Trust Deed Investments

What Makes a Good Note? 

"How to structure your note to sell"

By: Randy Wilkins Trust Deed Investments What Makes a Good Note

The value of a private real estate Note and Mortgage, Contract for Deed or Land Contract depends on a number of economic conditions supporting the value of the collateral; and most importantly the structure of the financing (interest rate & terms).

Collateral:

An owner-occupied single family home in a good neighborhood is the best collateral possible. A payer who has a good to excellent credit record and an on-time payment history further enhances this note.

Less desirable;

  • Owner occupied duplex's or triplex (owner lives in one unit). 
  • Non-owner-occupied single-family houses. 
  • Non-owner-occupied duplex's or triplex's. 
  • Other non-owner-occupied multi-family units. 
    • Commercial (non-industrial) properties. 
    • Resort properties; subdivided but unimproved lots. 
    • Improved land 
    • Raw land 
    • Industrial properties and properties with underground fuel tanks have many hidden liabilities. Notes secured by such properties are avoided by all but a select few investors due to potential HAZMAT issues.  

Rate and Terms:

Buyers and sellers agreeing on an appropriate interest rate is the single most important aspect!  Remember institutional lenders have unlimited resources from depositors and the federal government at less than 1% interest; as private citizens we do not have those advantages.

I can't remember the last time someone was stuffing money in my pocket at .2% interest can you?

Some may disagree with this observation however the interest rate should be 9%-10% proportionate with the risk.  For example if you have a buyer who obviously has very good credit and comes in with 50% down payment can you give them 6% interest?  Sure, it's your note you can do anything you want; but I'm going to suggest you don't try and compete with institutional lenders. Also, unless you want to be a long-term note holder don't make the rate so affordable that your buyer has no motivation to look for permanent long-term financing.

Remember as we all know most seller financed transactions are simply not that good. In this economy the cost of money in the private sector is typically 10% or greater this fact has a significant impact on what any buyer will pay for your note; this contributes to the discount.

The second most important aspect is the term; the average lifecycle of home ownership is less than five years (according to the national Association of realtors) when you structure a note with a 30 year term we must discount that note for the entire 30 year term; this contributes to the discount.

If the buyer has little or no equity in the property, the loan-to-value ratio is a barometer of the likelihood of default. A property purchased with seller financing with a very low down payment $1,000 or less) typically have higher default percentages; this contributes to the discount.

Obviously the higher the down payment the better.

An amortized note is more preferable than one with a short-term balloon, as the concern is the payers may not be able to make the balloon payment. Extremely short-term balloon payments (less than five years) are affectionately referred to as foreclosures in embryo.

A very important financial aspect determining the value of a note is the amount of the monthly payment and the term; there is a very delicate balance between these two aspects. For example, all else equal a 10-year note with a large monthly payment and no balloon is worth more than a 10-year note with a smaller monthly payment and a balloon.

A 30-year note with a 10-year balloon is more valuable than a 30-year note with No Balloon because of the time value of money. The longer the term the less valuable the payments become; this contributes to the discount.

Make the payments manageable for the buyer, but not "comfortable." Again if they are comfortable with the rate and terms of your seller financing they have 0 motivation to ever pay you off they will gladly use your money at a low interest rate for a long time. The term needs to be long enough for the buyer to refinance or sell the property; however not too long to severely diminish the present value of future payments.

 

A seasoned note; one with a payment history of several years or more is better than a green note (little or no payment history). The lack of seasoning and or payment history on a new note can easily be offset by the information you obtain during the sale process of the home. For example if you ask for a verification of rent, your buyer will gladly accommodate you (this can be beneficial because they are paying someone), if they are making that payment on time it's reasonable to assume they'll make your payments on time. Verification of rent and verification of employment are two items every mortgage lender always asked for, why don't you?

The payers credit history or credit score is important to help determine the character of the payers and likelihood of default, but it is not infallible.

Everyone, even those with the best credit, can lose their incomes, have medical emergencies or suffer other unforeseen catastrophes. The best use of a credit report is to identify a potential bankruptcy candidate.

 

For More Information on Creating a Marketable Note

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