The terms of owner financing dramatically impact the price an investor is willing to pay should the seller ever decide to sell their note, mortgage, trust deed or contract.  Use these optimum terms to structure a seller financed transaction for top dollar pricing.

• Down Payment – The more a buyer has invested in the property the less likely they are to quit paying, go into foreclosure, or just walk away from the property.  Ideally you would like to see 30% equity or down payment but realistically it will likely range between 10-20%.  Much less than 10% and investors will severely cut the investment to value, limit to a partial purchase, or decline altogether, depending on credit.

• Credit Rating – The credit report reflects the buyer’s past payment habits making it a good indicator of how timely they will pay the seller.  With the sub prime mortgage crisis, it is better to keep the buyer’s credit score above 625 with an ideal of 675 or higher.

• Interest Rate- The interest rate for seller financed notes should be 2-4 percent higher than traditional bank loans.  That puts an ideal interest rate between 8-10% for a standard residential home based on today’s market. Commercial or non-conforming properties would demand a higher rate.  Be sure to read the post on What’s the Big Deal with Note Rates? for more great details.

• Term – Interest Only payments are out. The best scenario is to require monthly amortizing payments with a balloon payment.  A payment schedule based on a 360 month amortization will keep the payment affordable for the buyer. While a 5-7 year balloon will shorten the term and minimize the discount effects to the seller that come from the time value of money.

One of the advantages with seller financing is that the terms are negotiated and agreed upon by the buyer and seller. Just keep in mind that if the buyer gains too many advantages, the seller will pay with a larger discount or longer holding time should they decide to sell their note.

Think of the negotiating process as balancing the scales.  If the down payment is higher, the seller might accommodate by lowering the interest rate.  If the credit is poor, a higher down payment and interest rate might be called for.  Just don’t end up with a zero down, interest only, poor credit note or the seller will struggle to find an investor even willing to make an offer.  Unfortunately these notes are much more likely to lead to a foreclosure situation that both a seller and a note investor want to avoid.

Would you rather have $97,000 to sell your $100,000 note or only $80,000?  The difference usually comes down to the big three. Here’s the three biggest mistakes note sellers make and how to avoid flushing money down the drain.

Mistake #1 – Failing to Check Credit

The payer’s credit report lets you know how timely they have paid bills in the past. This is a good indicator of how they will pay on a seller-financed note.  It also has a huge impact on how much an investor is willing to offer, should the seller ever decide to sell the note payments.  Sadly, many sellers never check credit when offering owner financing.

The solution?

Have the buyer fill our a simple one page application that grants permission to pull their credit upfront or ask the buyer to pull their own credit and provide the report.  Whenever possible, avoid accepting owner financing from any buyer with a credit score below 650 (above 700 is ideal).

Mistake #2 – Charging a Low Interest Rate

Money today is worth more than money tomorrow.  A simple look at escalating food and gas costs will show a dollar today won’t buy as much next year or the year after! This concept, known as the time value of money, plays a large role in investor note pricing.

All factors being equal, an investor will pay more for a higher interest rate note.  We’ve seen sellers charge 5% or less on notes.  Imagine the discount when an investor wants a 10% yield!

The solution?

Charge at least two to four percent above the standard bank loan rate for a similar loan transaction.  Be sure to take into consideration the credit, property type, and down payment, which may justify further increases in the interest rate.

Mistake #3 – Low or No Down Payment

The down payment determines how much equity the buyer has in the transaction.  The greater the equity, the less likely a buyer will default.  There is a reason banks require mortgage insurance whenever a buyer puts down less than 20%!

In desperation, some sellers will even accept a zero down payment.  Unfortunately, these buyers have even less at stake than a renter.  A renter at least has a security deposit along with the first and last months rent! 

The solution? 

Require at least a 10% – 20% cash down payment at closing.

So these are the BIG three when it comes to valuing a note.  Sure other things come into play (including property type, seasoning, terms, etc) but these are the three that impact pricing the most. 

While a seller might not be able to find a buyer that meets the ideal in each category, they can attempt to compensate for any deficiencies.  For example, a lower credit score might result in a higher down payment and interest rate.  A great credit score might result in a more favorable interest rate.   Just remember that when the buyer receives a break, it’s coming out of your pocket as the seller!

Keeping an accurate record of the payments received on the note shows how much the buyer still owes along with their payment habits.  Plus, note sellers can also improve the value of their note by providing a verifiable payment history to the investor!

