The Benefits and Drawbacks of Notes vs Index Fund Investment

The most common investment advice given on financial independence blogs is index fund investing.  To a large degree, I agree with this advice.  Index fund investing is completely passive, easy to access if you need to sell some shares to make a purchase (or pay your bills) and over the long term they can provide a reliable return.  I personally have about half of our savings in index funds, and the other half in notes.  Let’s compare the major differences between note investing and index fund investment.  (Some of these will be repeats from the Notes vs Real Estate posts).

Benefits:

 

  • Higher return – This is the big obvious one, and the main draw for most.  I have averaged about 14% return on my notes so far.  You can do even better if you are willing to take on riskier notes or do a bit of “rehab” on a non-performing note (if you don’t know what that is, don’t worry… we’ll go over it all soon!).  This
  • Predictable return – I have averaged about 14% return on my notes so far.  You can do even better if you are willing to take on riskier notes or do a bit of “rehab” on a non-performing note (if you don’t know what that is, don’t worry… we’ll go over it all soon!).  This is steady, (mostly) predictable income that I can plan around.  While the stock market has proven to go up by about 7% per year, it certainly has down years and can be an uneven ride.  It is comforting to know that a set payment is coming in a given month.
  • The Kicker! – You can’t predict this one, but when it happens it’s phenomenal.  If you bought a note at a discount and at any point the borrower refinances or sells the property, you get paid back the full amount they owe all at once, not just the discounted rate you bought it at!  This can shoot your yield to a much higher than planned level.  I’ll have a full article on this phenomenon soon.

 

Drawbacks:

  • Opportunity Cost of tied up funds – One of best thing about stocks (and index funds in this case) is that there is a large market of buyers and sellers.  When I press the sell button in Vanguard for some of my shares, I know they will be gone by the next day.  I can have this money in my checking account in less than a week.  It’s not the same with notes, as it may take weeks or months to find a willing buyer if you need to cash out.
  • Significant Drop in Real Estate Value – When we buy a note, we generally need to make sure there is enough equity in the home to cover our loan.  I personally would not pay $100K for a note if the property is only worth $80K.  I’m aware, of course, that property values can fluctuate quickly…so even if I think I have a decent cushion, it’s still possible that the property value could sink below what we bought the note for.
  • Foreclosure – In a perfect world, the borrower would always make their monthly payment and everything would be fine.  Unfortunately sometimes things happen.  It’s up to you how much leeway you are willing to give.  Ultimately I need to be prepared to be the “bad guy” and take back the property to recoup your investment.  Nobody likes kicking someone out of their home, and I would like to think I’m much more understanding than a big bank would be.  At the end of the day, the borrower needs to fulfill their part of the bargain.  If they don’t, you need to take action.  These are not things you have to deal with with index funds, as you are very far removed from these personal emotions.  Much more on how this works later.