Eric Scharaga
Founder, Damen Capital Fund
Private lender and direct land note buyer serving land investors and note holders nationwide. Featured on REtipster, Legends of Land, and Land Investing Online. LinkedIn →
A note hypothecation loan (also called a collateral assignment of note and mortgage, or note on note financing) lets you pull cash out of a pool of seller financed notes you already own without selling them. Land, houses, or commercial property behind the notes. Advance rate and terms quoted on your paper, written quote in 24 hours.
Investors who sell on terms end up holding paper. A note pays 9 to 12% and throws off a monthly check, but the principal is locked up for years. The usual way out is to sell the note at a discount. A hypothecation loan is the other way out: you pledge the note as collateral, borrow against it, and keep it.
The industry uses three names for the same deal. Note hypothecation is the note investor's term. Collateral assignment of note and mortgage (or deed of trust) is the name of the recorded document that makes it work. Note on note financing (or loan on loan, or lender finance) is what lenders call it. Whatever you call it, there are three parties: the property buyer who pays on the note, you as the note holder who becomes our borrower, and Damen Capital Fund as the lender.
You sign a new promissory note to us. You assign your existing note and its mortgage or deed of trust to us as collateral. The assignment is recorded in the county where the property sits, we file a UCC financing statement, and we hold the original notes. Your payor keeps paying the servicer. The servicer sends our payment to us and the rest to you. When the loan is paid off, we release the assignment and hand the notes back.
Nothing about your sale changes. The buyer still owes you, the interest rate on the note is untouched, and you keep every dollar of principal above what you borrowed.
We buy notes too, at 80 to 90% of balance. Selling is the right call when you want out for good. Borrowing is the right call when you want the cash now and the note later. Here is the honest comparison.
| Sell the Note | Hypothecation Loan | Partial Sale | |
|---|---|---|---|
| Cash today | 80 to 90% of balance | A percentage of balance, quoted per pool | Price of the payments sold |
| Who owns the note | The buyer, forever | You | Buyer owns the sold payments, you own the rest |
| Future interest | Gone | Still yours, less our interest | Split by payment |
| Cost | The discount, paid once | Interest while you use the money | The discount on the sold payments |
| Documents | Purchase agreement, absolute assignment | New note, collateral assignment, UCC-1 | Purchase agreement, partial assignment |
| Tax treatment | Sale, gain recognized | A loan, generally not a sale | Sale of the payments sold |
| Payor default risk | Buyer's problem | Still yours | Shared |
| Best when | You are done with the note | You hold two or more notes and need the cash for 6 to 24 months | You hold one note and want some cash with no debt |
Tax lines are general and not advice. Ask your CPA about your situation, especially the installment sale pledge rule covered below.
A land flipper in Tennessee holds six seller financed notes with a combined unpaid balance of $310,000. The notes average 10.5% interest and are all serviced by a licensed servicer. She has a 40 acre tract under contract and needs $200,000 to close in two weeks.
If she sells the notes at 85% of balance she nets $263,500 and gives up $46,500 of principal plus about $32,000 a year of interest income, forever.
If she hypothecates she borrows against the $310,000 pool at the advance rate we quote, say $200,000 for the example, and gives up nothing. The servicer collects roughly $3,900 a month on the six notes, sends us our interest, and sends her the rest. Twelve months later she sells the subdivided tract, pays us off, and gets her notes back with the balance now down to roughly $296,000 because her payors kept paying principal the whole time.
Her cost for a year of liquidity is twelve months of interest on $200,000 plus closing costs. Selling would have cost $46,500 of principal up front, plus the income stream, forever. On a strong pool the interest for a year runs well under the discount, and the tract she bought with the money is where the real return came from.
That is the whole case for hypothecation. It is not free money. It is cheaper than selling when you only need the cash for a while and the notes are good.
Cost of a 12 month loan: a year of interest on $201,500, plus closing costs.
Cost of selling instead: $46,500 of principal, plus every future interest payment.
Numbers rounded for the example. Rate, term, and fees are quoted on each pool from its payment history, property values, and states.
