When set up correctly, mortgage notes are a great investment. They provide steady cash flow with a good return. If you are new to the world of notes and have never completed an owner financed transaction, this blog will help you set up a valuable note. If you have already created your note, this blog will help you understand how to determine the value of your note.
Here are 4 things you need to consider before creating your note:
1. Down Payment. The size of the down payment is one of the best indicators of a payor’s future performance. The payor will benefit from a down payment as it adds instant equity to the note. A larger down payment means the payor is more committed to the property, and therefore, less likely to default on the note.
The down payment also provides security for the note holder. The more equity the note has, the more valuable it will be, should you decide to sell.
2. Interest Rate. It is important for the buyer and seller to agree on a reasonable interest rate. The rate should account for any potential risk of default. The riskier the payor or property, the higher the interest rate should be. A higher interest rate also means you will take a smaller discount if you choose to sell your note in the future.
Before setting the interest rate, it is important to take into consideration what your payor can afford, since the rate will ultimately affect their monthly payment. If it is set too high, the payor may default on the note or seek another source of financing.
3. Amortization and Balloon Payment. Amortization is the length of time that your note is written for. While some sellers prefer a long amortization of 20-30 years, a shorter one will garner a higher value, should you decide to sell the note. However, shortening the amortization could increase the monthly payment on the note. One way to avoid this is by setting up a balloon payment.
A balloon payment will require the payor to pay the full balance of the note at a certain date, usually 10 years after the note was created. A balloon will shorten the amortization without increasing the monthly payment. If a balloon is due too soon, less than 3 years after the note was created, it will have the opposite affect and decrease the note’s value.
4. Contract Servicing. If you are not interested in managing the mortgage note, then you need to consider hiring a contract servicer. For a small monthly fee, the servicer will handle all communication and reporting with your payor. They will even manage impounded taxes and insurance.
A good contract servicer will save you time and money in the long run.
When drafting your mortgage note, there are many things to take into consideration, and these are just a few of the most important ones.