A Knowledge Based User Friendly Approach

Note Solutions For You - Part1

Puzzle Pieces Fitting Together

Introduction

By Robert Duplicki      March 29, 2024

Note Solutions can come in the form of answers, and questions as well, or simply ideas that will help you produce your own solutions. So here and in future articles I will offer potential questions, ideas and answers. that you can utilize to implement and expand on what I offer at NoteSolutions.us.

Owner Financing Mistakes To Avoid

A recent podcast provided by Scott Carson of We Close Notes, covered this topic. While Scott has done many podcasts, he emphasized fundamentals that you may be familiar with. Of course there is value in Scott's insights irrespective of your experience with owner financing. And it's good to keep up with ongoing changes in thinking which can be subtle yet relevant.

In his podcast related to this topic, Scott Carson focused on the approach of using owner financing, only if you don't plan to sell the note you create in less than twelve months. But the experts often disagree. Certainly there is much more advice to consider than one can fit in any one article or podcast.

As I've stated in this website before, techniques that fail for one may be perfect for another. And one note buyer may offer good advice while maintaining a perspective that fits their business model. So I will share some of Scott's advice with you while adding thoughts from NoteSolutions.

  • The first mistake he mentioned, is taking a down payment of less than 10%. More is better especially for business notes. While this emphasis is based on creating a note that you will sell, a sufficient down payment is always good practice. However a Robert Allen mindset may lead a prospective property buyer to ask for nothing down. As a seller offering owner financing, you may have good reasons to take a down payment that is considered too low, or require one that others will find prohibatively high. So be open to a down payment that works best in view of your priorities.

  • The second suggestion is don't overvalue the asset you are selling. Since you are offering owner financing, it's not uncommon to think that because you are offering terms you can get a higher price. This often works but to what extent? It will depend somewhat on your market and how motivated your buyer is.

    In the current market because of extensive upward price bidding, very high prices are being reached. The concern is that if your sales price is overvalued, when you try to sell the note, the note buyer will perceive a lower value for your asset than the sales price. So you will face a larger discount in the price you are offered to sell your note.

    I think that it is interesting to consider the timing of these transactions. If the plan is not to sell your note for at least one year to maximize the value, what will happen to the value of similar assets in your location, in a year or more? Might it be better to sell your note in six months, because the perceived value of the property you sold, will be higher at that time then in the future?

  • A third mistake is providing a below market interest rate. Scott mentioned someone that contacted him to sell a note with a below market interest rate for a borrower with a 500 FICO score. The creator of the note thought it was a good idea to do so. Of course that didn't make sense. So find the market interest rate that applies in your situation. Often note buyers are expecting a higher than market interest rate for owner financed notes.

    A key point once again is what interest rate is going to work best to sell your asset, in the time frame you prefer. If you are receiving a sizable down payment and the borrower has a high FICO score, you may decide to accept a lower interst rate. That could be more important to you than reducing the discount when you sell the note.

  • If you accept a down payment less than 20%, Scott Carson recommends that you create two notes. For a real estate note if you take 10% down, and try to sell a note for 90% of the unpaid balance, a note buyer may only offer 70% of value, so you face a 20% discount. An alternative is to create a 75% LTV (loan to value) first note and a 15% LTV second note. The idea is that you can sell the first note for only a 5% discount, and keep the second note.

    My ongoing caveat is consider all the factors that lead to the creation of a note, along with all the factors that determine what you can sell that note for. Don't get too excited or disappointed about any one factor.

    The recommendation to create two notes can be helpful, but the discount you face by selling the first note could be greater than you expect. Also you may have no desire to hold a second note. But you might take a 20% down payment, and make only a partial sale of the note initially, which will reduce the discount. You can sell the remainder of the note later if you decide to.

  • The next mistake Carson covered is collecting the payments from the note yourself. Some note holders are experienced at this and have the rsources to do a good job on their own. But many note holders will only handle one note.

