While the theory as to exactly what any first or second mortgage is varies among states in the Union, a mortgage is for all practical purposes a promise on the part of a property owner to pay with interest a certain total sum in periodic payments over a given number of years to a person who lent him this sum of money. If the payer (mortgagor) does not meet the payments to the one who lent the money (mortgagee) the mortgagee can have the property taken away from the mortgagor, sold and pay himself what he is owed.

It is hardly necessary to belabor the point as to exactly what the legal defini­tion of a first or second mortgage is. The vast majority of home owners in the United States have a mortgage on their homes and are only too familiar with the fact that a mortgage is what they owe on the home and that if they do not meet their pay­ments they will lose their homes.

The leading and most conservative financial institutions in the country invest in mortgages—commercial banks, savings banks, insurance companies, building and loan associations, pension funds, union funds and trust funds. There is a serious question as to whether we could have such a thing as life insurance as we know it in the United States if the insurance companies were not able to place their funds in mortgages which provide income on which to operate these companies. If the first or second mortgage were suddenly wiped out overnight so would building and loan associations, in all probability, since their major assets would disappear.

The safest and most conservative kind of first or second mortgage for an individual investor to buy is a first mortgage on a dwelling which mortgage is insured by the Federal Housing Administration or the Veterans' Administration. If the homeowner defaults on his payments, the government pays off. There is thus practically no risk in this type investment and the purchaser of such a mortgage generally does not need to examine the terms of the mortgage in detail, the financial soundness of the debtor or the value of the property.*

* It should be pointed out, however, that the FHA does not pay off in cash but in FHA debentures, which bear an interest rate about 1% below the mortgage rate and mature in 20 years. There are foreclosures on about M of 1% of all FHA insured mortgages.

First mortgages which are insured by the government generally carry a rate of 5¼% to 5¾%. This is the return you receive on your money. Actually the rate may even be 6%, but the mortgage firm often does the collecting and for this service may charge as high as one-half of 1% per annum. This is not money thrown away on the part of the investor. The receipt of payments by the investor is never, and can never be an automatic procedure. It is well to fix this fact clearly in mind at this point in the study of securing a return on your money and never forget it.

On the paying end of any investment is an individual just like you who must make out a check to you every month, put it in the mail and send it to you. Obviously this individual may die like so many people do. In that event he can send no more checks. He may become ill and unable to work and earn his pay for a short period of time or even for a long period. Possibly he will write you a letter explaining that he is ill and temporarily cannot pay, or that his wife is ill or other members of his family may be, or that he has lost his job.

You are then in the position of being able to stand on your legal rights and say, "Too bad. Pay up or I will take your home away." That is not an enviable position in which to find oneself. What to do in such a difficult but entirely common position will be discussed later.

Very fortunately the vast majority of credits do not turn out like this, and an FHA or VA insured mortgage probably is a mortgage of a pretty sound credit risk. It may be, however, desirable to have the mortgage, banking or realty firm that sold you the first or second mortgage do the collecting for you, even though the service may cost you up to one-half of 1%. They are the ones, not you, who will have to face up to the possibility of death or loss of job on the part of the debtor.

If the investor undertakes to receive mortgage payments directly instead of having them serviced by a mortgage or realty company or some other organiza­tion, he is bound to run up against this situation sooner or later over the life of the mortgage he holds, when he does not receive his check on the first or second of the month or whenever it is supposed to arrive. The investor at this point must find out what is wrong, either by writing a letter or by telephoning. Right here in our review of investments it is enough to point out that all will not always go well, and that troubles must be anticipated. The technique of collecting will be discussed later.

There are many sources of guaranteed first mortgages. Almost any newspaper in any major city carries advertisements of such mortgages for sale. In almost every issue of the Sunday New York Times there is at least one large advertise­ment of government guaranteed mortgages for sale. Very often the selling organization will collect and remit payments to the investor for the fee men­tioned earlier.

In nearly every city there is at least one bank that can locate a guaranteed first or second mortgage for individual investors and in the larger cities there are many banks, mortgage brokers, mortgage bankers, title companies and mortgage exchanges which can locate such mortgages. These organizations are all listed in the classified telephone directory and are easily found.

We now come to second mortgages specifically, which are often a very different type investment from first mortgages. In the first place the rates are usually vastly higher than first mortgage rates. This difference is explained by the fact that the position of a second mortgage is frequently very much inferior to that of a first mortgage. In the next place there is no FHA or VA guarantee on second mortgages.

In 1959 I sold my house on Florida Avenue in Washington. The purchaser, a very substantial man, the Washington editor of a prominent business magazine, already had a house. The bank gave him a substantial first mortgage on our home but he was still required to make a heavy down payment in cash. This he could not do since all his funds were tied up in the home he lived in.

He consequently proposed to me that he be given 18 months in which to pay me the difference between his small down payment and the balance owed over the first mortgage. I replied that I would be glad to take a second mortgage for 18 months as this period would be ample for him to dispose of his home. This is the way the deal was worked out (figures have been altered slightly):

SALE PRICE OF HOUSE	$50,000
FIRST MORTGAGE	30,000
BALANCE DUE FROM PURCHASER	20,000
DOWN PAYMENT PURCHASER COULD RAISE	10,000
SECOND MORTGAGE	10,000

The rate on my second mortgage was set by the custom in the area—6%. Sometimes this rate is higher in other areas. Sometimes it is limited by law to a maximum of 6% or 8%. *

* In all financing be sure to check the applicable state laws with Roger S. Barrett's "Compilation of Consumer Finance Laws" National Consumer Finance Association, Hildreth Press, Bristol, Conn. This volume is available in many libraries.

My home purchaser not only met his payments, but met them ahead of schedule. If he had defaulted I could have paid off the first mortgage of $30,000. Since he had already paid me $10,000 down, I would have been $10,000 to the good less the commission of 5% I paid to the real estate agent ($2,500) and I could again put the house up for sale.

