Investing in mortgage bonds: Pros and cons

Investing in lending can be an attractive supplement to the share portfolio, partly because it is a more stable source of income that is not affected to the same extent by political currents.
This is one of the reasons why I find crowdlending so interesting.

The disadvantage of investing in loans, however, is that it can be quite difficult to get your money back if the borrower can’t or won’t pay – especially those who invest in consumer loans will be able to sign on to this. Fortunately, this risk can be lowered by investing in mortgage bonds, where there will always be an underlying asset to make an outlay on.

What are mortgage bonds?

A mortgage deed is a form of promissory note where the borrower has pledged real estate as security for the loan. The borrower can be a private person or a company, and the mortgage deed must be registered and prioritized in relation to any other creditors before it becomes effective.

The instalment method can be an annuity loan, standing loan or (less common) serial loan. There can also be a shorter or longer grace period, just like a mortgage loan. The chosen repayment method is of course important for the borrower, but certainly also for the individual investor, depending on their strategy.

Due to the collateral requirement, mortgage bonds generally have a lower risk of loss than shares and a correspondingly lower expected return. At the same time, they typically have a higher return than government bonds and a correspondingly higher risk. In other words, mortgages lie between the two widespread extremes.

Why do you borrow money via mortgage bonds?

As a starting point, most borrowers will prefer mortgage credit because of the lower interest rate, but there are many loans that cannot be financed in whole or in part with mortgage credit. There can be many reasons for this, but the typical reasons are:

  • The borrower has poor finances or low income and cannot be approved for a mortgage: Some mortgage loans are issued because the bank will not accept the applicant’s budget. This may be due to a mess in the economy and large debts, but it may also be people with a low income and a correspondingly low available amount.
  • Borrowers cannot get mortgages because they are self-employed: Even with a high and/or a stable income, it can be difficult for the self-employed and entrepreneurs to be approved for a mortgage loan.
  • The property is located in the countryside: In parts of the country, the marketability of housing is very low. This means that the creditor may find it difficult to sell the home at a price commensurate with the debt, and therefore mortgage loans are often not granted.
  • The loan amount is too low: Loans of less than half a million cannot normally be approved for mortgages.
  • The borrower cannot or does not want to put 20% in down payment, and therefore seeks a loan for the part that cannot be financed by real estate: Many homeowners take out loans in addition to the mortgage’s maximum of 80%. Often it will later be converted to mortgage credit when/if the home increases in value.
  • The borrower is a property investor and cannot be approved for multiple property purchases: If you already have debts in other properties, can eg debt factor quickly become too high. The debt ratio is your debt divided by your annual gross income. A debt factor of 4 is high in the FSA’s view.

There are thus several reasons for taking out mortgage loans. Many of us may have come across the concept in the TV show The Luxury Trap, where heavily indebted people have financed their homes with high-interest loans.

Why invest in mortgage bonds?

Why might it make sense to invest in mortgage bonds as a supplement to other asset classes such as stocks, bonds and gold?

Security in assets

A loan secured by the property is considered to be relatively safe, all other things being equal, depending of course on the property and the seller’s ability to pay. Because the creditor can foreclose on the property if the loan has defaulted.

At the same time, mortgage deeds in private homes, in particular, provide a certain security, because as a homeowner you typically prioritize instalments on the home over other expenses. After all, most of us do quite a lot to stay in our own homes and thus be more likely to prioritize housing debt over pleasures or repayments on consumer loans.

Real estate is easily negotiable

It is relatively easy to repossess real estate if the borrower does not pay. It means, that you as a creditor do not have to wait for years to get your money back in whole or in part in the event of non-payment.

Other types of collateral are usually significantly more difficult to make payments on. For example, a car can disappear or be totally damaged. In addition, the vast majority of cars have quite high depreciation, and therefore it can be more difficult to cover the outstanding debt with the price of the used car.

Business loans secured by the company’s inventory or similar assets can also be difficult to obtain and resell. And if the security consists of one or more guarantors, the process becomes even more complex.

