Owner financed offer and amortization schedule

[Carlos Webel]

Dear all,

I'm working on a 3/2 SFR rental lead in Houston Metro area. Asking price is 175k$ and I'm coming back with the following 2 offers:

• a)160k$ cash, no contingencies
• b)175k$ Owner financed with 40k$ down and 135k$ financed over 30 years at 4% with no pre-payment penalty

I’m structuring the amortization schedule such that the monthly payments are exactly the same $ amount as with a conventional loan; however, I’m turning it into a fixed interest / fixed capital amortization schedule to build up equity much faster. The way I came up with the numbers was using a conventional amortization schedule and summing up the total amount of interest over the term of the loan (360 months), then dividing that amount over 360 to come up with a fixed monthly interest and hence a fixed capital amortization.

As a result of this change, my equity build up during the first 5 years is $22500 instead of $12896 (with conventional amortization schedule).

Has anyone done this before? Any comments on your experiences? Is this considered legal in Texas and/or other states? Can this be called a 4% interest rate loan? We will run this through a lawyer and provide full disclosure of the details to the buyer but wanted to get some feedback from the greater community upfront.

Thanks, Carlos  

[Dion DePaoli]

The issue that you have OP is that when you apply an equal interest amount to each period the interest rate is no longer 4%.  

Interest due per period is a computation of the amount of outstanding principal.  If you fix the amount of interest being paid the loan interest will at first be less than 4% but around year 15-17 the amount of interest being paid will exceed 4%.  

Example:
Fixed Interest idea annual interest:  $3,234
Interest due in Year 1 = $5,356 ($2,123 less than 4%)
Interest due in Year 18 = $3,047 ($187 more than 4%)

Interest surplus paid in Year 17 to Year 30 = $19,805

That bell curve does zero itself out.  The reduced payments in the begining equal the surplus in the end.

HOWEVER, when we apply the principal reduction by way of a fixed principal portion of payment obviously the repayment of principal goes faster.  This causes the actual interest being paid to increase steadily.  Since interest is paid in arrears on the "outstanding" balance.  

OP idea of Outstanding balance in Beginning of Year 2 = $130,500
Correct Outstanding balance = $132,623
OP Year 6 Begin = $108,000
Correct = $122,104
OP Year 25 = $27,000
Correct = $34,996

So the rate of interest actually exceeds 4.0% after year 12 when the principal reduction is applied and goes all the way up to 71.87% in year 30.

Year 30 OP principal due $4,500.  Interest due $3,234.  

In most cases then you would knock on the door of usury by year 22.  

"Could" you make a loan like this? I suppose so. Disclosure of each year's APR would be required since each year causes a different APR. It is probably not a stretch to think someone looking at that disclosure who sees the rate of interest exceeding the pegged rate (for no better words to describe it) would simply refinance the loan which would mean the lender makes less than the pegged rate at the end of the day. In summary, a bunch of extra confusing work for no reward.

Now, there are fixed principal payment amortization loans, however interest is calculated normally on those at 1/12 the interest rate on the outstanding balance.  This causes the payments to be higher than a fixed payment amortization in the beginning and lesser at the end.  

That said, if you want your principal back faster the best method is probably just make a shorter term loan.  Exotic plans will likely never work out in your favor.