If, however, I had wanted all cash for my house after the transaction had been closed, the only way I could have secured cash would be to sell my second mortgage for cash.

This I could do only at a discount, and herein lies the attractiveness of invest­ing in second mortgages.

In the Washington mortgage market I would have had to sell my $10,000 second mortgage for a discount of at least 10%, which would net me $9,000. Almost no one will pay the face amount for a second mortgage.

Now what kind of an investment has the buyer of my second mortgage made? The purchaser of my house agreed to pay off the second mortgage of $10,000 in 18 months, and he agreed to pay me 6% interest per annum. His total interest payment is thus 6% on $10,000 for one year ($600) plus 6% on $10,000 for the remaining six months ($300).

The purchaser of my second mortgage thus gets this $900 interest plus the $1,000 discount, making $1,900 as his return on his $9,000 invested for a period of 18 months. His monthly interest income is therefore $1,900 divided by the 18 months, which equals $105.50 per month, or $1,266 per year, if we put it on a yearly basis.

His annual rate of return is $1,266 divided by his investment of $9,000, and the result is 14%. This is the rate of return, which compares with the 5% to 6% on government guaranteed first mortgages. It has no government or any other guarantee. It is not a first mortgage. It does not have first claim on the property. The first mortgage has first claim. It comes second; but the rate of return is 14%.

In many of the large city newspapers there are advertisements of "Trust Notes" or "Mortgages for Sale" or some similar designation. A typical mortgage for sale is a second mortgage for $3,000 due in eight years to be sold at a discount of 40%.

The mortgage bears interest at the rate of 6% on the balance outstanding at a particular time. If the mortgage is for eight years and is for $3,000, the yearly interest is 6% of $3,000 or $180. Actually monthly payments of both interest and principal are made. In eight years there are 96 months, so that $3,000 divided by 96 equals the amount of his original investment the investor gets back every month—$31.25. Each month his investment is lowered by this amount; therefore, at the beginning of the eight year mortgage period he has his entire $3,000 invested, and at the end of the period his entire investment has been returned via the road of monthly payments.

What is his average investment over the eight-year period? It is midway between the $3,000 he invested originally and the zero he has invested at the end of the eight-year period. The average is thus $1,500—midway between $3,000 and zero.

This is a very simple calculation, and the justification for belaboring it is that it underlies almost all high rate investments. It must be understood fully or else rate of return on your money cannot be calculated.

To return to our example of the $3,000 second mortgage bearing a rate of 6% on the balance remaining outstanding after each monthly payment has been made, we can calculate the exact total amount of interest by computing 6% annual return on the average investment over the eight year period, which is $1,500. Six percent of $1,500 is $90 per year, and for the entire eight year period the investor gets eight times $90 or $720.

He bought the note not at the face value of $3,000, however, but at a 40% discount. He paid $3,000 less 40%, or $1,800. He gets this 40% ($1,200) back over the eight-year life of the mortgage.

This total return on his $1,800 invested is thus $720 in total interest and the $1,200 in discount-$l, 920 in all—which, divided by eight years, is $240 per year.

Hence, the annual rate of return is determined by dividing $240 by $1,800. The yield is 13.3%. But since the $1,800 initial investment is returned over the eight year period, the average investment for the period is midway between $1,800 and zero, or $900.* The real rate of return is thus $240 divided by $900, or 26.6% per year.

* This calculation is not mathematically precise, but it is close enough for all practical purposes.

Some of the advertisements of second mortgages offer a discount of 50%.

The investor gets the same total interest—$720—and $1,500 discount, instead of $1,200. He gets $2,220 in all—on a $1,500 investment. His annual income is $2,220 divided by eight—$277—and his rate of return is determined by dividing this $277 by one half of $1,500 ($750), which is 37%.

In the second mortgage market of the early 1960's, a return of about this level on second mortgages can be obtained. To get it on fairly good mortgages re­quires a lot of hunting and a good deal of analysis of the mortgages offered. I, myself, would want a rate of return of at least 18% on a second mortgage. I would not accept a return as low as 12%, and I would search for a good deal with a return of over 18%.

Why do first mortgages bring so little in comparison with second mortgages, and conversely, why do second mortgages yield so high a rate? A part of the explanation has already been given, but let us see whether the second mortgage is proportionately weaker than the first mortgage so as to justify a rate of 18% or more through its very weakness.

A first mortgage is a first lien on the property. If the owner cannot pay, the investor can cause foreclosure proceedings which will result in the sale of the property, which sale would pay him off.

In order for the investor to be paid off, the property must bring enough to pay him off. If, for example, a home which sold for $20,000 has on it an $18,000 first mortgage in which you have invested, it is entirely possible that in a foreclosure sale it would bring less than $18,000. A foreclosure sale is entirely unlike the real estate agent's normal sale which is often attended by glowing advertising and excellent salesmanship. A forced sale of property is to a real estate agent's normal sale what a Police Department sale of confiscated cars is to a used car dealer's operation. Little elaboration on this point is required.

If the property brings only $17,000 after foreclosure expenses which are deducted before the mortgage holder is paid off, he has obviously lost $1,000 since his mortgage is for $18,000 in the case we have hypothetically set up.

Now if the first mortgage is for $18,000 and there should be a second mortgage for $2,000 on the house that sold for $20,000 and the results of the foreclosure sale were as set forth above, the first mortgage holder would lose $1,000, but the second mortgage holder would be entirely wiped out.
This is the exact safety factor of many second mortgages being sold today. A real estate firm prices a house over the market and effects a sale by pointing out to the purchaser that he can buy this $20,000 house for only $1,000 down. The real estate firm explains that it will take the second mortgage for $2,000 at only 6% interest and the bank or building and loan association will take the first mortgage for $17,000.

