Not so many years ago with low interest rates in real estate, there was not a lot of news about owner financing. Banks and credit unions had scrambled to find more customers by lowering their lending criteria and competing on rates, so that nearly anyone could find a loan for their house or business somewhere. Then, the real estate crisis hit and banks were hesitant to lend money for anything that wasn’t practically gold-plated. The credit market was tight and foreclosures climbed for several years. During all of these economic cycles, owner financing continued to be used for the sale of real estate and businesses.
Owner financing is an excellent option that many sellers of properties and businesses use to create cash flow by creating a real estate note (also called a deed of trust note or mortgage note). After the property is sold, they can choose to keep the note or sell the mortgage note to a mortgage note purchaser. The reasons for using a mortgage note or deed of trust note vary, but include:
- attracting more potential buyers
- seller wanting to defer taxes on capital gains
- saving the banks’ high closing costs and fees
- creating more flexible terms and payment schedules
- dealing with weak buyer credit scores
- managing sales between family members or divorce agreements
Owner financed notes can vary, but always include an agreed upon term, interest rate, payment amount, and payment date on which the buyer of the property must pay the seller. The conditions are formally and legally written in a note.
Sometimes, the seller of the property would have preferred to have received all of the cash upfront. Even if that wasn’t the case at the beginning, circumstances may have changed or new investment opportunities may have appeared that cause the seller to need cash quickly.
The holder of the deed of trust note has the option of selling all or part of the note to one of the nation’s many mortgage purchasers. The value that would be placed on the note varies among many factors, with the most important being the amount of equity in the property (cash down payment plus principal payments received) and the credit of the buyer. The more equity and the better the buyer credit, the more that the note is worth.
So, if you or your client is creating a deed of trust note, here are some tips to maximize the amount that you would receive if you later need to sell it, as well as help protect yourself if you don’t:
- Obtain a good down payment. This means at least 10% for a standard house, and 20% for commercial properties, land, and mobile homes. These numbers cannot always be reached, so try to get as much as you can without putting the buyer into a financially precarious position.
- If you can, sell to a buyer with decent credit. A FICO (credit score) of at least 680 is preferable, though 625 or slightly lower is often adequate. You can sometimes still sell the note even if the buyer’s credit is below 600, but be prepared to take a larger discount, and recognize that everything else about the note will need to be solid.
- Ensure that the interest rate being charged is at least as high as comparable bank lending rates.
Other items that we consider to be positive when deciding whether to buy a note and how much to pay include:
- property is owner-occupied
- access to power, water, and roads (for land)
- in regard to commercial notes, multi-unit apartments or general purpose office buildings are easier to place than specialty businesses like restaurants. A note on a property that was previously a gas station or anything that could have adverse environmental consequences will be harder (though not impossible) to sell due to the potential liability
- the property and surrounding area being in good condition
You’ll also want to be sure that the sales price does not exceed the market value (if you might someday sell the note) and that the title to the property is clean.
If you have questions about structuring your note or potentially selling it, feel free to contact us anytime.