Seller financing offers opportunities to home sellers, buyers, and investors. When done right, it can help affordable housing markets grow for buyers and create interest income for sellers. When note investors get involved, they can help note sellers find solutions to problems by providing liquidity.
But that doesn’t mean it shouldn’t also be profitable.
When investing in a note, note buyers look at various performance indicators, including down payment, payment history, property value, interest rates and their desired yield.
Interest Rates and Real Estate Notes
The interest rate, also called the note rate or face rate, plays a BIG role in helping investors determine the value of a note, mortgage, or deed of trust. Once created, the interest rate is set for the duration of the note. (It would take a formal modification to ever change the rate during that term.)
Ideally, that interest rate is fixed at around 9-10%. This helps protect the note as the market rates fluctuate.
Let’s look at interest rates in action for a real estate note.
Let’s say Bob decides to sell his home using owner financing. He creates a note for $100,000, with a 30-year term, monthly payment of $477.42, and a note rate of 4% (super low in today’s market). With those note terms, after the 30-years, the borrower pays a total of $171,871.20 — Bob received $71,871.20 in interest.
Now, let’s say Bob took our advice and kept the same original balance ($100,000) and term (30 years), but instead, he set the note rate at 9.5%, making the monthly payment $840.85. After the 30-years, the borrower paid $302,706 — $202,706 was made in interest.
That’s a $130,834.80 difference! This allows Bob to be compensated fairly for his risk at market rates.
That’s the benefit if Bob were to keep the note for the duration of the payments. But what if Bob wants to sell? He is getting older, and he doesn’t want to worry about collecting payments anymore. He would rather retire worry-free with extra money in his pocket.
So he sells his note. Enter the note buyer and yield.
What Yield Means for the Note Buyer
Yield is, by definition, the amount of income generated outside of the principal. Since it takes into account cash flow over time, it is also referred to as IRR or Internal Rate of Return.
For the home seller and note creator, the set interest rate is their yield. However, investors can choose their desired yield and invest accordingly. This allows them to make up for a note’s low note rate and also protect themselves from inflation and market changes.
Many investors look for a range of 10% – 14% yield for performing notes. Of course, this varies! For new notes, borrowers with a low credit score, or non-performing notes, investors adjust their yield and investment to value (OTV) to accommodate for the added risk.
Let’s take a look at an example of yield in action.
After five years of collecting timely payments, Bob has decided to sell his note at the 4% interest rate. Here is where the note stands now:
- Original Balance: $100,000
- Term: 360 Month
- Interest: 4%
- Monthly Payment: $477.42
- Payments Made: 60 (300 left)
- Unpaid Principal Balance: $90,447.20
As an investor, we are aiming for a 12% yield on this note. So, what would we have to invest to achieve that?
In our office, we are fans of the HP12C Calculator. Everyone likes their own financial calculator, but for this example, we are using the HP12C (you can blame Tracy).
Enter $90,447.20 for Present Value (CHS – PV), $477.42 for Payment (PMT), 4% for Interest (g – i), and solve for term (n), which is 300, and solve for Future Value (FV), which is -3.27 (the difference in the last payment).
Now replace the interest rate of 4% with 12% (g – i) and solve for the Present Value (PV). You get $45,329.22 — the amount you’d invest to get a 12% yield.
Net Yield vs. Gross Yield
Now, keep in mind that this is your Gross yield. Meaning that it is your yield without considering any of your fees or servicing charges.
In this instance, due diligence costs (BPO, Title Insurance, etc.) are $1,200. Additionally, you are going to set up the note with a third-party servicer to collect the monthly payments and keep track of the note, which is $25 per month. So, in reality, you’re spending $46,529.22 upfront and receiving a net payment of $452.42 for 300 months.
That brings your Net Yield after costs closer to 10.89%
The Importance of Setting Beneficial Interest Rates
This brings us back to Bob. When he sees the offer of $45,329.22 for his note with a remaining balance of $90,447.20, he has a bit of a fright. Surely it’s worth more than that?!
And to some investors, it may be. Remember, you’re playing your own game. If you are looking for 12% yields, that’s what you are looking for.
Remember, discount is the DIFFERENCE between what the face rate of this note is, and the yield requirement of the investor (note buyer). The larger the difference, the greater the discount.
But Bob is still scratching his head. This brings us all the way back to the creation of his note—and his chosen interest rate. Interest rates matter! As note creators, it’s important to create notes that create opportunities, and that includes for yourself. Setting yourself up for success starts at the beginning, and that includes starting with the interest rate.
Additional Note Investing Resources
Are you looking for more information on creating notes and investing in notes as a buyer or broker? We’ve got you covered!