The real estate firm in this hypothetical case would have realized its usual profit on the house if it had sold it for only $19,000 instead of $20,000, but the purchaser has been induced to pay $20,000 since if he pays $1,000 more the real estate firm tells him all he needs to pay down is $1,000.

The deal goes through. The real estate firm receives the $17,000 first mortgage money plus the down payment of $1,000 plus the second mortgage for $2,000— $20,000.

If the real estate firm had received $19,000 it would have realized the normal profit, and since it wants to buy up more houses for resale, as purchase and sale is its business, it wants to get its cash out of the second mortgage. It consequently sells the $2,000 second mortgage for $1,000 cash to the investor—at a 50% dis­count—and goes on to something else.

If the property purchaser continues to pay, all is well. But if he should lose his job or have unusual financial strains placed on him or if he should be offered a comparable home at $19,000, the real value, particularly in time of national business recession, he may very well default with the result that the second mortgage is impaired and possibly wiped out.

This hypothetical example of a second mortgage leads us to one of the major criteria for judging the soundness of a second mortgage—equity—and equity is what the buyer has in the house. To look at equity in another way, it is the excess of what the house is worth above any and all mortgages—first and second.

A safe equity is 30%, a borderline equity 20%. Hardly any lower equity pro­vides enough safety to warrant investing in any mortgage—first or second, unless the mortgage has a government guarantee. 30% equity might be illustrated by a house worth $10,000 on which there is a first mortgage of $5,000 and a second mortgage of $2,000. The equity is thus $3,000, and $3,000 is 30% of the value of the house which is $10,000.

Now let us illustrate another first and second mortgage combination in deter­mining equity and the safety of investing in first and second mortgages:

In the earlier illustration the house worth $19,000 was sold for $20,000 and an individual investor might be induced to purchase a first mortgage of $18,000. Such mortgages with this hypothetical equity are offered for sale all the time. It is $2,000 or 10%. In a business recession, it was pointed out, the house might bring only $17,000. It might bring no more in a foreclosure sale even in good times. The first mortgage holder would thus lose $1,000.

Now suppose this house had a first mortgage on it of $5,000, and a second mortgage of $2,000 was offered to you. The equity would then be the difference between the price of $20,000 and the sum of the first and second mortgage ($5,000 + $2,000 = $7,000). Hence the equity is $13,000. If the house is con­sidered to be worth really only $19,000, the equity is still $12,000, and if in a forced sale or in poor times it might bring only $17,000, the equity is $10,000.

Which mortgage is sounder, a first mortgage of $18,000 in the original example, or a second for $2,000 in this example? Obviously the second mortgage in this example. The equity is far greater and offers far more protection. It is a cushion and is often referred to as the equity cushion. This term adequately describes the function it performs from the point of view of the investor. It is a cushion which absorbs the effect of economic shocks and adversities. The bigger it is the more it absorbs.

If this illustration is adequate, one must arrive at the conclusion that a second mortgage is not per se inferior to a first mortgage, yet the second mortgage rate is almost always not only higher, but very much higher. Guaranteed mortgages are, of course, extremely sound by their nature, but we are referring to unguaran­teed first mortgages.

Because this situation exists that generally second mortgages regardless of their soundness carry a rate which is higher than that on first mortgages regard­less of their soundness, the opportunity is offered the investor to search for and secure good investments in second mortgages carrying a rate which is dispro­portionately higher than that on first mortgages, considering the comparable risks in both.

There are such things as third, fourth and even fifth mortgages. I have personally never bothered to examine them. I am traditionally and emotionally opposed to them, but there is no intrinsic objection against a third mortgage, as for instance, a $1,000 third mortgage on the above described property worth $19,000 with a total of $7,000 in first and second mortgages.
In certain cities, such as Washington, D. C., where home values skyrocketed in a period of two years (particularly values of large in-town homes), it is conceivable that a home which sold for $50,000 in 1958 might have a $30,000 mortgage and, later on, the owner, needing money to improve his property, might have put a $10,000 second mortgage on it. In the 1961 market this home could easily have been worth $90,000. If the owner wanted to raise more money on it, it is conceivable that neither of the holders of the existing mortgages might want to raise his mortgage. The owner might then find it expedient to raise, say $5,000, through a third mortgage. The first, second and third mortgages would then total $45,000 on a home worth $90,000. The equity cushion would then be $45,000, ample to protect the third mortgage holder.

We have talked a great deal about the value or market price of a home. How is this determined? It is best determined by securing independent appraisals on the property—two at least. Appraisal firms are located in the classified section of the telephone directory. These should be well-established firms with a reputation for impartiality, and you may want to check their reputation with your banker or with the Better Business Bureau.

In almost every city property tax rates are based on some kind of appraisal. This appraisal may be accurate and it may be fairly up-to-date. On the other hand, it may be far out-of-date and inaccurate to begin with, but it does offer some guide to the value of a property. A hypothetical tax on a home might be $850 per year. The rate might be $2.00 tax per $100 of assessed valuation. In $850 there are 425 "$2," so we multiply the 425 by $100 and we come out with an assessed valuation of $42,500. But we find that it is the policy of the local assessors to value property at 60% of the real value. So we can find the real value by dividing the $42,500 by 60% and we arrive at the true appraised value of $70,830. This is what the assessors felt to be the true market value of the property at the time they appraised it, and one would have to know when the appraisal was made, through contact with the revenue department of the city, to determine how applicable to present day values the appraisal was.

In many cities there is a Property Directory indicating specifications on each dwelling—dimensions of the land, appraised value of the land, appraised value of the structure, and often revenue stamps in dollars which stamps were affixed at the time the property was last sold. Since the stamps bear a direct relation to the price, from the stamp total the last sales price can be figured, and the year of sale is usually given. Thus there is some indication of the value of the property from its sales price in the past.

