Why create promissory note? Over the past ten years, the criteria for individuals and families to purchase a home has become overbearing as regulations have tightened credit markets. Banks and credit unions have stiffened the lending standards, in order to decrease the foreclosure percentage. Because of this difficulty in acquiring financing many families and individuals have turned to owner financed real estate to either buy a home or sell a home and thereby creating a promissory note. Once a real estate owner sells a home by creating a real estate note they have a choice to keep the note and collect the payments or sell the note to a mortgage note buyer.
There are many reasons for utilizing owner financing which include:
Access to a larger pool of available candidates to purchase the home
Savings from eliminating cost on closing fees through a conventional lender
Ability to create more flexible terms and payment schedules
Flexibility to work with individuals with lower credit scores
Orchestrate sales between family members, or settle divorce agreements
When creating an owner financed promissory note you should always include the following:
- An agreed upon term amenable to both the seller and the buyer
- Interest rate that represents the local market
- Payment amount the buyer can afford
- Payment date that works for buyer of the property to pay the seller
At some point in the future the owner of the promissory note may have a need for a large lump sum of cash. This may not have been the case when the note was created, however, conditions, life events and circumstances can change which would cause the owner to need cash immediately by selling the promissory note.
A very interesting aspect of selling a note for cash is that the holder of the promissory note can sell the entire note or a portion of the note. The amount of cash the seller receives is base on the current cash value of the note which is based on several factors; some of which include:
- Amount of equity in the property (cash down payment plus principal payments received)
- Credit of the buyer
- Interest rate
- Length of term
If these items are all positive the cash offer will be higher and vise versa. For example, the more equity and higher credit score of the buyer, the more the note is worth and the higher the cash offer.
So, if you or your client is creating a promissory note, here are some tips to maximize the amount that would be received if the note is sold at a later date, as well as help protect yourself if you don’t:
- Acquire the largest down payment possible as this represents the buyer’s commitment, making it difficult for them to walk away if things get difficult down the road. Remember, if the buyer struggles to make the payment early in the process they are likely to bail out and move on. If they have made a sizable down payment, they have as they say “more skin in the game.” I would try and use these percentages as a gauge, depending on the property type: 10% for a standard house and 20-30% for commercial properties, land, and mobile homes. Try to never provide a zero down arrangement, even if you’re converting a renter to a buyer.
- Always run a credit report on your buyer before committing to the deal. If possible, sell to a buyer with a decent credit (eg. 650+). The higher the credit score, the more the note is worth. You will still have the ability to sell the note if the buyer’s credit is lower, however, be prepared to take a larger discount, and recognize that all the other factors of the note should be more appealing.
- The interest rate is considered negotiable until closing but remember a higher interest rate will lessen the discount if you eventually sell your note. Confirm that the interest rate you have choose is comparable to bank rates.
If you have questions about structuring your note or potentially selling it, feel free to contact us anytime.