How to make a zero interest rate note sizzle!

Question

I have found a note with a upb of 28,500, zero % interest,  with 114 payments of $250 remaining.   A note at zero % interest is unenforceable in Texas and the note cannot be purchased as it is.  I offered $13,636.35 which results in an 18% yield, but the seller knows that the note cannot be sold until we revise it to everyone's satisfaction.  If I "lower" the upb  and put in the minimum required interest rate of 1.5%, the mortgagor will still pay $28,500, but I would be hurt if they refinance or pay off early.

If I could convince the mortgagor to raise the payment from $250 to $350, and take $500 off of the total amount which will be paid over time, I would raise my yield to 24%.

The big question is how can I prevent an early payoff at the upb which will show on the amortization chart?

Any other ideas on how to "fix" a zero % interest rate note.

Dion DePaoli · Answer

The information on the minimum interest rate is not a function of Texas but rather the IRS.  The IRS has a minimum, called the "Applicable Federal Rate", which is updated every month for short, medium and long term debt instruments secured by property.

Essentially, the IRS says, if you create a 0.0% interest rate and the prevailing AFR is 3.0% you will be taxed (as the note owner) on the 3.0% regardless of the 0.0% note rate.

The issue is, without the AFR, the loan is really equity disguised.  The rule also was meant to curb inter-family loans with no interest as a tax sheltering event or alike.

To Bill's point, the note is enforceable.  In fact, the state of Texas, as many other states actually have zero interest rate loan programs through community programs which are secured by DOT on real property.

You can look up sections 7872, 1274 and 483 of the Internal Revenue Code.

Bill Gulley · Answer

The interest rate is important to the original holder but is pretty much irrelevant to a buyer as the buyer fits thier required yield on the note based on the payments remaining. If a note has a higher original note rate the payment will be higher and it will likely have less of a discount to achieve the investor's required yield.

As I mentioned above, a buyer may have an initial required yield on the purchase, but by getting a discounted note paid off quickly the yield goes up like a rocket, that because the yield is measured over time. :)

Bill Gulley · Answer

Yes, I drafted the notes for a Habitat For Humanity affiliate at zero interest and called the IRS, getting the "oh no, we won't do that to them" exception. Texas has some strange laws in RE, so I wouldn't be suprised, but I believe this is a mix up as mentioned by Dion and he is right as to IRS requirements, they simply impute interest, it doesn't make the note uneforceable. So, to the OP, double check, but knowledge is power in RE and the buyer and seller may not be as sophisticated, having completlt equal knowledge at all times ;)exas

Mike Mitchell · Answer

Any note can be bought if the seller is willing to take the discount that the buyer requires.  This zero % note required a large discount in order for me to be interested.

Dawn Anastasi · Answer

Do people buy only high-interest notes?  Seeing this post at 0% makes me wonder what the average % rate note people generally buy is.  Would note buyers even consider notes at 5%?

Bill Gulley · Answer

Your note may have been made before the current restriction, if they are correct, it doesn't mean you can't buy it IMO, just release the lien and it's unsecured debt but timing matters.

You do know a note purchase is not a real estate transaction and you don't need to close at a title company, but there is insurance matters.

Your note was funded by equity in the sale by the holder, he didn't lend cash. Sellers tax liability could be less selling at a discount.

If you have a default you will have any deficiency judgement, if allowed, limited to your purchase price not the upb.

Yes, buying notes is better than saying, "Welcome to Walmart" for a living! Good luck and good night! :)

Mike Mitchell · Answer

Bill, 
Thanks for the good ideas.  The note is secured by land only and has a mobile on it which is personal property and is not a part of the note.  In my mind it gives the mortgagor a little more incentive to stay current.    The title agency informed the seller that the notes are not enforceable at 0% interest, and that the minimum rate is Texas is 1.5%.    I'm basing my assumption on that, perhaps this is wrong, I'll check it out with my attorney.  The seller is wanting to cash out quickly.

I don't understand your question about it being funded with cash or equity carried back.  The seller of the note owned the land free and clear and received a down payment from the mortgagor and received payments for one year.  All payments are current.

I'll look into a new note showing the discount on my books.

Below is proof that you are right about lowering the upb.

Assumption:

Buyer can't pay extra, payment remains at $250/month.  So I've had to lower upb to $26,547.05.  payment $250 x 114 at 1.5%.  If he refinances after 12 months I will have received $3000 in 12 payments  plus a payoff  $23,927 on an investment of $13,636.35 which is a yield of 69.442% if I did my charts correctly.  This beats working as a greeter at Wal-Mart!

Bill Gulley · Answer

Hmmm, first, is it a residence securing the note?

Unenforceable as a mortgage or secured debt or as an obligation, even an IOU, an acknowledged debt can be enforced, so I assume due to it being a mortgage. Many installment transactions carry no interest, just sounds like that is due to it being RE.

Was it funded with cash or was it equity carried back?

To add interest you'll need to modify it with the borrowers signing again.

I assume the note is current, the debt has been acknowledged, even if it is not in compliance.

Did an attorney say it can't be sold or is that an assumption?

Why don't you get a sale agreement, option,with the right to service the debt. Then approach the borrower with servicing agreement/assignment in hand. Offer the borrower a lower the payoff as an incentive to pay it off. If he can get it refied let him, accept the money and hold in escrow. Release any security agreement, now it's not a mortgage, buy the paper at your price. Release the escrow less your fee. That yield is off no money in it, can't beat that!

If he can't refi, now you know. Head to a modification with a cut on the upb. You'll need to note the security dot again in the modification reaffirming the debt.

You can lower the unpaid balance and keep it at the original amortization with interest with the borrower signing the mod agreement.

Might be better to make the refi loan, a new note and payoff the old obligation, show the net difference on your disbursement with the discounton your books.

Another way is to leave sleeping dogs lie, buy the right to service the obligation, not buy the note, you service it, net out your servicing fees plus any advance you made of future payments with interest to you. Service with recourse in the event of defualt. That's if you are a broker.

If the note is on a residence you can't prohibit early payoff under the SAFE Act, I suggest you follow the Act with any new modification. As a modification you aren't the seller creating the note, you may need an attorney under the Act, unless you are a broker.

You might explain how an early payoff of a discounted note decreases your yield, it doesn't, it increases, your money is out for less time and the discount is paid sooner, yield increases, that's a good thing.

Later, :)