The other major factor in determining the soundness of a mortgage, either a first or second mortgage, is the financial soundness of the owner of the property. In the chapter on Judging Credits and Making Collections, the matter of the financial soundness of the homeowner will be gone into in some detail. It is enough to point out here that a credit report should be secured on him from the local credit agency in your city or town, and there is one for every town, although its office may be in a nearby city. Dun and Bradstreet can be induced to secure a report by application for such a report to your local banker. He will let you see the report, but it belongs to the bank, which will in all probability be a subscriber to the Dun and Bradstreet service. Stone's Mercantile Agency is another reputable credit reporting service located in many cities.

While the information on the homeowner contained in these credit reports is useful, it is not and cannot always be perfect. Sometimes past defaults are not discovered and judgments are not recorded, since a poor credit is not anxious to mention his defaults to the credit agency.

These are some of the things, which mean that the homeowner is a good credit, and they will be gone into in more detail later:

History of prompt meeting of his debts and his time payments.

1. Long employment by one firm.
2. Long residence in the city.
3. Income adequate to cover payments.
4. Income adequate to cover his other payments—car and household appliances,etc.

Besides (1) this equity cushion to protect the position of the mortgage holder and (2) the credit reliability of the home owner, the prospective investor should look into (3) the reliability of the realty company or other company sell­ing the mortgage. He does this by making exactly the same type credit inquiry to (a) the local credit agency, or (b) Dun and Bradstreet, or (c) Stone's Mercantile Agency. In addition the realty company may supply the name of the bank with which it does business to use as reference. This bank should be checked with by a personal visit to see whether the bank (1) has any knowledge of defaults on the mortgages sold by the realty company or (2) has any reserva­tions about the credit standing of the realty company.

Very often the realty company can supply the names of former purchasers of their mortgages, and these should be checked with. They may be "rigged" in that the realty company may refer prospective mortgage purchasers only to those purchasers who have never run into any trouble with the mortgages purchased. The credit standing of these past purchasers of mortgages should be checked into.

The question may be asked of the realty company, "Will you guarantee the mortgage?" In many cases the seller will provide such a guarantee but, of course, wants some compensation for the guarantee. The 18% interest might be reduced to 12% if the guarantee is provided. Collecting and guaranteeing are sometimes important functions, and this 6% differential is not at all out of line.

Some companies specialize in selling a guaranteed first or second mortgage, and these pro­vide the investors with a return of 10% to 12% or 13%. Upon default the mortgage company will repurchase the mortgage from you for the balance still owed. The Mason Mortgage and Investment Corporation in Washington, D. C. pro­vides such a service.

In order for such a guarantee to mean much, the company must have some liquid assets (cash or mortgages held by the company). It should have sub­stantial assets in relation to what it owes, because out of these assets the mortgages that default must be paid.

A mortgage guarantee company will often give you a history of its defaults and losses over a period of years, and its profit and loss statement, which it will supply to you, often has an item such as "losses on guarantees" or "mortgage losses" by which you can gain some insight into the soundness of the mortgages in which the company deals.

How do second mortgages arise? In the first place, a real estate company purchases a house for resale as is or after it has been rehabilitated. It then marks up the price of the house and offers it for sale. In this type purchase and sale which involves a second mortgage, the market appealed to is the "low down payment" market, the person who may have only $1,500 or $1,000 or only $500 for a down payment. The difference between what the buyer pays down and the first mortgage taken by the bank or building and loan association must be supplied by the real estate company in the form of a second mortgage, which the real estate company will sell in order to get its money completely out of the house.

Closely related to this source of second mortgage, is the homebuilder. In order to move his houses he may have to take back second mortgages, which he wants to sell in order to put his money back into his building business. Once in a while a builder cannot move a house; particularly in the winter months he may not be able to get along with a first mortgage and may need to put on a second mortgage. Here the appraised value of the house is all-important, as no buyer has put any money into it. No one made any down payment, no one is obligated to make monthly payments and no one is benefitting by living in the house. The first and second mortgages may together equal the quick selling price of the house, or even exceed it.

The builder as mortgagor on the second mortgage may or may not be responsible. If he is overbuilt he may be obligated to pay on mortgages on so many houses that he can go bankrupt, and it makes little difference if he agrees to repurchase the second trust in a year's time. If he needs the money by creating a second trust now he may need it even more and not have it when at the end of a year he is called upon to repurchase.

The individual home seller may create the second mortgage in order to move his house. In these times of rapidly rising home values the banks and building and loan associations may lag in raising their appraisals of properties. If a house, which sold for $50,000 in 1958, is worth $90,000 in 1962 (and this appreciation is not unusual), it is entirely possible that the bank will not even reach $50,000 as the first mortgage limit. Few people have $40,000 as a down payment, so the seller may have to take a $20,000 or $25,000 second mortgage to sell his house. But this he does not want. Instead he generally wants to buy another house somewhere.

Title companies in every city have an "in" on this type second mortgage, which can be very sound, since they participate intimately in closing property sales. They are to be found in the phone book, and they can often put a person in touch with prospective sellers of second mortgages.

Sometimes the homeowner creates a second mortgage simply to get money to invest in something or to buy a boat or a summer place or a second car. These mortgages are hard to locate, and they suggest the homeowner may be living beyond his means. They are generally, although certainly not always, second choice investments.

One of the greatest recent sources of second mortgages in the country is home improvements. Many, if not most, home improvements are beyond the ability of the homeowner to finance out of his bank account. A home improve­ment can be any addition or alteration to a house which makes it of greater usefulness to the occupants—from partitions which make two rooms where there was one before, to a garage or a modern combination furnace-air conditioning system. Frequently, although not always, the improvement increases the market value of the house. One recent writer on home rehabilitation even states that only those improvements should be undertaken which result in $2 of increased value for every $1 spent. If it is possible to improve a home on this kind of basis, and it sometimes is, then the second mortgage created by the homeowner to finance the improvement provides its own equity cushion of $2 for every $1 spent.

