These accounts presently are paying about.8 % to 1.8% interest annually. If the inflation rate, which has historically averaged about 2.5%, continues in the future as it has in the past, these bank deposit savers/investors will loose an average of about 1% of their investment annually. The loss of purchasing power over time is actually a hidden tax on the investor.
Interest rate risk is the possibility that by chasing the highest interest rates available, the investor takes on higher and higher risks of loss--unknowingly. In the world of investing it is usually true that a high interest rate paying investment also will carry a high risk of loss. Ignoring, or being unaware, of this proven fact can cause the untrained investor to venture into a "mine field" of risk and not realize it until the investment "blows up".
Shortfall risk is the possibility that the investor, because of poor planning and/or poor execution, discovers that they do not have the funds necessary to accomplish their planned objective. That objective may have been to provide funds for their children's education, to provide funds for some special event, or to provide funds for their own retirement at a specified standard of living level. Planning and monitoring progress over time are necessary steps that will avoid investor disappointment in the future.
RISKS SPECIFICALLY RELATED TO PROMISSORY NOTES
Now that we have reviewed some of the general risks that impact all types of investing, let's shift are focus to some of the risks that are specific to promissory note investing.
Unenforceability risk is the possibility that the promissory note and the loan documents have not been drafted properly and cannot be enforced in court to collect what is owed. An experienced, properly trained attorney should draft all loan documents. But, the problem facing the promissory note investor is that the attorney's skill with promissory notes is unknown. Many attorneys think they understand how to properly draft loan documents, but, in fact they do not know all of the recent laws and regulations-they do not know what they do not know. To avoid this risk, locate an attorney through references from an experienced, successful investor. Don't expect the ordinary attorney to volunteer to you that they are not qualified to do your legal work.
Borrower default risk is always a possibility. The borrower may have been of good character, had a good job, and was in good health when the promissory note was created. Subsequently, the borrower may have suffered a set-back. Examples of typical set-backs include loss of employment, reduction of hours worked, personal illness, family illness, a bad investment decision, etc. Any of these set-backs can cause your note payments to not arrive on time, or not to arrive at all. This risk is in integral part of promissory note investing. When this happens it is your collateral security that becomes your next line of defense. Your collateral security can avoid the risk of loss upon default.
Collateral security risk Normally, the borrower repays the amount borrowed. But, if the borrower cannot repay, then the collateral security must be sold to repay the debt.
The risk of loss is created if the value of the collateral security is inadequate to cover the amount owed on the note. To avoid this risk, have a qualified, experienced real estate appraiser value the collateral security and provide a written repost. The appraiser should be familiar with the real estate market (activity, typical values, financing available) in the subject neighborhood. Ideally, the amount loaned should not exceed 75% of the value of the collateral security.
Priority of the lien risk Normally, the promissory note should be secured by a first position lien-mortgage or deed of trust-on the collateral security. In order to know for certain that the mortgage line is in first position, a Lender's Title Insurance Policy should be purchased from a reputable title insurance company. Without a Lender's Title Insurance Policy in your file that states that your collateral security is a first position lien, you have a risk of loss; at the time of enforcing your mortgage lien you may discover that you actually have a "junior" position mortgage; your mortgage may actually be in second or third position. There may not be enough collateral security available to you to repay what is owed. The rule: Don't assume that you have a first mortgage-buy a Lender's Title Insurance policy to avoid the risk of loss.
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