    A private loan servicing company offers a menu of services including collecting payments, depositing funds whereveryou direct, providing monthly statements and year-end financial accounting required for the IRS. Other services include online access to your account, managing escrow accounts and different levels of follow-up on late payments. Here are two companies that provide such services:

    When you are ready to sell your note, verification of payments is important, and the loan servicing company can transfer documentation to the note buyer. Carson suggests that when the note is first created you include a provision that the borrower will pay for the loan servicing in additon to principal, interest, taxes and insurance.

  • The next advice is make sure the borrower has a decent FICO score. Scott Carson said that under 680 is going to lead to a larger discount when you sell the note. Different note buyers will have different views on a particular credit score and the overall credit history is important, not just the FICO score. As with the other factors, credit history does not stand alone in evaluating your note.

    Once again the importance of this process begins with creating the note, whether you sell it or not. Who will you choose to sell your home to, or a commercial property or your business? The answer may change when you provide owner financing. Understanding the buyer's credit history is important.

    In order to help you deal with this aspect of owner financing, I suggest that you read my article Have You Checked Their Credit?

  • More advice from Scott Carson urges you to be compliant with the Dodd-Frank Act. If your paperwork is not Dodd-Frank compliant, that could have a negative impact on the price you get for selling your note. But Dodd-Frank does not apply to commercial property or the sale of a business and there are exceptions for residential property that apply to many sellers.

    The Dodd-Frank Wall Street Reform And Consumer Protection Act was enacted as a result of the financial crises of 2008. It is meant to regulate financial institutions and to provide sageguards for consumers obtaining residential mortgage loans. Some aspects of the act pertain to owner financing.

    Before you research this topic on your own, realize that much of what you find will apply to banks and related financial institutions. If you find something that may pertain to owner financing, take the time to understand it well. Much of what is available can be confusing, misleading and outdated. To help you with this topic I offer:

    • A very helpful flowchart produced by the Barnes Walker law firm. You can use it to determine whether Dodd-Frank applies to you. Whatever resource you utilize, you do need to be clear on whether Dodd-Frank applies to you.
    • For further understanding, review my article Dodd-Frank And Safe Act Considerations. The Safe Act adds to the complexity of regulations you may face.

    Before we continue, keep in mind these points. If Dodd-Frank applies to you, the issue that seller-financers must be licensed mortgage originators, can be handled by hiring a mortgage broker. As with any real estate purchase or sale, using a local real estate atttorney is recommended.

    The Dodd-Frank Act authorized the creation of the Consumer Financial Protection Bureau (CFPB). They are an agency of the United States government, resposible for consumer protection in the financial sector. CFPB also has the job of enforcing Dodd-Frank and has issued various rules and revisions to do so.

    In my Dodd-Frank And Safe Considerations article, I mention that CFPB enacted the Loan Originator Rule in 2014. This is the rule that includes exceptions for residential property sellers. The specific rules are part of the Code of Federal Regulations (CFR). Those exceptions are:

    One-property exclusion under 12 C.F.R. § 1026.36(a)(5):

    (5) Seller financers; one property. A natural person, estate, or trust that meets all of the following criteria is not a loan originator under paragraph (a)(1) of this section:

    (i) The natural person, estate, or trust provides seller financing for the sale of only one property in any 12-month period to purchasers of such property, which is owned by the natural person, estate, or trust and serves as security for the financing.

    (ii) The natural person, estate, or trust has not constructed, or acted as a contractor for the construction of, a residence on the property in the ordinary course of business of the person.

    (iii) The natural person, estate, or trust provides seller financing that meets the following requirements:

    (A) The financing has a repayment schedule that does not result in negative amortization.

    (B) The financing has a fixed rate or an adjustable rate that is adjustable after five or more years, subject to reasonable annual and lifetime limitations on interest rate increases. If the financing agreement has an adjustable rate, the rate is determined by the addition of a margin to an index rate and is subject to reasonable rate adjustment limitations. The index the adjustable rate is based on is a widely available index such as indices for U.S. Treasury securities or SOFR.