There is a great source of second mortgage paper available on home improve­ments from the home improvement firms (dealers), of which there are some in every city. They are essentially general contractors who farm out specific repair and improvement jobs to subcontractors. The dealers (home improvement firms) frequently do not have any carpenters, plumbers, etc., on their own payrolls. They subcontract the entire plumbing job or grading job, or whatever kind of job it is, to a subcontractor and it is this individual who actually employs the plumbers, etc. The dealer obviously pays the contractor less than he gets from the homeowner, and he operates his business on this differential. He often has a large group of salesmen who work entirely on commission, so that the differ­ential must cover their commission as well as the dealer's costs and profits.

If the home improvement job is done according to Federal Housing Adminis­tration specifications, it may qualify for an FHA guarantee. It then is a guaran­teed mortgage and carries the usual guaranteed first mortgage rate of interest.

Sometimes banks have their own home improvement plans and they generally carry a higher rate.

There are, however, home improvement jobs, which will neither qualify for an FHA, guarantee nor be acceptable to banks. These jobs are not by any means necessarily substandard credit risks. The first type of job in this category is one on a home located outside a major city which city has a bank financing home improvements. Banks generally conceive their job to be one of financing enter­prises and property in their city and its immediate environs. They sometimes do not go outside their city limits by more than say 50 miles.

In this outer area there may thus be little or no finance available for home improvements from any source. A dealer may be unable to do home improve­ment jobs in the area because he cannot sell the mortgages to anyone. Or he may do business all over the state or in more than one state. He may have one bank ready to finance home improvement jobs in one area but not in another, while in a third area he may have no available finance.

These dealers or general contractors can be a source of some very high grade investments. They may be able to supply not only a second mortgage, but first mortgages as well, on homes which are free and clear of any mortgage, but where financing for home improvements is not available from any financial institution.

In any area home improvement firms are listed in the phone book—roofers, aluminum siding and room companies, foundation builders, gardening firms, builders and any number of other companies installing everything from tile flooring to furnaces. If these firms do not do such unfinancible home improve­ment work themselves they may know who does and who has paper for sale.

Every major city has home improvers who have mortgage paper for sale. A few years ago I visited about two-dozen of them in one city. They varied all the way from high-grade construction companies to what appeared to be a den of thieves.

If you buy one of these first or second mortgage, you must look over the bill for the job and check it with a builder to make sure it is not grossly over­stated. Home improvers sometimes do a $100 job for which they charge $200, or even more, and the customer buys the deal because he has no cash but feels he can make time payments no matter how high the total amount of his payments may be.

Whether he paid too much or not may not affect the legality of a contract, but if the home owner on thinking the whole thing over comes to the conclusion that he was played for a sucker, he may refuse to pay, no matter what happens.

It is necessary to interview him in person or by phone to be sure the job is done and done to his satisfaction. All too often mortgages are offered for sale when the job has not been completed, and in some cases not even started. If the homeowner feels the job was not done properly he may refuse to pay. He must likewise understand exactly how much he owes in total and what his monthly payments are. Only when all these things are cleared with the homeowner should the mortgage be bought. Obviously independent appraisals on the value of the home and a credit investigation on the homeowner must be secured.

One organization financing home improvements calls each homeowner on the telephone and asks him whether the job has been completed, whether it has been done to his satisfaction and whether he understands what his payments are and how much in total he owes. All this is taped on a recorder. If the homeowner tries to raise objections later, the tape is played back to him and he can hear what he said.

The mortgage should be made by the homeowner in favor of the construction company. You, the investor, buy it from the construction company, usually at a discount so as to yield you 18% or more. If you establish a mortgage directly with the home owner at a rate of 18%, your mortgage will, in all probability, be usurious and against the law. Purchasing the mortgage from the construction company at a discount where the interest rate stated in the mortgage is not above the legal maximum, generally 6%, does not constitute usury.

Needless to say, in the home improvement business the character and reputa­tion of the home improvement firms are of the essence and must be checked out thoroughly with credit agencies and with banks and other financial institutions, which have purchased their mortgages.
Strangely enough it is not unusual in suburban or semirural areas to purchase first mortgages covering home improvements where the equity may be as high as 50% and in some cases even higher. The owner of a home which has for years been free and clear of any mortgage might possibly want to add a room or put on a tile roof or build a garage for which he cannot pay all cash. The location of the property might be away from the city and out of the local bank's financing area. In such cases, and there are many similar cases, a first mortgage is often taken by the home improvement firm simply because it cannot get cash. The home improvement firm sells this mortgage at a discount; often at a discount large enough to yield up to 18% per annum.

Another great source of high rate mortgages is the shell or pre-cut homebuilder. A shell (pre-cut) home is made in a factory on a semi-mass production basis and shipped unassembled to the land owned by the person who wants to erect the home. This land he must own free and clear. The homebuilder or dealer then erects the home, but usually only the "shell" of the home. The owner must put in plumbing and wiring at his own expense. Frequently he per­forms the labor himself and contributes what is known in the building and mortgage business as "sweat equity."

The dealer creates the mortgage, which covers the land, the shell and all completion costs and labor. This mortgage he will sell so as to yield the investor about 15% return. It is a first, not a second, mortgage, and in addition it carries full recourse by the builder. If the homeowner defaults, the builder must pay off the balance due the investor.

In this case, however, just as in the case of the mortgage guarantee company, the investor must examine into the financial statement and credit reputation of the builder to see if his guarantee means anything.

These shell or pre-cut mortgages can be located by looking in the phone book and at newspaper advertisements of shell dealers in many states, including Virginia, North and South Carolina, Georgia, Alabama and Florida.

What then, in summary, are the characteristics of a good mortgage? What characteristics should be sought?

Equity of 30% or more and certainly not under 20% of the appraisal of the property for quick sale.

