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The
easiest way to explain how seller financing works is by way of example. This
approach strips away all of the terminology and mathematics, leaving the stuff
that matters. Keep in mind that we protect the confidentiality of all of our
clients, so we'll change their names below.
Note
Creation
Two
years ago, in the spring of '94, a client of ours, Mary, decided to put her
house on the market. Mary and her REALTOR(TM) tried many approaches: that weekly
TV program, fresh cake at the open houses, even that new-fangled emerging
technology called the World-Wide Web.
Eight
months later, Mary meets a young executive, Bill. Bill and his family are moving
to this area from the other side of the country. He and his wife absolutely love
the house. One week later, they and Mary agree on a price of $140,000. Bill
writes a deposit check for $5,000. He pledges a total down payment of $40,000.
Let's
quickly review the basic mechanics of the normal real estate transaction:
traditional financing. The buyer pays the seller a substantial down payment. The
buyer then applies to a bank for a loan. If accepted, the bank pays the seller
the rest of the money for the house, and the seller transfers the house to the
buyer. At the same time, the buyer gives the bank a promissory note (an I.O.U.),
which indicates that s/he will pay the bank every month for a given number of
years.
The
Realtor starts to arrange financing for the remaining $100,000, only to find
out: uh, oh! ... This young executive, who previously had a salary in the mid
six-figure range, recently left his employer to start his own consulting firm.
Bill's wife and two kids were at the Airport Hotel waiting for the house to
close.
Guess
what! The bright young executive, even though financially quite capable, can't
qualify for a mortgage. He was new to this area and had no verifiable
employment. Even with $40,000 down, no lender would qualify him. ... The sale
started to crumble.
The
Realtor then suggested to Mary that she offer seller financing. After thinking
about it, and all of the time and effort spent so far marketing her house, she
reluctantly agreed. Mary got the $40,000 down payment, and she took back a
mortgage note from Bill. Bill and his wife promised to pay Mary an additional
$100,000 principal over the next 15 years, at an interest rate of 10%. Their
monthly payment is $1,074.61.
Mary
is happy: In January of '95, the house is finally sold. Bill and his wife are
happy: they finally left their hotel room and started to unpack all of those
boxes. The Realtor is happy: she finally got paid for those eight months of
work.
Here
are the basic mechanics of seller financing. The buyer still pays the seller a
substantial down payment. The seller then accepts a loan from the buyer
directly, and in exchange, transfers the house. There's no bank, and the seller
just takes back the promissory note instead of the full cash amount. The buyer
is agreeing to pay the seller directly every month.
Note
Basics
About
20% of the houses sold in the U.S. involve some form of seller financing; one in
five mortgage notes created are privately held.
The
legal contract containing the terms of the loan is called a promissory note. It
is also known as a mortgage note, a trust note, or a purchase money note. It
specifies the principal amount, the interest rate, and the timing of the
payments.
The
promissory note is collateralized, or secured, by a second document. East of the
Mississippi, the security is a mortgage deed. The mortgage allows the seller to
foreclose on the property in case of default.
The
payor, the person making the payments, is called the mortgagor. The payee, the
person receiving the payments, is called the mortgagee.
An
easy way to remember this is that the words "payor" and
"mortgagor" end with the letters "or", just like in the word
"door". The mortgagor lives behind the door of the house, and makes
his/her payment each and every month in order to keep it that way.
In
the Western part of our country, we have trust deeds as collateral. The payor is
called the trustor, and the payee, of course, is called the beneficiary. (huh?)
(There is a third party, called the trustee, who holds the deed to the house,
and is bound to give it to the appropriate party, because there are only two
possible outcomes to a promissory note. Either the payor makes their payment
each and every month, on time... or they don't.)
There
is a third instrument used primarily in the mid-West called a land contract or
an agreement for deed or a contract for deed. The property is not legally
transferred until all of the payments have been made. Just to keep things
simple, the payor is called the vendee and the payee is called the vendor. (Hey,
we didn't make up the rules; we're just reporting them.)
The
ideas in each case are the same; the legalities vary from state to state.
Full
Purchase
Back
to our story. Let's fast-forward one year. It's now January '96. Bill and his
wife have paid Mary twelve payments of $1,074.61, a total of $12,895.32. That
$100,000 balance on the note has shrunk all the way down to a mere ...
$96,968.22. Now, Mary has decided to invest in a restaurant franchise. She had
liquidated as many assets as she possibly dared, and she still needed an
additional $80,000. A friend suggested that she call us, and we explained to
Mary that we could get her the money she needed. A promissory note is a
negotiable instrument. Mary sold her note, and instead of waiting fourteen more
years to get her money, we handed her a certified check for $83,109.76. Mary was
thrilled -- she even baked us one of those cakes that she had been making for
the open houses.