A list of the notes with balance, rate, payment, maturity, property address and type, and the servicer's payment history. Two notes or two hundred. We quote within 24 hours.
Original notes, recorded mortgages or deeds of trust, closing statements, and title. We check the property behind each note the same way we do on a purchase: value, condition, access, and for land, no wetlands or flood zone.
You sign a promissory note and loan agreement with us. We prepare a collateral assignment of note and mortgage for each note, record it in the county, and file a UCC-1 in your state of organization.
The original notes, endorsed by allonge, go into our custody. Your servicer gets a notice directing our monthly payment to us and the remainder to you. Self serviced notes must move to a licensed servicer before funding.
We wire the advance. Typical timeline is 7 to 14 days from a complete file, most of it waiting on county recording and the servicer setup.
Pay us off per the loan terms. We record a release of each collateral assignment, terminate the UCC, return the original notes, and the servicer goes back to paying you 100%.
| Item | Detail |
|---|---|
| Advance rate, rate, term, and fees | Quoted in writing on each pool within 24 hours of receiving the tape and servicer history. The advance is a percentage of the performing balance and follows seasoning, investment to value on the property, property type, pool size, and states. Recording and UCC filing fees at cost. |
| Loan amount | No set minimum or maximum. Pools of two or more notes, priced case by case. For a single note, ask about a partial purchase instead. |
| Payment source | Your servicer remits our payment from the note collections, or you pay us directly. Either way, on time. |
| Servicing | All pledged notes must be serviced by a licensed third party servicer. We work with the major land note servicers and can help you set one up. |
| Collateral documents | Recorded collateral assignment of note and mortgage or deed of trust for each note, UCC-1 financing statement, allonge, original notes held by Damen Capital Fund or a third party custodian under a bailee letter |
| Payoffs and prepayments | When a pledged note pays off or prepays, that principal pays down our loan. Substitution of a note of equal or better quality is allowed at our option. |
| Advance rate test | The loan must stay at or under the quoted advance rate against the performing balance. A note 90 or more days late no longer counts. If the test is broken, you have 10 business days to pay down or pledge another performing note. |
| Maturity | We size the loan so the pool is still paying when it comes due. Notes that mature inside our term count for less. |
| Pledged notes | No modifications, extensions, releases, or partial sales on a pledged note without our written consent. Each note is checked against UCC records and the servicer before funding so it cannot be pledged twice. |
| Borrower | LLC, corporation, trust, or individual borrowing for business purposes |
A note secured by a mortgage is personal property under Article 9 of the Uniform Commercial Code. The UCC calls it an instrument. A lender perfects its interest in an instrument two ways, and a careful lender does both.
Possession. We take the original note, endorsed to us on an allonge, into custody, or a third party custodian holds it for us under a bailee letter. Under the UCC a lender who holds the original note has priority over one who only filed paperwork, which is exactly why we will not fund against a note the borrower cannot produce.
Filing. We file a UCC-1 financing statement in your state of organization naming the notes as collateral. It puts the world on notice and protects us during the short windows when the note is out of our hands, for example when a servicer needs it to enforce.
Recording. The UCC says that a perfected interest in the note automatically carries the mortgage with it. We record a collateral assignment of the mortgage or deed of trust anyway, because county records are where title companies and future buyers look, and because it keeps anyone from quietly selling or releasing the lien while our loan is outstanding.
At payoff we record a release of the collateral assignment (not a satisfaction of your mortgage, a mistake county clerks have been known to make), file a UCC-3 termination, and return the notes.
Read more: how a collateral assignment of note and mortgage works.
When you sell a land note you report the deferred gain from the original installment sale. Borrowing against the note is different. A pledge is not a disposition of the installment obligation, so in most cases nothing is triggered.
There is one exception worth knowing. The installment sale pledge rule in Internal Revenue Code section 453A(d) treats the net proceeds of a loan secured by an installment obligation as a payment on that obligation, but only when the original sale price of the property was more than $150,000. Most seller financed land and small home sales are under that number, so the rule rarely reaches a note pool, but it can on larger properties. When it does, it accelerates the gain on that note to the extent of the loan proceeds, and later collections are not counted twice.