1. As much down payment on the part of the property buyer as possible. The more he pays down the harder he works to preserve his investment.



2. Good credit rating of the homeowner as determined by a credit check.



3. Good credit rating of the organization selling or guaranteeing the mortgage.



4. A simple interest rate of at least 12% on first mortgages and 18% on second mort­gages (for mortgages not carrying any government guarantee).



5. A term of eight years or shorter.

One point must be brought out in connection with the term of the mortgage. Very often the seller does not tell you that at the end of the term of six or eight years, or whatever it is, there is what is called a balloon balance. If a mortgage is for $5,000 for five years and is payable at the rate of $50 monthly plus interest, the mortgage is reduced every year by $600 ($50 X 12). In five years five $600 annual payments have been made or $3,000 in all. But the mortgage was for $5,000. At that point the homeowner must scrape together $2,000 immediately. This he usually cannot do and the investor has little choice but to go on accepting $50 a month for 40 more months until the $2,000 balance is paid off.

The balloon balance represents unrealistic financing and is little more than a high-binding gimmick.

The real estate firm offers you a $5,000 second mortgage at 6% for five years at a discount of 50%. It sounds as though you might get your money back in five years. Nothing could be more unrealistic.

Furthermore, 50% discount sounds as though you would pay $2,500 for a $5,000 mortgage and thus earn not only the 6% interest in five years which amounts to about $750 in total, but the $2,500 discount also, or $3,250 in a five year period. This yearly interest would appear to be $3,250 divided by five or $650. On an investment of $2,500 the annual return would be 26%, and obviously much more when you consider that your investment is reduced each time a pay­ment is made.

Actually the homeowner would have to have the balloon balance extended for another 40 months (three-and-a-third years). The interest in total would be about $1,245 and the discount $2,500 ($3,745 spread over eight-and-a-third years), $451 per year, not $650 per year.

Banks very often place a limit on the number of years over which they will finance anything but a strong conventional first mortgage. This limit is frequently five years, and once in a while an investor or investment company can persuade a bank that such a contract as we have described, with a balloon balance, is really a five year contract and thus within the policy of the bank.

We now come to the closing investigations and documents required.

On each homeowner the following information should be assembled by the in­vestor in person, by mail or by phone and verified by writing to credit references. Where a dealer (home improver) sells you the mortgage he will get the infor­mation for you. Form 1 (page45) is a sample of a usable credit application.

In the purchase of home improvement mortgages, Form 2 (page 46) is used as well. This document is sent to the purchaser or taken to him to make sure he understands his position with regard to his debt and his payments on the debt before the investor buys the mortgage. If this form is filled out first, then trouble in the future is often forestalled. The debtor cannot state that he really did not understand what he was getting into.

Form 3 (page 47) is an appraisal form. Appraisers probably have their own forms which they will submit indicating the value of the property.

One of the essential examinations, which must be made, is a title examination to make sure the debtor owns the property and has clear title to it. This examina­tion is made of local property records by an attorney, and it might possibly cost $25. The results are indicated by the attorney on Form 4 (page 48).

A clear title is far more important than might appear on the surface. In 1922 my father purchased a piece of property with a house on it. It was located in the country and was to be used as our summer home. I inherited the property. One day a major oil company came along and offered a good price for a portion of the land. After some negotiating we arrived at a figure, the deal to be subject, of course, to the obtaining of a clear title by the oil company. It soon became apparent that there was no clear title. The clear title extended as far as 1918 when the property was purchased by Julia Shailor. In 1922 the property was sold to us by Mrs. Antonio la Rocca. What happened between 1918 and 1922? After a great deal of investigation for which a fee of $1,000 was charged, it was deter­mined that Julia Shailor and Mrs. Antonio la Rocca were one and the same person. Why was this fact not obvious after only slight examination? Time had moved on. Some members of the seller s family had died. Others had moved to parts unknown. The neighbors did not remember them. This is a prime illustra­tion of the need for a title search before purchasing a mortgage.

Form 5 (page 49) is a completion certificate on home improvements. A few years ago there was an interesting television show on the home improvement racket. A home owner, a young husband, signed a mortgage on his home in advance of getting a room added to his home. The room was never put on but he had already signed the mortgage. The investor would be in a very unenviable position if he had such a mortgage on a home on which the work had never been done. The court might be inclined to look with favor on the homeowner who paid for having exactly nothing done.

If everything checks out to this point, you send the payment book to the homeowner Form 6 (page 49) along with the letter telling him how to make his payments Form 7 (page 50).

Although you might require him to purchase credit life, health and accident insurance to pay you off in case of his death, accident or illness, it is more im­portant that you satisfy yourself that he has fire insurance.

The basic document is the deed of trust. The correct form to use depends on the state in which the property is located, and the correct document for that state must be used. This document can be purchased in any large stationery store Form 8 (pages 51-57).

Upon completion, this deed of trust must be filed with the proper official of the county in which the property is located, usually the county clerk in the county courthouse in the county seat. Any local attorney can file this document for you for a small fee, or you can do it yourself. But do it immediately before anyone else files any prior lien of any kind. This sometimes happens.

The next step is optional, but it is advisable. You should take the deed to your bank and ask your bank to collect for you. They will charge a nominal fee per payment, probably $.50 or $.75. They may suggest sending out their own pay­ment book instead of yours for their convenience. It must be understood what, if anything, they will do if they do not receive a payment when due. They may very well do absolutely nothing. Many banks do nothing and pay no attention to whether a payment comes in or not. You may be able to get them to send the debtor non-payment letters. If not you will have to know every month that the payment came in and was credited to your account in the bank. When it does come in the bank will send you a notification of payment.

The reason for having a bank collect is not just convenience to you. It is even more the prestige of a bank. A debtor does not like to default in paying a bank. He sees his credit destroyed for all time and he feels that somehow the bank will use drastic means to force him to pay or will take his home away.

