The easiest way to explain how seller financing works is by way of example. This approach strips away all of the terminology and mathematics, leaving the stuff that matters. Keep in mind that we protect the confidentiality of all of our clients, so we'll change their names below.
Note Creation
Two years ago, in the spring of '94, a client of ours, Mary, decided to put her house on the market. Mary and her REALTOR(TM) tried many approaches: that weekly TV program, fresh cake at the open houses, even that new-fangled emerging technology called the World-Wide Web.
Eight months later, Mary meets a young executive, Bill. Bill and his family are moving to this area from the other side of the country. He and his wife absolutely love the house. One week later, they and Mary agree on a price of $140,000. Bill writes a deposit check for $5,000. He pledges a total down payment of $40,000. Let's quickly review the basic mechanics of the normal real estate transaction: traditional financing. The buyer pays the seller a substantial down payment. The buyer then applies to a bank for a loan. If accepted, the bank pays the seller the rest of the money for the house, and the seller transfers the house to the buyer. At the same time, the buyer gives the bank a promissory note (an I.O.U.), which indicates that s/he will pay the bank every month for a given number of years.
The Realtor starts to arrange financing for the remaining $100,000, only to find out: uh, oh! ... This young executive, who previously had a salary in the mid six-figure range, recently left his employer to start his own consulting firm. Bill's wife and two kids were at the Airport Hotel waiting for the house to close.
Guess what! The bright young executive, even though financially quite capable, can't qualify for a mortgage. He was new to this area and had no verifiable employment. Even with $40,000 down, no lender would qualify him. ... The sale started to crumble.
The Realtor then suggested to Mary that she offer seller financing. After thinking about it and all of the time and effort spent so far marketing her house, she reluctantly agreed. Mary got the $40,000 down payment, and she took back a mortgage note from Bill. Bill and his wife promised to pay Mary an additional $100,000 principal over the next 15 years, at an interest rate of 10%. Their monthly payment is $1,074.61. Mary is happy: In January of '95, the house is finally sold. Bill and his wife are happy: they finally left their hotel room and started to unpack all of those boxes. The Realtor is happy: she finally got paid for those eight months of work. Here are the basic mechanics of seller financing. The buyer still pays the seller a substantial down payment. The seller then accepts a loan from the buyer directly, and in exchange, transfers the house. There's no bank, and the seller just takes back the promissory note instead of the full cash amount. The buyer is agreeing to pay the seller directly every month.
Note Basics
About 20% of the houses sold in the U.S. involve some form of seller financing; one in five mortgage notes created are privately held. The legal contract containing the terms of the loan is called a promissory note. It is also known as a mortgage note, a trust note, or a purchase money note. It specifies the principal amount, the interest rate, and the timing of the payments. The promissory note is collateralized, or secured, by a second document. East of the Mississippi, the security is a mortgage deed. The mortgage allows the seller to foreclose on the property in case of default. The payor, the person making the payments, is called the mortgagor. The payee, the person receiving the payments, is called the mortgagee. An easy way to remember this is that the words "payor" and "mortgagor" end with the letters "or", just like in the word "door". The mortgagor lives behind the door of the house, and makes his/her payment each and every month in order to keep it that way. In the Western part of our country, we have trust deeds as collateral. The payor is called the trustor, and the payee, of course, is called the beneficiary. (huh?) (There is a third party, called the trustee, who holds the deed to the house, and is bound to give it to the appropriate party, because there are only two possible outcomes to a promissory note. Either the payor makes their payment each and every month, on time... or they don't.) There is a third instrument used primarily in the mid-West called a land contract or an agreement for deed or a contract for deed. The property is not legally transferred until all of the payments have been made. Just to keep things simple, the payor is called the vendee and the payee is called the vendor. (Hey, we didn't make up the rules; we're just reporting them.) The ideas in each case are the same; the legalities vary from state to state.
Full Purchase
Back to our story. Let's fast-forward one year. It's now January '96. Bill and his wife have paid Mary twelve payments of $1,074.61, a total of $12,895.32. That $100,000 balance on the note has shrunk all the way down to a mere ... $96,968.22.
Now, Mary has decided to invest in a restaurant franchise. She had liquidated as many assets as she possibly dared, and she still needed an additional $80,000. A friend suggested that she call us, and we explained to Mary that we could get her the money she needed. A promissory note is a negotiable instrument. Mary sold her note, and instead of waiting fourteen more years to get her money, we handed her a certified check for $83,109.76. Mary was thrilled -- she even baked us one of those cakes that she had been making for the open houses.
