What is the most common question sellers ask me about creating a note?
Answer: What interest rate should I charge?
This question typically comes from someone who perhaps has done or will do 1 or 2 owner carry back transactions in their lifetime. Many times, it comes after a transaction has closed, and the seller is telling me his logic for agreeing to the terms in the note.
My experience in this area finds sellers giving 1 of 2 reasons for agreeing to the “too low” interest rate in the note. One, they would look at the current mortgage rates lenders are charging. If a person can qualify for a mortgage loan and get a 3%-4% interest rate, the seller will use a similar rate for their note transaction. The logic is that if a bank is charging that rate, that’s what they should charge. The fact their buyer does not qualify for a loan from that bank is irrelevant.
The second most common logic for agreeing to a very preferential rate goes like this: “The buyer is a friend”, or, “The buyer is a family member”, or, “I’ve known the people for a long time and they are very good people.” So, there is no business logic behind the agreed to interest rate.
Interest rates of 3%-5% are commonly seen in note transactions. This year, I have closed 2 transactions where the interest rate was 0%. That’s right – 0% ! In each case, the buyer was a friend, and the seller wanted to accommodate his friend and make it easier for him to purchase the property. I understand the motivation. But, the reality is this – the buyer would not have been able to purchase the property unless the seller was willing to carry the paper. The seller allowed the transaction to happen. In return, the seller needs to be rewarded, if you will, for making this accommodation. And, one of the key ways for this to happen, is in the interest rate. A reasonable rate would be in the 6%-9% range – not a bank rate which the buyer does not qualify for, nor a 0% rate which offers the seller nothing for his acceptance of the inherent risk in owner carry back.
Plus, when the seller decides to sell his note in the secondary market, he now faces this reality: The industry is driven by discounting. Note buyers demand an interest rate return that is consistent with the risk assumed. If a note buyer seeks a double digit rate return and the note has a 0% interest rate, the seller is about to have a rude awakening when he receives the price offer for his note.
The bottom line is simple: If you are selling a property and creating a note to allow the deal to happen, you must be compensated for the risk you are taking, whether you keep the note to term or whether you decide to sell. Your key areas of compensation are a satisfactory down payment, a short amortization period, and an above market interest rate. This is a business transaction, and friendship aside, the parties must approach it as such.
