Calculating the payment needed to cover just the interest on an owner-financed contract or promissory note is simple. Just follow three easy steps and avoid two common pitfalls.
Follow 3 Easy Steps To Calculate Interest Only
Step 1: Obtain the current principal balance and interest rate from the land contract or promissory note
Step 2: Times the balance by the interest rate
Step 3: Divide by 12
In fact it is so simple you don’t need the best financial calculator, any standard calculator will suffice.
Here are the steps in action:
Step 1: A seller-financed note has a balance of 100,000 at 8% interest
Step 2: $100,000 x 8% (or .08) = $8,000 (interest for the year)
Step 3: $8,000 divided by 12 = $666.67 (monthly interest only payment)
What It All Means
If the buyer pays just the interest every month then the balance stays the same and does not decrease.
If the buyer makes a payment that is more than the interest only portion then there is a principal reduction and the balance goes down.
Unfortunately there are three common mistakes people unknowingly make with interest only (I/O for short) payments.
3 Mistakes With Interest Only Balloon Notes When Owner Financing
Big Mistake #1 – No Balloon Mortgage Date
When a note calls for interest only payments the balance does not amortize. This means the repayment terms must state a date in the future when the full balance will be all due and payable.
When a note amortizes a portion of the payment goes to interest and a portion goes to principal. Each month the balance goes down and the note eventually pays off.
With an interest only payment there is no application to the principal. That means if the note fails to include the balloon date then it would never have to be paid off! Sellers and note buyers alike want to know that the buyer will eventually have to pay for the property they purchased.
Big Mistake #2 – No Equity Build
Since the payment is only covering the interest the buyer is not building equity through amortization. A buyer without equity or “skin” in a property purchase has a much higher likelihood of both delinquency and foreclosure.
This high risk factor can be offset when a buyer makes a large down payment at closing. On the flip side the risk is increased when a buyer makes a low or no down payment with an interest only repayment plan.
If values decline it can quickly lead to the buyer being underwater, owing more than the property is worth.
In the current market an amortizing payment is preferable to the majority of note investors.
Big Mistake #3 – Buyer Can’t Make The Balloon Payment
Eventually the balloon payment will come due. It’s important to ask, will the buyer realistically be able to make the balloon payment when it comes due?
To make the balloon payment they will likely need to obtain refinancing in the future. Will they be able to afford going from interest only payments to a potentially higher amortizing payment that includes principal and interest?
What about equity? It can also make it hard for the buyer to obtain refinancing when the balloon is due if they haven’t built any equity.
You want to set the buyer up for success when selling with financing.
Also consider whether the buyer is living in the property as their home or is purchasing as a rental for investment. The introduction of the Dodd Frank Act in 2014 put some additional requirements on sellers offering financing to owner occupants with balloons depending on the entity and number of times offering seller financing in a year. It is now more typical to see balloon notes on investor deals or hard money loans.
Are you a buyer looking to purchase property with seller financing?
A seller that wants to create notes with owner financing?
A finder that wants to earn money referring deals to note investors?
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