Down Payment

The  primary factor in determining the value of a note is the leverage of the asset. A potential investor will first look at the down payment to determine how much “skin-in-the-game” the borrower has in the deal, be it cash or equity, and evaluate the risk based at least partly on those numbers.

Small  borrower down payment will make it harder to sell your note on the secondary market. The less equity the borrower holds in a property, the riskier it is for a note holder to ensure they can recover their investment. While a decent down payment is about 15%-20%, try to keep your mortgage notes, especially the ones you are planning on selling, above 20% equity. Keep this in mind: the higher the down payment when the note is created, the better the chance you have to sell it for a higher price.

Borrower Credit

Credit score isn’t the overriding determining factor in originating a private loan, a note buyer will be looking at a Tri-Merge credit report to determine the creditworthiness of each borrower. Individual buyers may not consider a note where a borrower has less than a 600 middle FICO score; however, there are some institutional buyers that will buy into the 500s, depending on the circumstances.

Selling  a note in the future, it would be beneficial to make sure your borrower has a middle score at least in the 700s. Setting this score as a guide will give you more options when you go to sell the note. To be to the point, the better the credit score of the borrower, the more money you will get for your note from an investor.

Loan Terms

Consider the following when structuring your deal:

Keep the Loan Term 5 to 7 years

Note investors want to be out of the loan in between 5 to 15 years so they can reinvest. A loan term of 15 to 20 years will make it harder to sell and may lower the offers you receive from investors. Creating a note with a fully-amortized loan term of between 5 to 7 years, will draw the attention of many more buyers, and is a safe bet that you’ll get close to the value you expect.

Competitive Interest Rate

Be sure to keep your rate competitive with other mortgage note sellers on the secondary market. Aim for a rate between at least 4to 7 percent higher than what bank lenders are charging. Based on today’s market, this should put your rate somewhere between 8% and 15%, depending on the risk factors associated with the deal, such as credit score, down payment, and property type and location.

A higher rate protects the note seller by providing enough of a yield for a potential note investor, that a seller will have to worry less about discounting the note for a quick sale.

Loan Seasoning

A note buyer is going to require at least a few months of seasoning on a note before agreeing to purchase. Generally, you should have between two and six months of documented positive performance on a note before you place it on the open market. Some fix-n-flip borrowers may put up a more substantial down payment and request deferred payments while the property is being renovated. As long as the note seller can document the amount and demonstrate that the loan is seasoned, albeit, without multiple months’ worth of payments, some note buyers will accept this as adequately seasoned.

Besides providing a visual representation of performance via seasoning, it is crucial for a note seller to keep diligent payment records and statements. A savvy note buyer is going to want to see a paper-trail demonstrating that the borrower has been making payments in a timely manner.

Documentation

It should come as no surprise that the number one thing you should worry about when creating mortgage notes to sell is the documentation. Your asset is only as good as your contract. If you don’t have bullet-proof agreements, you are going to end up in the short line for selling your note. Before structuring a mortgage note, consider the possibility of not being able to sell it to an investor. Keep that in mind when creating a mortgage note, and concentrate on not only providing an opportunity for the borrower, but also as a way to create a value for the future buyer of the instrument.

1. Seller financing increases the number of potential buyers
2. Seller financing increases the likely purchase price (assuming the buyer pays off the note!)
3. Seller financing give the seller a stake in the success of the new owner, which is likely to help with transition issues.
4. Seller financing signals to the buyer that the owner is confident that the business will succeed under new ownership.

The downside, of course, is the the seller gets a note rather than cash.  Here are some steps to take to reduce your risk when you sell the business:

1. Get a substantial portion of the price in cash up front.  If you don’t, you are merely giving away an option, not selling the business.
2. Ask yourself if the buyer really does have the skills and temperament necessary to succeed.
3. Run a credit check on the buyer.
4. Ask if the buyer has other assets that can be pledged to secure the loan.
5. Set up some loan covenants, such as the buyer needing to maintain a certain level of working capital or a particular level of net worth.  That allows you to step in early if the business starts going downhill.  (You may need to ask a banker for advice; they do this sort of thing all the time.)
6. Demand regular audits to ensure compliance with the covenants, and also that the business is being run honestly.  If you need to take the business back, it’s imperative that you not have to clean up ethical issues left behind by the buyer.
7. Stay in touch with major customers.  Know if they are unhappy or cutting back their orders.
8. Sketch out a contingency plan for taking back the business.  There may well be some simple things that will help you if worse comes to worst.  Think it through ahead of time.
9. Do not sail around the world, trusting that all will turn out well (unless you can afford to walk away from the unpaid balance on the loan.)