The seller was holding a promissory note that entitled her to receive monthly payments from the buyer. In this case, the homebuyer was doing just that: he was making the payments. When the NoteBuyers buy the note, they pay the seller a lump sum of cash, and the homebuyer is now obligated to make the monthly payments to the new holder of the note. (The terms don't change, just the name and address on the check.)
Hey, wait a second! We just said that the amortization schedule stated a note balance of $96,968.22. How come a $97k note was only worth $83k?! Why is there such a difference? Why is there a discount?
Let's consider: Before Mary sold the note, did she have the right to force Bill to pay off the balance of the note in full? Could Mary force Bill to pay off some of the loan early, or to make extra payments? No! She did not have the right to force Bill to pay off, therefore she cannot sell the right. Mary only had the right to receive $1,074.61 a month for the remaining fourteen years. Money in the future is worth less than money today. Why is that? Two reasons, really: Inflation... and risk.
Inflation
If you were offered the choice of a $5 bill or a $10 bill, which would you choose? If the choice was $5 now, or $10 in ten minutes, you'd still probably take the $10. Now, what if your choice was $5 today, or $10 in fourteen years? Money in the future is worth less than money today. Think for a moment how many bags of groceries $100 will buy today. OK. How about ten years ago? How many bags of groceries could you buy for $100? What about ten years from now? Think about the number of bags. Money today is worth more than money tomorrow. Historically, our inflation rate has averaged out at around 7%. At 7%, your money doubles every ten years. Thirty years ago, our parents might have bought a house for $15,000. Thirty years; three doublings: 2, 4, 8. Today, that same house could be worth about eight times that price, about $120,000. But, that also works the other way. A fixed amount of money drops in value. Your purchasing power is cut in half every decade. A thousand dollars in ten years will only buy as much as $500 will today. In other words, a thousand dollar payment in ten years is worth $500 present value. Inflation. Why was that note sold at a discount? Inflation is one reason.... Another is risk.
Risk
What are the risk factors found with real estate mortgage notes? The biggest concerns, of course, are collection problems, or even outright default. Can't the note holder foreclose on the property? Yes... but it is rare that the property is foreclosed at full value. Consider that the FHA currently gets only 61 cents on the dollar for foreclosures. This is another reason why the note is bought at a discount: the note buyer is paying money up front for future payments that may never come. There is also the possibility that a property's value may decline, or be completely destroyed. We've all seen the TV news pictures after hurricanes, earthquakes, tornadoes, fires.... Those homes belong to ordinary people -- folks like you and us.
Risk Example
Let's take a typical thirty year mortgage -- that's 360 payments.
Payment #1 -- Arrives in Mary's mailbox... right on time.
Next month: payment
#2 -- Arrives in Mary's mailbox... right on time.
#3 -- Right on time.
#4... There's a pattern here. Of course. Bill doesn't want to lose his house!
Payment #100; 8 years. Bill loses his job; he's out of work for 3 or 4 or 5 months. There's a little glitch in the payments. No biggie. Payment #200; 17 years. Bill's wife needs hospitalization.... She stays for a while.... Those medical bills are pretty hefty. Payment #300; 25 years. Bill dies.... All of these issues go through a buyer's mind, or should go through their mind, when he or she buys a note. Inflation and risk. This is why mortgage notes are valued at a discount to their face amount. The example above shows the home seller holding the note for some time before selling it. There's another way to do this, however, called "simultaneous closing". Here's what happens: The buyer pays the seller a substantial down payment. The seller then accepts a loan from the buyer directly, and in exchange, transfers the house. At the settlement table, once the home seller takes back the promissory note, s/he then immediately sells it to the Note Buyers. We accept the risk of the buyer's default, and the home seller walks away from settlement with all of the money.
Partial Purchase
We'll close with a fun topic. Think what you would do if we handed you a check for $20,000. What would you do with the money? Invest? Pay off debts? Travel? Buy a car? Let's take our example with Mary. Instead of selling her entire note, let's say that she only wanted enough to buy that car. Remember, she has a note with a balance of $96,968.22. We could buy what's called a "partial" cash stream. In this case, we would buy the right to receive the next 24 payments. We pay Mary $20,753.05. For two years, we collect the monthly payments. In two years, the note would go back to Mary, and it would still have a balance of $89,919.02. She would then resume collecting those monthly payments of $1,074.61 for twelve more years.
Conclusion
How can you use a promissory note to help you sell your house? You can sell your house faster if you increase the size of the pool of potential buyers. One way to do this is to offer seller financing, just like Mary did. When you create the note, there are some things to keep in mind which will help you increase the value of the note. If you hold the note, the paper will have a higher value to you. If you sell the note, you'll get a higher price from the buyer.