How To "Write" A Mortgage Note Correctly To Sell In Future

[Steven Ellenwood]

I will be giving owner financing, writing up a mortgage, for a young family on a house I own. They both have decent jobs, but their credit is down from former divorce and other things.

The house is $25K, they are putting $5K down, and I will carry a mortgage for $20K -- amortized for 6 years at 9% interest.

If I decide to sell this mortgage note off in the future, what do note buyers want to see in a note? Would it make much of a difference if they put down $3K (instead of $5K) and the mortgage was for $22K?

How much of a discount do note buyers expect?

What else do I need to know to sell this note off in the future? Thanks!

[Dion DePaoli]

Steven,

First the idea of discounts is fairly misapplied in these realms.  Notes can and do trade for par and premiums all the time.  A note does not need to carry a discount unless there is an actual reason for the discount.  

Setting up a security instrument and note is not a DIY project.  In many states the preparation of a security instrument falls under the idea of preparing legal documents which reserved for members of the bar only.  That means documents found on line or documents prepared by a title company or a loan officer would stand the chance of being invalid.  South Carolina is one of those states, which if that is where your property is, you should seek an attorney to handle the documents.  The good news is they can also handle the closing.  Further, that will ensure you get proper clauses into the contract that are standard and proper.  

Down payments are used to reduce risk in lending.  Lower down payments can be riskier than those loans with larger down payments.  The general idea of a down payment is to give the mortgagee some equity to make advances in the near term if the borrower defaults.  Further higher down payments mean less borrowed money which translates into less monthly payment burden on the borrower. 

In the loan structure you have, at 9% over 6 years you have an interest rate above market which is to be expected.  If the borrower could go to the bank they should go to the bank.  So innately, the borrower is to some degree a credit risk.  In addition and bravo to you, the short term amortization means the borrower will earn equity through payments faster.  As such, that idea can to some degree be considered a compensating factor to allowing a 10% down payment opposed to a 20% down payment.  

The overall underwriting of the borrower is what is really going to be the meat and potatoes of the deal and how it may be perceived in the secondary market in the future.  If we assume the lesser of the two down payment options the borrower will be paying around $406 each month.  That monthly obligation needs to be a small percent of their monthly income.  In general you can shoot for 30% or better.  That means combined both borrower's monthly income needs to exceed $1,352.  The more income they have above the monthly mortgage obligation the better to some degree.  

You can inquire about other credit demands such as auto loans and credit car bills which they are responsible for to get an idea of how much real free cash flow they have each month.  The moral of the story, you want to ensure they can make their payments with some degree of ease.  In addition, they will need some money to manage the property demands that come about being an owner.  

In general it is always a good idea to escrow a seller financed note.  This means their total monthly payment will include the amounts needed to pay for taxes and insurance.  This demand will be incorporated into the loan documents but you may have to request its presence.  

Once the loan is originated you will want to have the account serviced by a licensed mortgage company.  They be able to handle all the accounting for the loan, the escrow and handle needed compliance paperwork and communications.

If and when you go to sell the longer you have held the loan the more equity insulation the par loan would have.  At the end of year two only 72% of the balance will be remaining, baring any prepayment and if the sale price is a good indication of property value the loan to value will be around 65%.  As such, and as I mentioned above, I would not willingly start discounting the loan in a sale unless they had some delinquency or flat out defaulted.

Last and final idea, don't make a loan you would not feel comfortable holding until maturity.  That idea will keep you pointed in the right direction.  Good luck.