Now the next step is collecting when the payment does not come in on the day due. The bank will show you what letters it sends out to its own debtors and you may want to use these. Or you may want to write your own. Whatever letters you write, however, must be firm and written quickly after a payment is missed—not over 10 days after the payment is due.

Strangely enough, the first payment is often the hardest to collect. When this payment is missed the tone of the collection letter should be one of surprise that a person with such a good credit record (he must have checked out well or you would not have purchased his mortgage) should miss his very first payment, that if he cannot make even his first payment how are we to believe that he can keep on making payments, and that maybe the thing to do is to foreclose on his home right now.

In collection letters you cannot mince words. You must make it clear beyond any doubt that you are going to collect or else you will take the home over. Otherwise be prepared to lose your money! If he has problems with other credits, remember that it is the squeaking wheel that always gets the grease.

Now let's go a step further in your credit misfortune and suppose the debtor does not respond to any collection effort, does not explain to your satisfaction why he has not paid so that you may postpone a payment or two, or does not even answer your collection letters. You then foreclose. This procedure varies in different states. It must be handled by a local lawyer who understands fore­closure proceedings, but almost all lawyers understand such procedure.

In a typical state the lawyer notifies the homeowner that he is going to fore­close. He then advertises the property for sale in the paper for four consecutive weeks. At the end of that time the sheriff conducts a sale of the property on the steps of the courthouse.

Prior to this time, or at this time, the homeowner will in many cases pay up. If not, you may want to make an arrangement with the bank holding the first mortgage (where you hold the second) whereby they will let you continue the first mortgage on the house provided, of course, that you make the monthly payments on it. If you have made such an arrangement with the bank prior to the sale, then you are in a position to bid on the house yourself if you see it is not going to bring enough in the sheriff's sale to pay off the first mortgage and your second mortgage.

At this point it becomes clear why the quick sale appraisal that you have made is so important and why the equity of the homeowner is so important.

This is certainly the gloomy side of the picture. A much brighter side is the prepayment of the mortgage. Very often the homeowner wants to get out of debt before he has completed his monthly payments. If you have purchased a $3,000 mortgage for $2,000 you are fortunate indeed because he pays off the $3,000 (less, of course, his reduction of the mortgage). This reduction of the mortgage is called amortization.

If the mortgage is $3,000 and the home owner has to pay $50 off every month plus interest at 6% on what is still owed, at the end of the first month he has paid off one $50 plus one month's interest at the rate of 6% per year on $3,000 ($180 divided by 12 months, which equals $15). His check is for $50 amortization plus $15 interest—$65 in all. At the end of the first month he owes you $2,950 on his mortgage since he has made only one $50 payment. You might ask him to pay off the entire $2,950 and you have a legal right to this sum, or you can compromise with him on some smaller sum if you feel so inclined.

Right here we will go back briefly into figuring payments. If you figure that 6% annual interest is owed on the remaining balance after each payment is made, then one-twelfth of 6% is ½% and you apply this to the $3,000 owed the first month and get $15 interest due. The next month the principal outstanding is only $2,950 and ½% of this sum is $14.75, and so on. It is obvious that monthly payments would vary and gradually go down. This is not customary and most debtors want to pay the same amount every month. They pay $65 each month, and as each month goes by and the mortgage is paid down less interest is charged and more applied to the principal so that the monthly payment is always the same.

At this point investment in mortgages may seem so complicated and so risky that it might appear wiser to put the money into the savings bank at 3% and forget about it. This may be the answer. The difference between 3% on an investment of $10,000 ($300) and 18% ($1,800) is substantial and it does not come easy.

The state in which foreclosure on a mortgage was described above is Georgia. The procedure is not cumbersome or lengthy. In some other states foreclosure takes a far longer time. In Michigan this difficulty in foreclosure was one of the reasons behind the development of what is called the "land contract."

If you hold a mortgage, either a first or a second mortgage, you have rights against the property owner in case he defaults on his payments to you. In Michigan if you hold a "land contract" you are the owner of the property, not the one living in the house who owes you the money. Since the property is technically yours, it is legally much easier for you to get the debtor off the property if he defaults. The law gives the debtor 90 days in which to pay off the property if you, the investor, bring the default to court. If the debtor does not pay you, you secure a writ of possession and then sell the property. Only if the debtor has paid off over one-half the purchase price can the procedure of eviction take more time than this. In this event the debtor is given six months to redeem his property instead of 90 days.

Although the nominal rate of interest is 6%, land contracts are sold at a discount like a second mortgage so that the actual yield can be as high as 20%. The holder of the land contract is at least nominally the owner of the property and it is he who is responsible for the first mortgage. Sometimes he gets a mortgage on the property himself, and sometimes the land contract is purchased by him with an already existing mortgage on it. When he takes over the property, however, he is responsible for the mortgage and must pay on it.

Although the nominal rate of interest is 6%, the discount is the thing that raises the real yield to high levels.

Only a few states have land contracts, and since investors obviously come from other states, a great service is performed by land contract servicing organizations which screen out the best of all land contracts offered to them, examine them and offer them to investors. They collect on them for the very reasonable fee of one-half of 1% per year.

A most important question to be answered in connection with land contracts or mortgages which are sold at discount is, "Since the nominal rate of interest is usually only 6% and rarely over 8%, and since effective rates of 12%, 15%, 18% or more are achieved through the discount at which the mortgage is sold, what determines the size of this discount?"

The over-all answer to this question is, "The more risky the investment the greater the discount as a general rule" The discount is greater if:

1. The mortgage or land contract has a longer time to run. Since you determine the effective rate by dividing the discount over the life of the mortgage, a 40% discount on a four year mortgage amounts to 10% yearly (40 divided by four years), but a 40% discount on an eight year mortgage amounts to 5% per year (40 divided by 8).