The
seller was holding a promissory note that entitled her to receive monthly
payments from the buyer. In this case, the home buyer was doing just that: he
was making the payments. When the NoteBuyers buy the note, they pay the seller a
lump sum of cash, and the home buyer is now obligated to make the monthly
payments to the new holder of the note. (The terms don't change, just the name
and address on the check.)
Hey,
wait a second! We just said that the amortization schedule stated a note balance
of $96,968.22. How come a $97k note was only worth $83k?! Why is there such a
difference? Why is there a discount?
Let's
consider: Before Mary sold the note, did she have the right to force Bill to pay
off the balance of the note in full? Could Mary force Bill to pay off some of
the loan early, or to make extra payments? No! She did not have the right to
force Bill to pay off, therefore she cannot sell the right. Mary only had the
right to receive $1,074.61 a month for the remaining fourteen years. Money in
the future is worth less than money today.
Why
is that? Two reasons, really: Inflation... and risk.
Inflation
If
you were offered the choice of a $5 bill or a $10 bill, which would you choose?
If the choice was $5 now, or $10 in ten minutes, you'd still probably take the
$10. Now, what if your choice was $5 today, or $10 in fourteen years? Money in
the future is worth less than money today.
Think
for a moment how many bags of groceries $100 will buy today. OK. How about ten
years ago? How many bags of groceries could you buy for $100? What about ten
years from now? Think about the number of bags. Money today is worth more than
money tomorrow.
Historically,
our inflation rate has averaged out at around 7%. At 7%, your money doubles
every ten years. Thirty years ago, our parents might have bought a house for
$15,000. Thirty years; three doublings: 2, 4, 8. Today, that same house could be
worth about eight times that price, about $120,000.
But,
that also works the other way. A fixed amount of money drops in value. Your
purchasing power is cut in half every decade. A thousand dollars in ten years
will only buy as much as $500 will today. In other words, a thousand dollar
payment in ten years is worth $500 present value. Inflation.
Why
was that note sold at a discount? Inflation is one reason.... Another is risk.
Risk
What
are the risk factors found with real estate mortgage notes? The biggest
concerns, of course, are collection problems, or even outright default. Can't
the note holder foreclose on the property? Yes... but it is rare that the
property is foreclosed at full value. Consider that the FHA currently gets only
61 cents on the dollar for foreclosures.
This
is another reason why the note is bought at a discount: the note buyer is paying
money up front for future payments that may never come.
There
is also the possibility that a property's value may decline, or be completely
destroyed. We've all seen the TV news pictures after hurricanes, earthquakes,
tornados, fires.... Those homes belong to ordinary people -- folks like you and
us.
Risk
Example
Let's
take a typical thirty year mortgage -- that's 360 payments.
There's
a pattern here. Of course. Bill doesn't want to lose his house!
-
Payment
#100; 8 years. Bill loses his job; he's out of work for 3 or 4 or 5 months.
There's a little glitch in the payments. No biggie.
-
Payment
#200; 17 years. Bill's wife needs hospitalization.... She stays for a
while.... Those medical bills are pretty hefty.
-
Payment
#300; 25 years. Bill dies....
All
of these issues go through a buyer's mind, or should go through their mind, when
he or she buys a note. Inflation and risk. This is why mortgage notes are valued
at a discount to their face amount.
The
example above shows the home seller holding the note for some time before
selling it. There's another way to do this, however, called "simultaneous
closing". Here's what happens: The buyer pays the seller a substantial down
payment. The seller then accepts a loan from the buyer directly, and in
exchange, transfers the house. At the settlement table, once the home seller
takes back the promissory note, s/he then immediately sells it to the
NoteBuyers. We accept the risk of the buyer's default, and the home seller walks
away from settlement with all of the money.
Partial
Purchase
We'll
close with a fun topic. Think what you would do if we handed you a check for
$20,000. What would you do with the money? Invest? Pay off debts? Travel? Buy a
car?
Let's
take our example with Mary. Instead of selling her entire note, let's say that
she only wanted enough to buy that car. Remember, she has a note with a balance
of $96,968.22. We could buy what's called a "partial" cash stream. In
this case, we would buy the right to receive the next 24 payments. We pay Mary
$20,753.05. For two years, we collect the monthly payments. In two years, the
note would go back to Mary, and it would still have a balance of $89,919.02. She
would then resume collecting those monthly payments of $1,074.61 for twelve more
years.
Conclusion
How
can you use a promissory note to help you sell your house? You can sell your
house faster if you increase the size of the pool of potential buyers. One way
to do this is to offer seller financing, just like Mary did.
When
you create the note, there are some things to keep in mind which will help you
increase the value of the note. If you hold the note, the paper will have a
higher value to you. If you sell the note, you'll get a higher price from the
buyer.
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