What Is A ‘Scratch & Dent’ Mortgage Loan Note?

Jul 22, 2021

What are ‘scratch and dent’ mortgage loans, and are they good investments?

There are a variety of classifications of mortgage loan notes available to investors. How are these loans different? What makes them appealing to investors?

Common Types Of Loan Notes For Investing

The most common classifications of mortgage notes for investors are ‘performing’ or ‘non-performing’ (also known as NPLs). 

Performing loans have met all of their compliance criteria, have been paid on time, and are sold at the highest premiums.

Non-performing loans are not performing as they should. Borrowers are late on payments, or are in some stage of default. That doesn’t mean that they cannot be resurrected. Yet, in this state, they are sold at the deepest discounts, and in turn can often prove to be among the most profitable. 

Scratch & Dent Loans

This is another classification of mortgage notes that is often overlooked. 

These may be under-performing loans, re-performing loans, or have minor flaws. 

In turn, these loan notes are typically sold at discounts. Not as deep discounts as NPLs, but in turn they carry less risk, and in pools may prove to offer great overall yields. 

There are several reasons that loan notes can fall into this category. They may have had a single late payment in the past couple of years, but may now be current. Or they could have had rolling 30 day late payments, but never fell into actual default. 

Loan notes can fall into this category due to flaws in the paperwork as well. There could be errors in documentation. Quality control may have found compliance issues after the loan was closed and funded. Appraisal flaws may have been found and LTVs may be off. 

Credit deterioration is another reason notes fall in this bucket. A borrower who had a 720 credit score two years ago, may have gone through a crisis like the pandemic or medical emergency in the family. They may have temporarily loaded up their credit cards, crushing their scores. Though they may have plenty of equity, other assets, income and cash in the bank to clear those debts and see their scores rebound. 

Investing In Scratch & Dent Mortgage Loans

These can be good loans for investing. The discounts may be more modest, but they are often not bad loans. Borrowers are typically trying to pay, may have had a temporary issue, and loans can be made reperforming or performing with time and workouts, increasing their value and yields.

Investment Opportunities

Find out more about investing in secured debt and real estate, go to NNG Capital Fund

Image by Ulrike Leone from Pixabay