An owner financed mortgage note can be called a number of different things – purchase money mortgage, real estate note, promissory note, etc. The mortgage note is created when a property is sold using owner financing. A mortgage or deed of trust is generally created at the same time as the note, but the owner financed mortgage note shows how much is owed, who makes the mortgage payments, when they must make the payments, and what happens if they stop making mortgage note payments.
The owner financed note is a legal document that is signed by the person or entity buying the property. As it is a very important document, the seller of the property should put the original owner financed mortgage note in a secure location like a safe or a safe deposit box.
Why Create A Mortgage Note
Properties – whether they are residential, commercial, or vacant land – are generally sold to a new owner who is paying cash, getting a bank loan, or agreeing with the property seller to use owner financing. There are advantages and disadvantages with each method, which will be discussed later in this article. When using owner financing, it is important to create the mortgage note so that there is no misunderstanding between the parties and to protect the interests of each. Unless both the buyer and seller are real estate experts with a deep knowledge of owner financing, it is best to have an attorney or title company create the note and the accompanying documents.
Mortgage Notes and Business Notes
A note can be created for any transaction type where money is owed. As a child, I remember writing on paper an “I.O.U.” to friends stating that I owed them a dollar. In its simplest form, this was a type of note. Of course, as the dollar amounts increase and the transactions get more complex, a more sophisticated document is needed.
An owner financed note is used for real estate. The note states what is owed, while the mortgage or deed of trust makes the property the collateral that the property seller can pursue if the buyer does not fulfill his or her obligations. If the buyer defaults, the seller has the option of foreclosing on the property as a last resort.
Similarly, a business note is used when a business is sold and there is little or no real estate involved. Instead of a mortgage, a separate security agreement is attached showing the equipment and inventory that are the collateral. A business note transaction is usually higher risk than with an owner financed mortgage note because of the collateral involved. If the payer on a business note defaults, it may not be feasible for the note holder to seize the business.
Creating a Strong Note
When starting with an owner financed transaction, it is important to have a strong note. Beyond what was stated earlier on having a professional create the note, there will be less chance of default if the seller of the property can ensure these items:
- Be certain that your note and mortgage are in first (senior) position. A title search can verify that there are no other liens against the property
- Make sure that the buyer is a good credit risk by getting copies of their credit report and credit scores
- Try to get at least a 10% down payment – more for commercial properties and vacant land
- Be sure that the interest rate on the note is a little above the going bank rate to compensate you for your risk
- If possible, keep the amortization period (term of the note) to 15 years or less
- Go over the note with the payer to make certain that they understand their obligations and the ramifications of not fulfilling them
You can see an example of a good mortgage note, along with the advantages and disadvantages of owner financing, at https://seascapecapital.com/owner-financing-example/.
Rules To Know About – A Quick Primer on the Dodd-Frank Act
Following the 2008 real estate crash, a number of state and federal laws were created in an effort to head off future problems. The best known of these acts that came out of the crisis was the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created the Consumer Financial Protection Bureau (CFPB). It expanded upon existing consumer regulations pertaining to the training, licensing, screening, and compensation of mortgage brokers, banks officers, loan originators, and other lenders. The Loan Originator Rule, which most affected seller financing in residential transactions, went into effect on January 10, 2014.
In regard to owner financed mortgage notes, the Act does not apply to loans secured by commercial properties, rental properties, investment properties, or vacant land. It also does not apply to non-consumer buyers like corporations and LLC’s, or if the buyer does not plan on living in the property.
The Dodd-Frank Act does come into play on many other transactions where a loan is secured by a property that a buyer will be using for residential purposes. The Act defines mortgage originators as “any person who for direct or indirect compensation or gain or in the expectation of direct or indirect compensation or gain takes a residential mortgage loan application or offers or negotiates terms of residential mortgage loan.” The loan originator rules state that such persons must be licensed and follow certain guidelines. In some cases, sellers of a property using an owner financed mortgage note will need to use the services of a licensed mortgage broker. The Act applies only for loans on residential dwellings such as houses (including vacation homes), 1-4 unit apartment buildings, condos, townhomes, mobile homes, trailers, and even some boats.
The Dodd Frank Act does allow certain exceptions if the seller:
- Is a natural person, estate, or trust
- Owns the property that they are selling
- Was not involved in the construction of the dwelling
- Financed only one or three properties (depending on the exception used) in any 12-month period
- Does not have a negatively amortizing loan, and
- The financing has a fixed rate or an adjustable rate that resets after five or more years, and there are restrictions, limitations, and caps on rate changes and lifetime caps of rates
When using the three property exception, the seller cannot have any balloon payments and must determine that the consumer has a reasonable ability to repay.
The above is only a summary of the law. The reader is encouraged to contact an attorney for more specifics and to find out whether the law applies to his or her transaction.