5 Ways to Make Seller Financing Work For You, part II
Seller carryback financing can be an attractive option for the reasons listed in the last post; however, it is important that the transaction be structured properly for maximum safety. If the note holder ever needs cash down the road, the note will command a top price (require a minimum discount) if it is well-structured, safe and secure.
The first items usually negotiated between the buyer and seller are: down payment, face value of the note, interest rate, monthly payment, and term or due date (or balloon payment, if any).
A seller should require no less than 10% of the purchase price as a down payment, with 20% being ideal. There is no substitute for protective equity. A seller needs to be able to protect their interests even if the payor defaults on the note and foreclosure is necessary. The higher the protective equity, the lower the discount if the note is ever sold for cash.
The interest rate on a note, in most instances, should at least be the going rate in the market at the time. It can often be a point or two higher. Even with a higher interest rate, the buyer is saving cash at closing by not having to pay points or loan origination fees.
Usury means charging a rate of interest that exceeds the interest rate allowed by state law. In California, seller carryback trust deed notes are not subject to usury limits. The opposite of usury is charging too little interest. While not illegal, it can have serious tax consequences. Ask your accountant or attorney for the current imputed interest rate formula.
To minimize the discount should the note be sold, it is important to understand that the due date is normally more important than the interest rate or the monthly payment. A dollar to be received today is more valuable than a dollar to be received in the future. The sooner the note pays off, the more the note is worth today.
The sellers carrying back a note would want:
1) A due-on-sale provision. If the buyers sell in the future, the note holders may want the loan paid off, or at least want the opportunity to determine the credit and financial strength of the new buyer/borrower. It also gives them an opportunity to adjust to current interest rates.
2) A balloon payment due on the note five years from closing.
3) A late charge of 6% of the payment if it is not made within 10 days of its due date.
4) A prepayment penalty (if early pay-off would generate adverse tax consequences).
5) The buyer to pay all closing costs.
The buyers would want:
1) No due-on-sale provision. If they sell, they want the note to be assumable.
2) No balloon payment. Where will they get the money in five years?
3) No late charge.
4) No prepayment penalty.
5) The seller to pay all closing costs.
A compromise would look something like this:
1) A due-on-sale provision will give the sellers some control in the event the buyers sell. They will be able to approve the new buyer.
2) A balloon payment in ten years, not five.
3) A late charge of 6% of the payment if not paid within 15 days.
4) A prepayment penalty only if the buyers make additional payments that reduce the principal balance by more than 10% in any given year.
5) Buyers and sellers agree to share closing costs equally.