When an owner financed property is sold, a number of documents are created. Two of the most important ones are the purchase money mortgage and the promissory note (e.g. the note). A purchase money mortgage is a mortgage issued by the seller of the property to the buyer as part of the purchase transaction. The note has critical items such as the original amount, the interest rate, the term of the note is years or months, the due date of the payments, etc.
A common question that I get from note holders is why a note is discounted – meaning why they receive less than the current balance of the note. After all, they surmise, the note buyer gets back all of the principal plus the interest. They will also ask for the “average” discount in selling a note.
Factors In Discounting A Note
When evaluating and pricing a note, these are the main factors that we consider:
- Credit of the payer
- Type of property (residential, commercial, mobile home, land)
- Location of property (neighborhood, urban versus rural)
- Amount of down payment
- Amount of equity in the property (the difference between the property’s value and the total of all unpaid liens and loans)
- Condition of the property
- Interest rate on the note
- Timeliness of payments
Why A Discount?
When a note buying company like Seascape Capital purchases a note, they are taking on a lot of risk. Because we pay for the appraisal, title, and other closing costs incurred in the note purchase, we could actually lose money if the note paid off quickly. In most cases, the buyer of the note only sees pictures of the outside of the house or building. We are not able to see interior photos that could show improvements or damage.
A note with a low interest rate will get require a higher discount so that the note buyer can meet their return on investment requirements. Obviously, the buyer of the note would not receive the interest on the note if the property buyer stops making payments.
While we never buy a note with the hope or intention of foreclosing, we must recognize that it is sometimes the only remaining option after all other avenues have been attempted. Foreclosing on a property is time consuming and expensive, and the note buyer is not receiving any income during the process.
All of the above items add up to more risk. The discount is intended to offset some of that risk. Notes with negative elements like poor payer credit or little equity will be discounted more heavily than notes without those issues.
For instance, let’s assume that you have a $100,000 1st-lien note that is being amortized over 15 years at 4% interest. Six payments of $739.69 have been received, so the unpaid balance is $97,541.46. Here are two different scenarios:
|Scenario # 1||Scenario #2|
|Original note amount||$100,000||$100,000|
|Credit score of payer||700||600|
Clearly, the scenario in #1 is less risky than #2 because there was a bigger down payment and the payer’s credit score is higher. For the note buyer, this means that the payer is less likely to default, and that there is plenty of equity in the property if a default does occur. On #1, the note investor might decide that they need a 6% rate of return, meaning their offer price to the note holder to buy the remaining 174 payments would be $85,824.64. Note #2 is riskier, so the note buying company might require an 8% rate of return to compensate. They will only offer $76,036.96 to buy the rest of the mortgage note.
If the payer’s credit is 500 or the property value is lower than expected, the discount would be even steeper. In some cases, a note buyer will pass completely on the opportunity to buy a high-risk note.
Advantages To Selling A Note
Despite the fact that a holder of a note will need to accept a discount, there are numerous advantages to selling a note and receiving a lump sum of money now. These include:
- Being able to pursue other investment opportunities
- Simplifying the finances for heirs of an estate
- Not having to worry about property taxes, insurance, and maintenance on the property
- Less stress about whether payments will come in each month
All in all, selling a note can be a great way to get cash now and avoid potential headaches. Be realistic about the value of the property and the value of your note, and everything will go much more smoothly.