How to Originate the Most Profitable Note

Michael
September 5, 2020
5:16 pm

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Advice, Intermediate, Selling, Tips

The key theme you will see in this article is to keep the interest rate high, get a down payment at the purchase, and keep the balloon short.

If you are thinking about selling your property with owner carry back financing, you will want to create the most profitable and marketable loan possible, just if you ever need to sell your note. A lot of the information in this article is my personal opinion. If another note buyer is asked their opinion, they most certainly will have a different view than I do. The key theme you will see in this article is to keep the interest rate high, get a down payment at the purchase, and keep the balloon short (see my disclosure below), but not too short. Personally, my preference is what I call the 10; 10; 10: get a 10% down payment, charge a 10% interest rate, and set a 10-year balloon (15-20 year amortization would be best, but a 30-year amortization is acceptable).

Contained in this article is my personal opinion for note structures. I am not your attorney or CPA; please seek counsel before making a decision you will have to live with for the mortgage life. The laws in your state could differ, and there is a great deal of consumer mortgage law that could apply or change the loan’s decision/structure.

You must take great care in forming your opinion on how to originate best your seller-financed note. Don’t let personal feelings hurt or hinder you for 20+ years. You could quickly be dealing with a HUGE problem for 20 years if you do not originate from your loan property and under reasonable terms. Can you imagine having to call and collect a late mortgage payment for 360 months!! I hope you find this article helpful and informative. Below are my six categories you need to consider.

Let’s get started!

» 1. Borrower’s Due Diligence

YES, just like a bank, you need to look into your prospective borrower’s financial position. Before signing a 10-30 year contract with someone, you need to know as much information about them as financially as possible. Below are a few of the items you would have, understand, or consider before agreeing to loan terms.

Did you pull a credit report on your prospective borrowers?

How is their credit?
How many charge-offs do they have?
How many accounts have they paid timely
What is their overall score?

What is your prospective borrower’s monthly income and from what sources?

How much income does your prospective borrower bring home each month?
How many monthly debt payments do they have to pay?
What are their total monthly debt coverage / load?
Did you collect pay stubs or W-2s?
Is their income salary, hourly, or commissions?

Employment?

How long have your prospective borrowers been employed at their current place of employment?
How long have they been employed in their field of work?
Are they long-term and essential to their employer?

Criminal History?

Did you perform a background check on your prospective borrowers?

Prior History?

Have your prospective buyers had any judgments or child supports issues or other public filings?
Have they had a previous foreclosure?

» 2. Required Down Payment

Most note buyers want to see some type of a down payment applied at the purchase of a house. The down payment implies the borrowers have some “skin-in-the-game” and do not want to walk away from home. You will need to have a significant down payment or a large number of months paid on the mortgage to have a black mark on your note later. How much of a down payment is needed? This is your call, but you have to blend a buyer’s ability to come up with the funds to close compared to their willingness to stick around. I prefer seeing 10%+ of the purchase price, a minimum of 5%.

» 3. Interest Rate

What interest rate are you going to charge your borrower? I bet your first thought was well, the banks are charging X%, right? The interest rate you set should be considerably higher than what the banks are charging for a mortgage. If your borrower could get a bank loan, I guarantee you they would have already done so.

Another way to think about this is where do bank get their money? Banks obtain their funds from either issuing bonds or borrowing from their depositors. Where did you get your money to be able to finance this house? You worked for it, RIGHT! Do you think you should charge more for your money?

So what is a reasonable interest rate? I would say you should be greater than 6% and no more than 10% for today’s market. This is a broad range, and the house and the quality of your borrower will move your interest rate based on the risk.

» 3. Balloon Payments

Should you have a balloon payment on the mortgage, your issue? I would. (Check your state and national laws) I believe you need to weigh the expense of renewing the loan compared to keeping the term short. Time value of money (TVM) comes into play when considering a balloon payment. The further out and the more monthly payments your note has, the less valuable it is; a dollar 30 years from now has far less value than a dollar in 1 month.
Another thing to consider is, do you want to be hitched to a poor decision or problem borrower for 30 years? Or do you want a set time to get off, if needed? I prefer ten years; I think it is a right blend between long enough to get off (if required) and not too long you are renewing the loan every time you turn around.

Balloon payments are small payments made monthly, but are finalized early by one large payment.

» 5. Amortization

The amortization is the length of time in which the loan is repaid over. Typically an amortization is set between 15 to 30 years. When looking at a loan value based on a Time Value of Money (TVM), the further out it takes to recoup the principal investment, the less valuable the loan is. This goes right back to the original statement of a dollar 30 years from now is not as valuable as a dollar received next month. The same loan on a 15-year amortization has far more value than a loan on a 30-year amortization. My advice is to pick an amortization as short as possible (within reason) and balance that amortization with a payment your borrowers can afford.

» 6. Other Terms or Conditions

Below are a few terms and conditions I would include in all of my loans originated:

Require escrow of property taxes and insurance (or at a minimum, include the right to advance and establish escrow if the borrowers do not honor their responsibilities)
- Nothing is worse than to have to chase a borrower for unpaid property taxes and property insurance year after year.
Include a late fee. The standard fee usually is 5% of the payment amount if the loan is paid over ten days past due. This helps to encourage prompt payment and will recoup expenses spent in collection efforts.
Include default interest. Default interest accrues at a higher rate if terms or conditions in the note are not kept and maintained.
Have a REAL ESTATE attorney draft all your documentation. An attorney should draft all your documentation. There is a difference between attorneys and an attorney specializing in lenders docs, and real estate should be used.
Close at a Title Company and buy a Lender’s policy. The title company specializes in ensuring the property title does not have any impediment and will issue insurance on the transaction and property title. Additionally, the title company will disclose all the fees being paid by each part.

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How to Originate the Most Profitable Note

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