When a seller agrees to carry back a note in order to sell a property he owns, he should make certain demands in order to be compensated for the fact he is not cashing out in the transaction. These demands would typically fall in four main areas – the sales price, the down payment, the note term or the interest rate. There could be others of course, but the emphasis will probably be on one or more of these four.
I want to talk about the interest rate. I speak to hundreds of note holders every year, most of whom have carried back a note for the first time in their lives. Some of these folks received little or no guidance as they worked their way through something that was brand new to them. Some of them made serious mistakes and made themselves too vulnerable to the possibility of a foreclosure. If a person sells a property, gets no down payment and agrees to a “0%” interest rate, the seller has a tenant, who may be willing to move on at the first sign of some financial difficulty.( Yes I have seen notes with no down payment and no interest!). I would call this a serious mistake!
It appears to me that many “new” note holders decide upon the interest rate they charge like this: “Well, if my buyer could get a bank loan, the bank would charge him about 3% for his mortgage. So I feel I should charge him 3%, or maybe just a little more than that – 4% perhaps, 5% tops.”
Here is the issue: Your buyer can’t get a bank loan, so what the bank would charge him is irrelevant. You are now the bank, so it is up to you to determine the rules – ethically and within the law. When the bank grants a mortgage loan at 3%, they know everything about the borrower. When our note holder agrees to 3%, or 4% or 5% – he knows almost nothing. Typically, he has no idea what his buyer’s credit score or history is; he may not know how long his buyer has lived in the area; he may know what kind of work he does, but does not know his employer or how long he has worked for him. Sometimes, he is not sure who and how many people will be living in the home he is selling. Maybe he likes the buyer or got a decent down payment and so he agrees to sell his home.
This is the reality of a sizeable segment of the seller finance community!
Savvy note holders will negotiate a 7%-9% interest rate, which will also make their note more attractive to a potential note buyer, who, other things being equal, would be willing to pay more for this note. But, I have come to accept the fact that many note holders will be stuck in comparing the local bank’s prime lending rate to the rate the note holder feels is fair or right for him to charge. And, in today’s climate, it looks like 5% is the maximum, psychologically acceptable interest rate.
Okay, I get it. So let’s charge 5% and get our demands elsewhere.
One of the easiest things for our new note holder to do is ask what his buyer is paying for rent, arrange a monthly payment that is comparable, and then get his money back as soon as possible.
Let’s say the note will be for $100,000 at 5%. Take a look:
30 years $536.82
25 years $584.59
20 years $659.96
15 years $790.79
10 years $1060.66
If the buyer is paying $700+ monthly rent, maybe he can pay back the note in 15 years. If he is paying $1000 monthly rent, maybe he can pay the note down in 10 years. The seller does not have to automatically agree to 30 years because that is what the bank does. The seller is now the bank! So, if the buyer has a small down payment and unknown credit history – get the shortest term possible. Make this the demand to provide more security to the sale.
Seller financing is a wonderful tool, but it is loaded with risk for sellers who choose not to protect themselves.
