Seller Financing Part 1
Seller Financing Part 1 of 3: Guidelines For Note CreationBy Thomas J. Franklin
Notes are evaluated and graded in four areas. These areas are property equity, seasoning, the payor's credit history, and the payment history. If a person is looking to create a note that investors that purchase these types of investment vehicles would look favorable upon, the following guideline are suggested.
Investors look for at least 20-30% of real equity (down payment plus principle reduction) in a property. This minimum level of equity serves to help protect their investment. The 20-30% of real equity (down payment plus principle reduction) in a property is a rudimentary guideline, in the equity area of note evaluation, to reduce the amount a note would be discounted. The majority of Note Buyers will purchase notes with a 10% down payment.
Many Note Buyers will consider the Payor’s credit score closely because Credit scores are indicative of performance with past and current debts, so it makes sense to assume that a Payor who has been responsible in consistently paying back other debts will be a good note Payor as well. With seller-financed deals, most Payors will not have stellar credit, but most buyers still prefer Payor credit scores above 575. However, a higher interest rate may entice an investor to purchase a note with a payor having a weak credit history assuming the other areas that I mentioned above are strong. With that said, the minimum interest rate that note buyers will consider is 8%. Most notes that I have seen have an interest rate of 10-15%. A competitive interest rate is important because it will make it easy for the buyer to purchase the note and yield the desired profit without much of a discount to the Note Holder. ALWAYS CHECK THE STATE USURY LAWS, FOR THE STATE IN WHICH THE NOTE IS CREATED, TO KNOW WHAT THE MAXIMUM INTEREST RATE THAT CAN BE CHARGED.
A note’s “seasoning” describes the number of payments that have been made overall. The more payments that have been made, the more money the Payor has invested in the property; therefore, default is less likely. Most Note Buyers look for 12 or more completed payments, but exceptions are made for notes with a large amount of equity or a Payor with a high credit score. I have sold notes with as little of 6 months of seasoning. In such cases, all payments were made on time during this six (6) month period.
Please keep in mind that people typically prefer notes that follow a traditional term (amortized over 120 months, 180 months, 240 months, etc). A two-year, interest-only balloon term is a perfect example of a note that many buyers would avoid. But remember, all notes are good notes at the right price. However, with the Dodd-Frank Law, a 30 Amortization Schedule is required, for seller financed Single Family Homes. The Dodd-Frank Law's Amortization Schedule Requirements does not apply, to Residential Multifamily Properties: Duplexes, Tri Plexes, and Four Plexes.
The note payment history takes any late payments into consideration. Understandably, most buyers prefer a consistent on-time payment history. Perfection isn’t required or expected - one isolated occurrence of a missed payment a few years ago won’t necessarily dissuade a potential Note Buyer. Sufficient equity also serves to counterbalance a history of occasional slow payment.
Of course, there are no absolute guarantees of a quick sale. But it is always easier to obtain an attractive offer for the Note Holder when the note is written with the buyers’ needs in mind. Please keep in mind, that structuring a note with the intention to sell is all well and good, but if the payor cannot afford the monthly payments, then you may face the possibility of having to foreclose. Therefore, you may need to find a balance between the two. The points described here are only a rudimentary starting point for note creation; buyers often examine many other factors.
I hope you found the above information valuable and would enjoy receiving your feedback.
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