2. The contract is just starting so that there is no experience on how well the debtor pays and he has not increased his equity through payments.



3. The equity is a low percentage of the value of the home.



4. The first mortgage is a high percentage of the value of the home.



5. The second mortgage or land contract is a high percentage of the value of the home.



6. The home is in run-down condition.



7. The home is not located in the city or in a suburb, or is in a poor neighborhood or in one, which is declining.



8. There is no sewer or water or electric connection.



9. The buyer of the home has a poor credit record.



10. His earnings are low in relation to his home payments and other payments.



11. He does not have a long record of employment or employment in the same firm.

A small number of the organizations offering mortgages for sale will now be listed. Some of these sell mortgages on office and apartment buildings, com­mercial properties such as shopping centers and industrial plants. The type of investigation to make on such investments is exactly the same as described in this chapter in the case of residential mortgages, but is obviously harder and more complicated. The size of the mortgage is larger too, often very much larger, so that the time and effort required to make a thorough investigation are not only justified by the size of the investment and the size of the return, but are absolutely essential. The list of organizations that follow is a sample only, nothing more, but it does represent companies that are offering mortgages for sale, and they have been located from a mail survey by the author of hundreds of possible sources of investments.

Since we described land contracts last, we might discuss sources of these contracts first. There are a number of such land contract companies in the state of Michigan, and in Detroit in particular. They occasionally advertise in the papers and they can be found in the phone book under "Mortgages" or "Land Contracts/'

Melvin F. Lanphar and Company of 4711 Woodward at Forest, Detroit 1, Michigan, will send sheets of particulars on land contracts offered for sale, including the date the house was sold, the purchaser's equity, the mortgage, the discount, credit information on the debtor, construction particulars on the home and even a picture of the house.

Second mortgage offerings are made by the following organizations and it must be emphasized that these are only samples of firms making such offerings:

Lewis Steinfeld, 2145 White Plains Road, New York, N. Y.; An extremely large number of mortgages are listed with particulars in some detail by the Steinfeld organization.

Dorfman and Company, 1724 North Capitol Street, Washington, D. C, from time to time offers mortgages for sale.

John J. Young, 103 Fleetwood Terrace, Silver Spring, Maryland.

Al Friedman, 939 East Missouri, Phoenix, Arizona.

S. L. Hammerman Organization, Inc., 16 Park Avenue, Baltimore 1, Md.

United Mortgage Company, 212 South Fifth Street, Las Vegas, Nevada, offers second trust deeds yielding 10% to 12%.

The organizations, which sell high, yield first and second mortgage vary in the services they perform all the way from those whose function ceases com­pletely at the time they receive your check to those providing a full guarantee.

The Mason Mortgage and Investment Corporation at 729 Fifteenth Street, N. W., Washington, D. C, offers a second mortgage for sale yielding up to 10% which are guaranteed and thus backed by the net worth of the Mason Corporation.

Trustors' Corporation of 5400 Wilshire Boulevard, Los Angeles 36, California, offers for sale guaranteed first trust deeds and first mortgages. To a great extent trust deeds and mortgages are the same except that in states in which trust deeds are used (California and Nevada, for example) it is usually not necessary to go to court and have a court sale of the property conducted.

The company takes investments of a minimum of $1,000 and places the money in trust deeds. These are guaranteed as to principal and interest and all servicing is done by Trustors. Obviously if $1,000 is offered for investment it will not necessarily be put into a deed of trust amounting to exactly $1,000. This amount will probably represent a fractional investment in a trust deed of $1,750 or $3,280 or $4,600 or whatever deeds the company has on hand.

Trustors also has a whole note plan in which the investor owns a first trust deed on unimproved property or a second trust deed on improved property, in most cases a single family dwelling. These notes yield 10%.
While Trustors does not guarantee these notes, they point out that in the past they have not only paid for foreclosure proceedings, but have always repur­chased defaulted notes from the investor prior to the foreclosure sale.

We now come to first mortgages and first trust deeds:

The United Mortgage Company, 212 South Fifth St., Las Vegas, Nevada, offers first trust deeds as well as second trust deeds.

Jack Collier East Company, Inc., 313 West Second Street, Little Rock, Ar­kansas, offers first mortgages on shell homes to yield the investor 8%. The yield before the servicing fee is deducted is 9½%, and the servicing fee is 1½% per annum.

American Buyers Mortgage Company, Inc., 2001 E. Roosevelt, P. O. Box 30, Phoenix, Arizona, deals in both a first and second mortgage. The nominal per­mitted rate of interest in the State of Arizona is 8%, and some mortgages bear a nominal rate as high as this. These mortgages are often sold at a discount to yield higher rates. Some of the mortgages are on commercial properties and run to high figures.

Federal Housing Administration guaranteed first mortgages are offered for sale by the following organizations among others:

B. Ray Robbins Associates, Inc., 500 Fifth Avenue, New York 36, N. Y.—to yield 5% to 5¼% with minimum investment of $8,500.

Louisville Mortgage Service Company, 215 South Fifth Street, Louisville, Kentucky: 5½% with a discount of 1% to 2%.

Mortgage Associates, Inc., 125 East Wells Street, Milwaukee 2, Wisconsin: 5%.

Bryon Reed Company, Inc., Farnam Building, Omaha 2, Nebraska: FHA mortgages at 2% discount.

Gilpin, Van Trump and Montgomery, Inc., 301 W. 11th Street, Wilmington, Delaware.

Again it should be pointed out that the above listed companies are only examples of the many, many firms offering mortgages and other fixed obligations for sale. They are located all over the country and, of course, the first place to look for such offerings is in the investor's own city because this is the logical, convenient place to invest. Inquiries and investigations are easier to make and if there is trouble, it takes place where it is easy to handle.

FORM 1	FORM 5
FORM 2	FORM 6
FORM 3	FORM 7
FORM 4	FORM 8