When creating seller financed notes, think like a bank or an investor.
- The Borrower is the most important factor. How invested are they in the transaction and will/are they able to make payments?
- Real estate loans have the security of being backed by a hard asset. Confirm the value of the property, and try to structure the deal so you as a lender are protected by as much equity as possible.
- Shorter term loans are best because early loan payments are mostly interest, and the value of the principal reduces over time (time value of money).
Want to know a secret about banks?
Banks make money because they give away money. That’s right. They aren’t valuable because we give them money. They’re valuable because they loan money to others.
Each bank loan becomes an asset. Those assets may be sold, or some remain on the bank’s balance sheet. The loan’s value is critical either way.
If you’re considering creating seller financed notes (there are many great reasons to do so), you should think like a bank, and consider the long term value of the asset you’re creating.
There are 7 factors to consider when offering seller financing:
1. The Borrower
This one tops the list for a reason: In lending, returns aren’t realized until payments are received. In other words, nothing will negatively impact the value of a seller financined note like a borrower who doesn’t pay.
Check the buyers credit score:
- Minimum credit score of 650 if they will occupy the property
- Minimum credit score of 675 if it won’t be owner-occupied
Beyond credit score, a credit-worthy buyer is one with current and stable income.
2. The Collateral
There are two important things here when offering seller financing:
- What’s the fair market value of the property?
- How quickly could be be sold?
If things turn south and your borrower doesn’t pay, then the property secures the loan. It’s value and how quickly it can be turned into cash are critical.
Fair market value when creating your loan is best confirmed by ordering a 3rd party appraisal. Save the appraiser’s report. Having one increases the value of your note.
How quickly a property can be sold is generally about demand. How quickly are similar properties in your area selling, and what are the overall market conditions? Is the local job market strong? Are more people moving into the area the leaving?
The property type also impacts how quickly it might sell. Listed in order from more likely to sell quickly, to least:
- Single Family Residences
- Single Family Residences with “Jumbo” loans – approximately $453K+
- Mobile Home + Land
- Land Only
3. The Down Payment
A 10% or greater cash down payment (15% or greater for non-owner occupied) from the borrower achieves a number of things:
- Your borrower has skin in the game. If they were to default on their loan, they’d be walking away from cash put into the deal.
- Loan to Value (LTV) – Consider a house worth $100,000, where the buyer puts down $10,000 and you extend a loan of $90,000. That creates an LTV of 90%. Should the property’s value fall, there would be a 10% cushion before the loan would be underwater. During the financial crisis of 2008/2009, houses in many parts of the country dropped by much more than 10%.
- Assuming your borrower’s down payment wasn’t from a generous relative or some other windfall, a borrower saving a down payment while covering other expenses shows they are financially disciplined.
The larger the down payment, the less risk to you as the lender, and the greater the incentive for the borrower to perform on their obligation.
4. The Terms
The terms when creating seller financed notes include:
- Principal – Sometimes referred to as Unpaid Principal Balance (UPB). Represents the property’s sales price, minus your borrower’s down payment, then factoring in further principal reduction from payments.
- Interest Rate – Target 9% or more. The higher the interest rate, the more valuable the loan will be. As of writing this article, banks are still offering rates at around 5%. However, as a private lender you aren’t spreading risk across as many assets as a bank, and your cost of money is higher. True if your borrower qualifies, they’d save money borrowing from a bank. But some properties and many borrowers don’t qualify for a bank loan. As a private lender you’re helping people who fall outside the “perfect” underwriting requirements.
- Term – The actual time until all money and interest is paid back. Sooner is better because money is worth less over time. As an example, $1,000/mo was worth more 20 years ago than it is today. 20 years into the future it will be worth even less.
- Amortization – You may choose to offer 30 year amortization, but that doesn’t mean you couldn’t write a balloon payment (see below) paying off the outstanding balance after 7 years. Without a balloon payment, ask for a shorter amortization and matching term – like 5 to 15 years.
- Balloon – Investors don’t want to wait a long time to get their principal back. A seven year ballon is reasonable, because there will have been 7 years collecting mostly interest with each amortized payment, then the remaining unpaid balance is returned.
5. The Pay History
A well cooked steak is good… but a well cooked and seasoned steak is even better. A seller financed loan is considered “seasoned” once there is history of on-time payments received by the borrower. Verifiable payments made to and reported by a 3rd party such as a licensed loan servicer are best, and will preserve your note’s value.
If you process payments yourself, save proof of payment records such as cancelled checks.
How many on-time payments until a loan is considered seasoned? It depends. if everything else is great – typically six months to one year.
6. The Paperwork
The ensure the value of your note, store original copies of:
- Promissory Note
- Security Document (may be a mortgage, deed of trust/trust deed, or land contract)
In addition, when buying an existing note, most note buyers will require a lender’s title insurance policy. This type of title insurance covers the note owner (including you) in case, due to a prior title issue, all or part of the loan’s unpaid balance is uncollectible.
Lender’s title insurance generally sells for a one time payment of 1% of the loan amount when the loan is originated – but much more after the fact, such as if you were wait to buy the policy until when you are selling your loan.
7. The Originator
While not always a requirement – ensure top value for your note by engaging a Mortgage Loan Originator (MLO) licensed in the state where the transaction will occur.
From the California Department of Business Oversight (each state varies):
A mortgage loan originator is an individual who, for compensation or gain, or in the expectation of compensation or gain, takes a residential mortgage loan application or offers or negotiates terms of a residential mortgage loan.
Your MLO will help you meet regulatory requirements by originating your loan, qualifying your borrower and providing required disclosure documents within the governmental mandated time frame.
While not currently required for one-off seller financed transactions, current US Federal regulations phase in after transacting more than one loan per 12-month period. State regulations may come into play as well.
Beyond the law, simply having a “compliant” loan increases it’s value.
When creating seller financed notes, perfection may be elusive. Don’t worry, and don’t let these factors discourage you from making deals. If you have questions, drop us a line and we’ll be happy to help.