    Three-property exclusion under 12 C.F.R. § 1026.36(a)(4):

    (4) Seller financers; three properties. A person (as defined in § 1026.2(a)(22)) that meets all of the following criteria is not a loan originator under paragraph (a)(1) of this section:

    (i) The person provides seller financing for the sale of three or fewer properties in any 12-month period to purchasers of such properties, each of which is owned by the person and serves as security for the financing.

    (ii) The person has not constructed, or acted as a contractor for the construction of, a residence on the property in the ordinary course of business of the person.

    (iii) The person provides seller financing that meets the following requirements:

    (A) The financing is fully amortizing.

    (B) The financing is one that the person determines in good faith the consumer has a reasonable ability to repay.

    (C) The financing has a fixed rate or an adjustable rate that is adjustable after five or more years, subject to reasonable annual and lifetime limitations on interest rate increases. If the financing agreement has an adjustable rate, the rate is determined by the addition of a margin to an index rate and is subject to reasonable rate adjustment limitations. The index the adjustable rate is based on is a widely available index such as indices for U.S. Treasury securities or SOFR.

    Notice that the One-property exclusion does not require a good faith determination that the consumer has a reasonable ability to repay the financing. Compare this with item (B) in the Three-property exclusion. Of course it's still important that you determine that the borrower does have the ability to repay the financing for any note you create.

    Whether the one-property exclusion or the three-property exclusion applies to you, or neither does, the CFPB does provide a helpful resource you should consider. It's titled "Ability-to-Repay and Qualified Mortgage Rule", subtitled "Small entity compliance guide."

    This guide is a 53 page PDF which you may have no interest in reading. I suggest that you at least scan it, and you will probably find some parts helpful. My Dodd-Frank And Safe Considerations article lists the eight underwriting factors to consider in determining Ability To Repay. The CFPB guide starting on page 18, provides more details to help understand this process better. Links to other helpful resources are sprinkled throughout the guide.

    So Dodd-Frank has made owner financing more challenging. Yet owner financing remains a great tool. I suggest that you use Dodd-Frank as an opportunity to create notes that will minimize the discount, should you decide to sell your notes.

What Will Work For You?

If you consider all the insights above, you should be in a better position to create notes that will minimize the discount when you sell them. Different note buyers will have varying preferences of what notes they buy. And you don't have to wait 12 months before selling a note.

In the past, simultaneous closings were a way to create a note to sell a property, and at the closing table sell the note at the same time as selling the property. Today note buyers want at least one paymnent to be made on the note, before they will buy the note. Some note buyers will require more seasoning.

More seasoning may help you get a better price for your note, but if the terms of the note are deficient, those factors will have a greater impact on the price you get. If the terms of your note are excellent, six months of seasoning may not result in a better price for your note than after one month of seasoning.

What would you do if you inherited a four-family dwelling that you don't want to keep? Let's say you decide to sell the property using owner financing to someone you know, who has a low FICO score? Despite the low FICO this potential buyer has good income and money to make a 20% down payment.

How does your response change in the same example if you need a substantial amount of cash soon? If you could sell the note after the property buyer makes one payment on the note, you may not be too concerned about the discount. Certainly a low FICO score combined with a note lacking seasoning, will increase the discount when selling the note. But in circmustances like these as well as others, creating a note to avoid all the mistakes listed above, will probably matter that much less to you.

So if the concept of a simultaneous closing sounds helpful, go to Simultaneous Closings. If you have a seasoned real estate note that you want to sell, please complete this worksheet. I would love to pay cash for your cashflows!

References

  1. Photo by Edge 2 Edge Media on Umsplash.
  2. We Close Notes, 8 HUGE Owner Financing Mistakes to AVOID
  3. Legal Information Institute, Electronic Code of Federal Regulations 12 CFR § 1026.36 - Prohibited acts or practices and certain requirements for credit secured by a dwelling.
  4. Consumer Financial Protection Bureau, Ability-to-Repay and Qualified Mortgage Rule, Small entity compliance guide

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