There are two main ways to keep track of the payments.  The first and easiest is to let a professional handle it.  The payments are made to a third party servicing agent that keeps track of the balance and sends the money along to the seller.  They will also send out the annual 1098 Mortgage Interest Statements and can hold original documents in safe keeping.

If a seller chooses the “Do It Yourself”’ method over a third party pro they will need to follow these steps.

1. Place original note and other original documents in a safe deposit box.
2. Make a copy of each check or money ordered received (accepting cash is not recommended as the lack of paper trail makes it hard to verify).
3. Keep a copy of the bank record of deposit for the payments received
4. Create a ledger reflecting the date and amount of payments received
5. Calculate the amount applied to interest, principal, late fees (if any), and the resulting principal balance.  An amortization schedule or calculator can be helpful. Once calculated, record in the ledger.
6. Send out an annual statement to the buyer or payer along with the IRS1098 Mortgage Interest Statement.
7. Verify the real estate taxes and property insurance are being kept current.  Consider establishing a tax and insurance escrow wherein the buyer pays 1/12th of the annual amount into a reserve account each month.
8. Send collection letters as necessary for late payments.

When an investor agrees to purchase a note they will request a payment history.   A verifiable payment history can improve the value of a note as it provides proof of timely payments.  A payment history is considered verified when it is either provided by a third party or is backed up by the documents and records outlined.

Unfortunately many sellers fail to keep track of the payments received.  When they go to sell the note they try to recreate the history from memory.  Without any proof of payments received, an investor has to go on faith.   Sometimes a payment history affidavit can substitute for a payment record but it still doesn’t add the value of a verifiable proof.

Protect the value of the note by setting up a verifiable payment tracking method today!

The interest rate a seller agrees to accept when providing owner financing to the buyer has a large impact on the note’s value.  Unfortunately, many sellers overlook this important decision.  Here’s why the interest rate on a note is such a big deal.

Inflation Fighter

Each year it seems the cost to buy the basics just keeps going up.  It’s not your imagination; it’s inflation.  In fact in July 2008 that inflation rate was 5.6 percent higher than in July 2007 (based on the Consumer Price Index reported by the U.S. Department of Labor on August 14, 2008).  Worse yet, some basic items like energy increased 29.3% over that same time frame.

So what does inflation have to do with seller financed notes?  Well a seller would need to at least charge an interest rate equivalent to the inflation rate just to break even!

Return on Investment

Rather than just breaking even, a seller desires a return on their investment.  By accepting an IOU or payments from the buyer that money is tied up. Plus, once the property is sold the new owner will be the one to directly benefit from any increase in property value.

The seller is now acting as the bank and should expect a return at least equivalent to the interest rate a bank is charging for a similar loan.   The seller does not have the protection of private mortgage insurance that many banks require adding another level of risk that should be rewarded by an increased rate.

Since the buyer is saving the costs a traditional bank might charge for a loan (points, underwriting fees, origination fees, etc.) it is reasonable to expect them to pay an interest rate above what a bank would charge.  On average, it is recommended that a seller financed note carry an interest rate of 2-4% higher than bank rates to compensate for these matters.

Improves Resale Value

If a note holder ever desires to sell their future note payments for a lump sum of cash, they will quickly realize how important the note interest rate is to investors.

While investors look to a variety of factors to determine their pricing, all things being equal, a higher interest rate results in a higher purchase price from a note investor.

For example, a seller holds a note with a balance of $100,000 with monthly payments of $1,110.21.  If the note rate is 6% and the investor wants a 9% yield then the offer would be $87,641.  Now if the note rate were 4% the offer would decrease to $81,623, but if the note rate were 8% the offer would increase to $95,274.

For simplicity of comparison, these examples assume the monthly payment amount remains the same and there are acceptable credit, equity, and documentation.  But you get the idea, the higher the interest rate the more valuable the note.

There’s no Take-Backs!

The time to give serious consideration to the note interest rate is at the time of creation.  There are no take-backs or do-overs.  The rate you agree to accept at closing stays the interest rate for the life of the note.  The only way to change it later is to get the buyer to agree and execute a formal note modification.  It’s highly unlikely a buyer or note payer is going to agree to have their interest rate increased at a later date (unless there is some advantage to them).

Be sure to give the amount of interest charged on a seller financed note serious thought.  It will affect the value of your note not only today, but also far into the future.