Evaluating potential foreclosure losses.

Many people are scared of investing in mortgages in case the borrower does not pay and they have to file a foreclosure.

This is a perfectly justifiable fear so let's look at the risk of loss.

Assume the property is worth $100,000 and you have loaned $75,000 against it at 14% per year, interest only or $875 per month. The borrower stops making payments. It costs you $1,800 to foreclose the loan in legal costs plus you have lost interest on your money for the 4 months it takes to foreclose the loan, thus 4 times $875 = $3,500.

Assume that you get the property back it costs to $1,000 to clean it up and remove trash and another 2 months to sell it at a bargain price for a quick sale. (2 months loss of income = $1,750). Let's say you get only $83,700 after selling expenses for a property worth $100,000. Now how much have you lost?

You invested $75,000 + $1,800 + $3,500 + $1,000 +  $1,750=  $83,050. So you end up with a small profit of $650. Not a lot but it beats a loss. Plus you have got 100% of your money back including lost interest and legal costs.

The situation changes if you have lent more against than 75% against the property, or it costs you more than $1,000 to clean it up and remove the trash.

But remember, not EVERY mortgage will go into default. With at least a 10% cash down payments, past history has shown it is likely to be less than 1 in 20. But let's be pessimistic and assume it is 1 in 10.

Assume you own 10 identical  mortgages similar to those above. Let's say that 1 in 10 go into foreclosure and on that one you end up losing 10% of the money you have invested. What has actually happened is that you have reduced your yield on your portfolio of 10 mortgages from 14% p.a. to 13% p.a. (Approximately). Is it still worth it? Is this as good or better than you would make in other investments?

Download Excel® compatible spreadsheet for foreclosure loss evaluation. This is a compressed file in ".exe" format, it will decompress when you double-click on the downloaded file.

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