The value of a note is significantly affected by the interest rate that the seller agrees upon while offering owner financing to the buyer. It is unfortunate that many sellers often tend to neglect this crucial aspect.
So why does Interest Rates matter that much?
Because of Inflation
Year after year, the expense of purchasing essential goods keeps rising at an alarming rate. This is not a mere perception, but a clear case of inflation.
As per the Consumer Price Index published by the U.S Department of Labor on August 14, 2008, the inflation rate in July 2008 exceeded that of July 2007 by a noticeable degree of 5.6 percent. This upward trend even affected essential commodities like energy which registered an alarming hike of 29.3% over the same period.
The correlation between inflation and seller-financed notes lies in the fact that, in order to recoup their investment, a seller must establish an interest rate that matches or exceeds the inflation rate. Without doing so, the seller risks failing to break even.
Expected Return On Investment (ROI)
A seller seeks a profitable return from their investment, rather than mere breakeven. Accepting an IOU or payments from a buyer effectively ties up the seller’s funds. Moreover, any increase in property value resulting from the sale will predominantly benefit the new owner.
As the seller transitions into the role of the financier, it is imperative that they anticipate compensation at a minimum on par with the interest rates charged by banks for comparable loans. It should be noted that the seller assumes a higher level of risk, as they lack the safeguard of private mortgage insurance, a requirement for many banks. Given this added vulnerability, an increased rate of return is warranted.
Given that a buyer can avoid expenses typically associated with traditional bank loans such as points, underwriting fees, and origination fees, it is reasonable to assume that they will be required to pay a more elevated interest rate above the rates charged by banks. To offset these expenses, it is advisable that a seller financed note be charged an interest rate approximately 3% to 5% higher than bank rates.
Improve the future note value to other investors
When a note holder opts to trade their future note payments for a one-time lump sum payment, the significance of the note interest rate to potential investors becomes readily apparent.
Investors consider various factors when evaluating pricing, but all else remaining equal, a note investor would pay a higher purchase price when the interest rate is higher.
Consider the scenario of a seller who possesses a note worth $100,000 and makes monthly payments of $1,110.21. If an investor with a 9% yield rate were to make an offer, it would amount to $87,641, given the note rate of 6%. However, if the note rate were to change to 4%, the offer would decrease to $81,623. On the other hand, if the note rate were to increase to 8%, the offer would climb to $95,274.
To facilitate clear comparison, the following examples presume a constant monthly payment amount and satisfactory credit, equity, and documentation. However, the fundamental principle is straightforward: the higher the interest rate, the greater the worth of the note.
Since the interest rate is set when the note is created there are no take-backs therefore, when creating a note, it is vital to give careful thought to the interest rate as it cannot be altered once agreed upon.
This rate will remain constant throughout the lifespan of the note unless a formal modification is executed with the buyer’s agreement. Bear in mind that it is improbable for a buyer or note payer to consent to a future interest rate increase unless there is a clear advantage for them. Ensure that you make an informed decision when selecting an interest rate to avoid any irreversible repercussions.
It is crucial to carefully consider the interest charged on a seller financed note, as it has a significant impact on the note’s value, not just presently but also in the long term. Ensure that you give it serious thought.
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