The most expensive real estate education is ignorance. We offer the antidote.View The Course
Lately we have received a number of seller financed notes to evaluate for purchase and a large share of these notes have balloon payments attached. In our opinion the balloon creates problems for both the seller and the buyer. We’ll cover a possible solution later.
Let me first cover the problems a seller may encounter.
Number one of course is compliance with Dodd Frank. While Dodd Frank may change in the near future, it is now remains the law of the land, and balloon payments are a problem . If a seller is not a business entity and does only one transaction per year then Dodd Frank does not apply. However the balloon still creates a problem for the seller and here is why.
Most seller financed sales take place because there is a deficiency in either the property itself or in the borrower. For some reason, conventional financing is not an option. Notice I said “most”. Certainly not all as some sellers look forward to the monthly payments they will receive.
The problem arises when the seller decides to sell the loan.
Most sophisticated note buyers will look at the balloon with a jaundiced eye. Why, as an investor, would I believe that the borrower will be able to finance balloon when it becomes due when they could not get financing originally? We do not want to take that risk and will either discount that balloon severely or pay for the payment stream and let the seller keep the balloon.
Number two deals with the other sellers, that is, business entities and those individuals that do three or more of these deals per year and sell to owner occupants. In these cases, a balloon is simply not allowed.
What is the solution when a seller wants or needs to carry the financing but does not want to be on the loan for the lengthy period a normal loan term would require?
Up pops the STEPPED Payment.
A Stepped Payment Note is simply a note in which the payments (not the interest rate) increase at regular intervals either by percentage or a fixed dollar amount. For example a payment on a loan carrying an 8% rate may have a beginning payment amount of $900 per month. Step Payments could be written into the note requiring the payment to increase $100 per month each year with a cap at $1400 per month. Or it could be written that the payment will increase by 10% a month each year. The $900 payment would increase to $990 per month the second year and $1089per month the third year, etc.
Writing the note this way eliminates the balloon totally, builds equity faster and shortens the term of the note significantly.
In addition, the value of the note increases as the payment increase takes place. The shorter the amortization period the more valuable the cash flow.
Next month we will go through the math using TValue software and show how the term of the loan is decreased and the value of the note increased. Stay tuned