Setting up a mortgage note properly is a critical step if you are doing owner financing, whether you intend to keep the mortgage note (also called a real estate note) or sell it to a mortgage note buyer. The first step in using owner financing, setting the sales price on a property, was covered in a previous article (see “Creating a Mortgage Note – Setting the Price”).
If you are selling a property using owner financing, be it a house, commercial building, or a parcel of land, you’ll want to make sure that you obtain a reasonable down payment. Of course, if you are selling the property and the bank is giving the buyer a loan, you won’t be concerned with the amount of down payment unless you are carrying a piggyback 2nd mortgage (more on that later).
The down payment is the difference between the sales price and the sum of all notes created. It reflects how much money the payer puts into the transaction, excluding any closing costs.
When creating a mortgage note, you should always try to maximize the amount of down payment that the buyer gives you. The biggest reason for this is to protect you in case of default. If the buyer stops making payments and you have to foreclose on the property, you’ll have costs related to that foreclosure and for repair of any damage caused to the property.
Another reason to have the buyer put in a large down payment is so that the buyer has some “skin in the game.” A buyer who has given a lot of money is more likely to try to make timely payments and to take care of the property. If a property sells for $100,000 and the buyer gives a $10,000 down payment, he’ll think twice before doing anything that could jeopardize that down payment.
Ideally, wouldn’t it be wonderful to receive a 40-50% down payment on any property that you sold! In the real world, that is usually not practical. So, if you’re selling a house, try to get at least a 10% down payment (10% of the sales price). If you’re selling a commercial property or a parcel of land, a 20% or more down payment is recommended because of the additional risk that those property types pose.
In regard to bank financing for the property, a buyer purchasing a property in which a lender is demanding a down payment larger than what the buyer can afford may ask you to carry a 2nd lien. For example, on a house with a sales price of $100,000, the bank may only be willing to lend up to $80,000. If the buyer only has $10,000 available, he or she may ask you to carry a 2nd (junior) lien note for the other $10,000. Having 20% equity in the property also allows the buyer to avoid paying private mortgage insurance (PMI) on the bank loan.
A 2nd lien note can be lucrative, but carries much more risk than a 1st lien. If the buyer defaults on the bank loan and the bank forecloses, your 2nd lien could be wiped out by assorted fees and costs incurred by the bank. To get into first position with you lien, you would have to pay off the loan owed to the bank, which may not be affordable to you.
Be sure to avoid “silent seconds”, in which you and the buyer set up a second note without the knowledge of the bank. These are risky and, more importantly, illegal.
Clearly, getting a large down payment helps to protect you in a number of ways. If you’re thinking about carrying a 2nd-lien note, make that you know what you are doing or are being advised by a knowledgeable and neutral person.
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Alan Noblitt is the owner of Seascape Capital Inc., which buys mortgage notes . He may be reached at (858) 672-4678 or toll-free at 1-800-634-4697. If you would like to learn more about notes and read informational articles, visit www.seascapecapital.com
Creating a Note – The Down Payment and 2nd Liens