Fixed, passive income

The interest rate on the vast majority of mortgage bonds is fixed and with a clear annuity. It does easier to budget and project the return. This is particularly in contrast to the stock market, which fluctuates considerably from day to day according to known and unknown micro- and macro-economic factors.

At the same time, mortgages are among the easier ways to invest in real estate, as you don’t have to bother with maintenance, comply with the Tenancy Act, prepare accounts, etc.

Risks and disadvantages of investing in mortgage bonds

Of course, everything is not just pancakes and dancing on tulips. If that were the case, there would be no reason to invest in anything else.

Often very long-term

As with mortgages, many mortgage bonds have a term of decades. It means that one must be willing to potentially wait a very long time until the loan is fully settled.

In practice, however, it is typically settled after 5-6 years, if the borrower is given the opportunity to convert to a mortgage loan. It can be both an advantage and a disadvantage, depending on how long-term you are, but you must be prepared for a given loan able to be very long-term.

However, it is sometimes possible to sell the mortgage deeds to other investors, but this will typically require some legwork and may also involve administrative costs.

100% downside and limited upside

Mortgage deeds, like all other types of loans, have a theoretical risk (downside) to lose the entire amount invested. Security in property is of course intended to minimize this risk, so that the real loss by investing in a non-performing loan is minimized or completely avoided, but as you know, nothing is guaranteed.

At the same time, the gain (upside) by investing in a given loan is equal to the fixed interest rate plus possibly a little default interest for late payments (a bank employee once told me that they loved the customers who were always a little behind on their payments). This is in contrast to shares in particular, where the downside is also 100%, but where the upside theoretically has no upper limit.

Pay attention to LTV and priority

The loan-to-value ratio, or loan-to-value (LTV), is the ratio between the value of the property and the debt that is in the property. If a property is, for example, 1 million worth and indebted for USD 500,000, then the LTV is 50%.

In other words, this means that the property in this case must be sold for 50% below the appraised value minus sales costs before the lender loses money. However, you should be aware that selling a property is not free, and especially for cheap properties, the selling costs can make up quite a significant part of the trading price.

Priority is another factor that affects risk. If multiple loans have been taken out on the property, each lender will be paid in order of priority in the event of a foreclosure. Typically, any mortgage loan will have first priority, followed by other lenders.

That is, if the sale price (minus sales costs) does not enable full repayment of a debt, then it is the lender with the lowest priority who loses money first. Debtors are of course still liable for the remaining debt, but it will typically be much more difficult to collect.

This also means that the lender’s priority is not as important for properties with a low LTV, since all creditors would like to be able to get their money back in the event of a foreclosure. But we would always prefer that it never come to that.

How do you invest in mortgage bonds?

Contrary to investment in bonds, mortgage bonds are not traded on the stock exchange. Although there are some connections between the two asset classes, the transaction takes place directly via those who issue the loan or an intermediary.

You have to have a lot of money

Investing in mortgage bonds has long been reserved for people with very large fortunes. This is because you often have to put down several hundred thousand to get access to a single mortgage deed.

While some of us may with a little good will be able to find the typical USD 500,000 to invest, there are not very many who dare to invest it all in one loan. At least 10 more loans are needed to spread (and thus equalize) the risk. This means that other things being equal, you must have USD 2,5 million invested.

At the same time, you have to continuously reinvest the interest and repayments received as they come in, and therefore you can easily have several thousand kroner in cash, which does not generate a return, while you are “saving up” to be able to buy a new loan.

I have no personal experience investing in whole mortgage bonds, but if you want to invest a large amount in a short time, these are good starting points to investigate the possibilities. You can possibly distribute yourself over several platforms in order to minimize the platform risk.

Mortgage deeds and crowdlending

Technically, this business model is crowdlending. This means that many people finance one mortgage deed. This is also why it is possible to invest such small amounts at a time, whereas according to the “classic” model they are financed with one investor per mortgage deed.

Within crowdlending, there are also foreign counterparts for investing in mortgage bonds. However, it is important to be aware that different countries have different legislation regarding claiming mortgages on real estate and other assets.

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