Although many people are not familiar with it, owner financing and the use of notes has been around for centuries. Owner financing is used a small percentage of the time in real estate transactions, but it is by no means rare. Of course, most people are familiar with the common way of getting a bank loan to buy a house or building. With owner financing, a bank is rarely involved, though attorneys, appraisers, and title companies are part of the process.
Let’s say that Barb wants to buy a house from Joe. The reasons why they choose to use owner financing could be any of these:
- One or both of them have an aversion to banks
- Barb may not have a high enough credit score to qualify for a loan
- The property would be considered non-conforming by banks
- The parties desire to close quickly
- For tax or steady income reasons, Joe prefers to sell with owner financing and collect monthly payments
Joe and Barb agree to a sales price of $200,000, and Barb will put in a $20,000 down payment. An attorney prepares a note for $180,000 ($200,000 minus $20,000). The parties have agreed that Barb will make monthly payments over 15 years at an interest rate of 4%. By using a calculator, we can figure out that her payments will be $1331.44 each month to Joe. The attorney incorporates all of that information in to the note document, in addition to other items like due dates of payments and what happens in case of a default. Barb signs the note.
When creating the note, it is important that the monthly payment be affordable to Barb to minimize the risk of default. Equally important is that Joe is protected in the transaction and feels like he has a strong note. In addition to receiving a nice down payment, he makes sure that the interest rate is at or above market rates and that he is likely to be around for the full term of the note. That protects him in the future and will also give him a better price if he decides to sell the note and purchase money mortgage in the future. The attorney or an accountant makes sure that the note note is legal under the Dodd-Frank Act and the SAFE Act if the property is residential.
Like most things, there are advantages and disadvantages for both the buyer and seller when using owner financing. For the person selling the property (the note holder who will be receiving payments), the advantages are:
- Steady income
- There may be tax benefits
- Avoids the expense and hassle of using banks
The disadvantages are:
- Risk of default if the new owner stops making on-time payments
- Need to ensure that property taxes and insurance are kept up-to-date, and that he/she is shown on the insurance policy as the mortgagee
- Will want to make sure that the property is well maintained in case a foreclosure is someday necessary
- Could be additional expenses each month if using a servicing company
For the new owner of the property (the buyer who makes the payments), there are also positives and negatives. The advantages are:
- Avoids the hassle and expense of dealing with banks
- The note holder may be more flexible and forgiving with late payments
- Avoids PMI (private mortgage insurance)
The disadvantages include:
- On-time payments may not help the credit score of the buyer, as note holders usually cannot report payment patterns to credit bureaus
- The note holder may not respect or even know the rights of the property owner
As mentioned earlier, Joe may receive payments for a few months or a few years, and then decide to sell the note. As long as the payments have been coming in on time, Barb’s credit is acceptable, and the property is in good shape, a national note buyer will make a good offer to buy the note. Notes are always purchased at a discount – meaning that Joe will receive less than the current balance on the note. The amount of the discount calculated by the mortgage note buyer depends on the perceived risk of the note.
Let’s say that Joe has received 12 on-time payments, which puts the unpaid balance at $171,060.02. To buy the remaining 168 payments, the mortgage note buying company offers to pay $151,087.80, which provides a 6% rate of return. The real estate note buyer agrees to pay for all of the costs, such as a drive-by appraisal, title policy, and preparation of assignment documents. Joe accepts the offer, and sends copies of requested items like the note, closing statement, and proof of payments. Next:
- The note buyer orders and pays for a drive-by appraisal of the property by a local, independent company. This takes about a week in most cases.
- Once the appraisal is in, the note buyer requests a title commitment from a local title company. This also takes a week to a week in a half.
- The assignment documents are sent from the note buyer to Joe, who signs and returns them.
- Within one business day after the note buyer receives the signed documents, the funds are wired to Joe.
Hopefully, the above description will help you to understand the basics of owner financing and the steps in selling a note. To get other information or to ask questions about your situation, feel free to call us.