The interest rate a seller agrees to accept when providing owner financing to the buyer has a large impact on the investment value. Unfortunately, many sellers overlook this important decision. Here’s why the percentage charged on a seller carry back is such a big deal.
Inflation Fighter
Each year it seems the cost to buy the basics just keeps going up. It’s not your imagination; it’s inflation. In fact in July 2008 that inflation rate was 5.6 percent higher than in July 2007 (based on the Consumer Price Index reported by the U.S. Department of Labor on August 14, 2008). Worse yet, some basic items like energy increased 29.3% over that same time frame.
So what does inflation have to do with seller financed real estate? Well a seller would need to charge an amount at least equivalent to the inflation rate just to break even!
Return on Investment
Rather than just breaking even, a seller Mezzanine Finanzierung desires a return on their investment. By accepting an IOU or payments from the buyer that money is tied up. Plus, once the property is sold the new owner will be the one to directly benefit from any increase in property value.
The seller is now acting as the bank and should expect a return at least equal to what a bank is demanding for a similar loan. The seller does not have the protection of private mortgage insurance that many banks require adding another level of risk that should be rewarded by an increased rate.
Since the buyer is saving the costs a traditional bank might charge for a loan (points, underwriting fees, origination fees, etc.) it is reasonable to expect them to pay above what a bank would charge. On average, it is recommended that a seller financed transaction be set at 2 to 4 percentage points higher than bank rates to compensate for these matters.
Improves Resale Value
If a seller ever desires to sell their future note payments for a lump sum of cash, they will quickly realize how important the terms are to investors. While they look to a variety of factors to determine pricing, all things being equal, a higher interest rate results in a higher purchase price from an investor.
For example, a seller holds a private mortgage with a balance of $100,000 with monthly payments of $1,110.21. If the mortgage rate is 6% and the investor wants a 9% yield then the offer would be $87,641. Now if the rate was 4% the offer would decrease to $81,623. On the flip side the offer would increase by thousands of dollars to $95,274 if the face rate was 8%.
For simplicity of comparison, these examples assume the monthly payment amount remains the same and there are acceptable credit, equity, and documentation. But you get the idea, the higher the interest rate the more valuable the note.
No Take-Backs
The time to give serious consideration to the interest rate is at the time of creation. There are no take-backs or do-overs. The percentage you agree to accept at closing stays the same for the life of the note.
The only way to change it later is to get the buyer to agree and execute a formal modification. It’s highly unlikely a buyer or payer is going to agree to have their interest rate increased at a later date (unless there is some advantage to them).
Be sure to give the amount of interest Mezzanine Finanzierung charged on a seller financed note serious thought. It will affect the value of your payments not only today, but also far into the future.