By Curt Epperson
When you agree to provide seller financing for the sale of real estate, you are converting your equity in the property into payments of principal and interest over time. Most of the purchase price will be paid to you in installments.
There are two main ways of doing this. The first is a real estate contract. The buyer signs a contract and agrees to pay installments to you. He then receives title to the property (a fulfillment deed) when the contract is paid off. The second is a note and deed of trust. The buyer signs a promissory note and gets a deed for the property at the closing. He also signs a deed of trust that gives the seller the right to foreclose if the buyer stops paying.
Sometimes, after the closing, a seller decides he wants a lump sum of cash instead of the installment payments. For this purpose, the buyer might agree to an early pay-off, or the seller might borrow money and give the note as security for the loan. However, more often the seller finds someone who will "buy" the note. (For the purposes of this article, the word "note" also includes a contract.) The value of the note will be less than the amount owed on it at the time. Sometimes, the price may be quite a bit less than the amount owing.
Here are some things you can do to maximize the value of a note:
Credit check: When you sell your property, get a credit report on the buyer. If you belong to a credit-reporting agency, have the buyer sign an authorization and then order the credit report yourself. Alternatively, the Purchase and Sale Agreement should require the buyer to provide a satisfactory credit report. Check it carefully and make sure the buyer doesn't have a history of late payments, non-payments, lawsuits, or judgments.
Downpayment: Require a sufficient down payment. Some bank loans require only a three to five percent downpayment, but that is risky for seller financing. A low down payment means the buyer starts out with very little equity in the property. The buyer might stop paying and walk away without losing much money. Except under special circumstances, the minimum down payment should be 10 percent of the price. However, it's much better to get 20 percent to 25 percent.
Interest rate: The interest rate on the note or contract should be at or above the "market" rate. Major newspapers publish home loan rates on the business pages. Seller financing should be slightly higher (1.5 percent to 2.5 percent) than comparable bank loans. Make sure the interest rate is sufficient, and it will be much easier to sell the note.
Payment schedule: Monthly payments are better than quarterly or annual payments and a shorter period of time (say 10 years rather than 20 years) is also better. However, shorter time periods mean larger installment payments so make sure the buyer can afford the higher amount. The shorter period is usually better, because a buyer of your note won't have to wait as long to recover his investment.
Balloon payments: Sometimes a note will include a cash lump sum payment in addition to the regular installments. That creates an extra payment of principal to reduce the amount owed, which reduces the risk of default. A lower risk of default will help you realize a higher price if you sell your note.
Timely payments: Regular and timely payments are essential. A note with a history of late payments is less valuable, so make sure that you receive the payments on time. If a payment is late, don't be complacent. Write a letter or hire an attorney to do so. Insist on timely payments.
Special clauses: The note should require payment of attorney's fees and should have a late payment penalty. These conditions will encourage payments on time. It's also a good idea to include a "due on sale" clause so the buyer can't sell the property and let someone take over the payments without your permission. (The new person might not be a good credit risk or as trustworthy or reliable.) Finally, consider a pre-payment penalty. That means the note ensures a certain flow of principal and interest over time, with a penalty if it is paid off early. (Your attorney can advise you on how such clauses should be drafted.)
All of these suggestions help to increase the re-sale value of a note by increasing the property buyer's equity or showing that the buyer is a good credit risk. More equity in the property and good credit decrease the risk of default. The seller financing will be a better investment for you, and the note will be more attractive to someone who buys seller-held notes. You may not be able to include all of the items, and you may need some professional assistance, but every suggestion will help maximize the value of the note if the time comes to sell it.
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