Carrying the note

[Justin Glass]

Hey guys I have a question. I am probably different than a lot of you in the fact that I deal in mainly land instead of houses. I do really well in this business and deal in the market of hunting and recreation land. My question is I have been carrying a few notes on some properties for investment income. To make it simple if I invest 100K on some property and sell it for 150k with 10% down at 8% interest for 20 years. This equates to drawing really good interest on my 100k. My question is as far the loan itself goes should I put in a balloon note at a certain year or should I stick with giving a fixed rate? I have some done both ways but am about to do some more and I just want to do them the right way. Thanks guys

[Dion DePaoli]

Originally posted by Justin Glass:

. My question is as far the loan itself goes should I put in a balloon note at a certain year or should I stick with giving a fixed rate?

I wasn't a fan of how this read, so I wanted to comment on it. These are not mutually exclusive ideas. A balloon is when the term of the loan is shorter than the amortization of the loan. A fixed rate is a rate that does not float with market indexes. A loan can have a balloon and be fixed or adjustable. Adversely, a fixed or adjustable rate loan has no requirement to balloon.

The OP suggested rate seems reasonable at 8.0%. The other loan stipulations will play into the risk on the 8.0% such as down payment percent and borrower income and asset underwriting. That interest rate seems to have large enough to cover extension risk on the rate. Bare in mind, conventional loans are around 4.0% still and hard money is around 9.0%, plus or minus on both.

The idea of making a balloon can be good or bad depending on your capacity to underwrite the borrower. A good borrower in the future will have no problem refinancing the loan when it matures. A bad borrower, not so much. It is also important to check your state laws on balloons before you make the loan. Some states have increased the minimal term for a ballooning loan.

I also want to correct the idea behind the way @David Beard is describing the loan. The better way to look at your loan is not through the idea of maximizing its value and more of maintaining its value. In other words, preventing or limiting any discount that might be applied in the future to the loan. It is a small and perhaps to some insignificant amendment but I think it speaks volumes to what you are trying to do. Coming from the crash of 2007, there tends to be a general idea that all things are discounted. That may be true at Costco but in RE discounts occur as a function of cause and effect. Discounts in loans are not innate. The loan at 100% of its balance is worth the balance plus the interest. Loans are not written to sell for 95% of balance as a matter of standard practice. Although some have been doing that, which I will come back to.

A balloon feature does not enhance nor diminish the notes value per se. The maturity event, if it becomes a barrier for the borrower to overcome, which then forces disposition back on to the Mortgagee, would be a defect. On its own merit. In other words, it is not the idea that there is or is not a balloon that makes this good or bad, it is the idea of whether the borrower can handle the balloon event through refinance, property sale or similar on their own, that makes it a good or bad event.

To some folks, like Tom, balloons are administrative tasks that are not attractive. To other investors, balloons do allow the Mortgagee to protect themselves from extinction risk. That is the risk the rate they issue does not fall below market rates.

I caution the over reliance on the balloon to be a substitute for good underwriting. When the balloon occurs one of two things will happen. The borrower will cause the resolution of the balloon or the mortgage will cause the resolution of the balloon. If the loan balance at the balloon date is greater than its value, the borrower will not be in a good place to refinance. So, the solutions will have to involve the Mortgagee. It is important to note at this juncture, that regardless of where the market is, the Mortgagee does not have carte blanche ability to simply refinance for a much higher rate.

A new rule in 2014 from the CFPB will deal with the concept of "Ability To Repay". While that has always been in loans in general, it now has some regulatory teeth. A borrower not in a good position at a maturity event which creates a balloon might have the ability to produce an affirmative defense to the balloon. This could affect foreclosure and modification remedies. We don't know for sure since the rule is new. We do know, that in general the CFPB doesn't seem to like the idea of a balloon. (probably don't like clowns either)

The idea of 'maximizing' in Dave's post continues through some other tasks. (not picking on you Dave) The same correction in ideology needs to be applied. Using a Mortgage Servicing Company does not increase or decrease the value of the loan, per se. Using a licensed company will ease the administrative burden on the Mortgagee. The company will help mitigate some liability mainly dealing with borrower accounting and correspondence. The idea here though, is just because you do or don't have 3rd party servicing in place doesn't mean the value or price goes up or down. A Servicing defect in that case would create the need for a discount, as the defect could have risk consequences.

The Mortgage Servicing Company will not 'create' the mortgage file, a loan officer or loan broker can/will. It sounds like the OP has done these before and more than one in the future is being considered. As such, you should look into using a licensed and experienced MLO. Get with the MLO and your attorney and standardize your disclosures and documents used in the application and loan process. With some of the coming regulations in 2014, making sure details are attended to is a good idea.

Speaking on the idea of payment seasoning. Payment seasoning is not a requirement to achieve loan price requirements. A loan can be sold with no payments made and still fetch 100%+ of value. Payment seasoning does however, help an unsophisticated investor (possible future Buyer), peer into the underwriting of the loan in a simple manner. Did the borrower make payments? (Yes/No) If No, bad underwriting. If Yes, OK underwriting. Notice, the opposite of bad is not good here. Making payments on time is what is expected. So in that sense, making payments carries a negative when absent but its not really a notch up when present, since it is expected. Simply stated, the longer the time period of payment seasoning the more comfortable a potential buyer can with the borrower's ability to repay the obligation. It is not foolproof though when present. That is, just because a borrower paid yesterday doesn't mean they pay tomorrow. However, if the borrower didn't pay yesterday, the concern for not getting a payment for tomorrow increases.

Last, a couple of the ideas that accompany the OP last post. The idea of getting a property back is mentioned as a win win. This is more an idea supporting poor underwriting rather than good underwriting. Not only does it take a little bit of a haphazard approach to the borrower but it also ignores the process and final outcome of a foreclosure. When a property is foreclosed it does not mean it automatically reverts back to the Mortgagee. In fact, this only happens when the loan is poorly originated to a certain extent. A loan that is originated well will have a sufficient down payment and the borrower capacity to start with and improve on the equity position in the real property. That equity is consumed through the balance due back to the Mortgagee post foreclosure sale. A Mortgagee can only send the loan to auction for what is owed, nothing more. So when the property is worth more than what is owed, the likelihood of the property selling at auction increases. And of course, we have the opposite. A 50% downpayment in most cases will give the Mortgagee more than enough room to recoup costs of enforcing the remedies. A 5% downpayment likely will not. Further, the concept of the property reverting back to the Mortgagee is likely a loss not a gain in the real world. A property selling at auction carries less Seller costs in general as taxes, insurance and other customary real estate items are not paid for by the Seller, which in this case is the Mortgagee.

The idea of a loan is to put money out and get paid that money back plus interest. When banks look at lending money and the risk of default, they don't look at the idea of getting the property back, which also means managing it. They look at the ability to recover their investment capital. They are not the same ideas.

Hope that just freshens the vantage point you use when proceeding with your plans. Plans, like David mentioned, other investors practice successfully every day. Good Luck.