Interest you pay us on a business purpose loan is generally deductible against the note income. Self directed IRA investors should talk to their custodian before borrowing, since debt financed income inside an IRA is taxed differently.
None of this is tax advice. Run your numbers past a CPA who knows installment sales.
Read more: hypothecation vs selling your note.
A note on note loan is only as good as the rules that keep the collateral ahead of the debt. These are ours. They are in the loan agreement, and we would rather you read them here than find them at closing.
Every month the servicer pays in this order: our interest first, then any tax, insurance, or servicing fees owed on the notes, then principal sweep, then everything left goes to you.
When a pledged note pays off or a payor prepays, that principal pays our loan down instead of going to you. The pool shrinks, so the loan shrinks with it. If you would rather keep the loan balance, you can substitute a note of equal or better quality, at our option.
The loan can never sit above the quoted advance rate against the performing balance. A note 90 or more days late stops counting. Break the test and you have 10 business days to pay down or pledge another performing note. Miss that and the loan is in default.
We size the loan so the pool is still paying when our loan comes due. A note that matures inside our term is fine to pledge, it just counts for less in the advance.
Payment instructions at the servicer cannot change without our signature. On a default we direct the servicer, and if needed the payors directly, to send 100% of collections to us until the loan is cured or paid.
The notes are personal property under UCC Article 9. On an uncured default we can sell the pledged notes at a commercially reasonable sale, credit bid our debt, and apply the proceeds. This is a loan, not a sale, so any shortfall is still owed.
You sell lots with owner financing because it sells faster and at a higher price. The trade is that your capital sits in paper. Hypothecation recycles it into the next purchase without giving up the yield. How land investors use note on note financing →
You bought performing notes at a discount, land or houses, and your yield on cost is well above the note rate. A loan against the pool lets you buy more paper while keeping the full yield on the part you did not borrow against. Our note buying criteria →
You split a tract and sold the lots on terms, or you sell houses and mobile homes with owner financing, and now hold a dozen small notes and a closing in three weeks. Pledge the pool, close the deal, pay us back as the notes pay down. Subdivide financing →
A loan secured by a promissory note you own. You pledge the note and its mortgage or deed of trust to the lender as collateral, borrow a percentage of the unpaid balance, keep ownership of the note, and get it back free and clear when the loan is paid off. It is also called a collateral assignment of note and mortgage or note on note financing.
A percentage of the performing unpaid balance, quoted on each pool from its seasoning, the property value behind each note, property type, pool size, and states. Two notes is the minimum.
The collateral assignment is recorded in county records and your servicer receives new payment instructions, so the pledge is not secret. Your buyer's payment, rate, and payee stay the same. Most payors never notice.
We do, for the life of the loan. The UCC gives priority to the lender in possession of the original instrument, so custody is not optional. If you cannot locate an original, the payor can sign a replacement note before funding.
The note is still yours and so is the default. You keep making our payment while you or the servicer work it. Once a note is 90 days late it stops counting toward the advance rate test, and you have 10 business days to pay the loan down or pledge another performing note.
Generally no. It is a loan, not a sale, so the deferred gain on your installment sale stays deferred. The exception is the section 453A(d) pledge rule for notes from sales over $150,000. Ask your CPA.
No. We lend against pools of seller financed notes on vacant land, houses, mobile homes with land, and small commercial property, as long as each note is a promissory note secured by a recorded mortgage or deed of trust and is professionally serviced.
Not with us. Hypothecation loans are for pools of two or more notes. For a single note we offer a partial purchase: we buy a set number of the future payments and you keep the rest, with no debt.
No. A land contract is not a promissory note secured by a mortgage. We lend against notes with a recorded mortgage or deed of trust. If you want to sell on terms and keep the option to borrow later, use a note and deed of trust instead of a land contract.
Send the note tape and the servicer's payment history. Written quote in about 24 hours. If selling, or a partial on a single note, makes more sense for you, we will tell you that too.
Private lender and direct land note buyer serving land investors and note holders nationwide. Featured on REtipster, Legends of Land, and Land Investing Online. LinkedIn →