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How to Carry Back a Mortgage

by Ron Kilber

If you were going to build a home for yourself with the intention of selling it quickly after a few years, what design would you consider? Would you build an exotic, custom home with limited appeal, or would you build a three bedroom, two bath, with a double garage?

You would be wise to choose the later. The three bedroom, two bath, with its mass appeal, will not only sell much more quickly, but it will command a higher resale price too. Designing your home to include resale value and salability would be the smart choice.

On the other hand, what if you already own your home, and now you want to sell it and carry back a mortgage by receiving monthly payments? What design would you plan for your mortgage? Would you create an exotic, custom mortgage with limited appeal and value? Or, in the event that you wanted to sell your carry-back mortgage at some time in the future, would you create a mortgage which has high value and widespread appeal to investors who buy these types of real estate instruments?

You would be wise to choose the later. Here's why. Carry-back mortgages can be valuable securities, which can be sold at face value--provided the right criteria is met. On the other hand, if these certain conditions are not met, liquidity is not only greatly diminished, but the safety and cash value of the "paper" (carry-back mortgage) is too. This means that when you decide to sell your "paper", you will have to sell it at a discount.

Mortgage discounting is a function of many factors, however, relatively speaking, only three are the most crucial--the note interest rate, the term, and the loan-to-value (LTV). Anyone who is about to consider carry-back financing as an option when selling real estate absolutely must, without a single exception, learn and understand, at the very least, these three important factors, which determine the safety, salability and cash value of real estate "paper". Anything less can result in a huge cash loss for the note holder in the event of a default, or a huge cash loss in the form of a discount when it comes time to sell the paper.

LTV (loan-to-value) is the single most critical factor, which goes into creating a good carry-back contract. When you receive half of the purchase price as a down payment, and carry the remainder as a first mortgage, you own a golden piece of paper. In this case, your LTV would be 50%, and chances of a default would be slim to non-existent. If the interest rate on your promissory note is anything close to market yields, which satisfy investors, you stand an excellent chance of obtaining full face value for your asset, should you decide to liquidate. Not only that, the investor more than likely will not demand an appraisal, credit report or borrower profile--all of which means more money for you.

The reason LTV is so critical to an investor is based on the theory that real estate borrowers will not default when they have something significant to loose. I once called a borrower with a lot of equity in their home to find out why they had not made their payment to me. The wife told me that they were short of money and had medical bills which had to be paid because the doctor was threatening with a lawsuit. They were not sophisticated people, and they did not realize the strength and lethality packed into the deed of trust lien which I held on their home. After I explained to them that I could take their property, but their doctor could not, they immediately began paying. Never again have they been a day late with their payment.

Interestingly, I had no credit report on these people. Nor did I have an appraisal on their home. I did not know his place of employment, or if she was even employed. As you can see, none of this mattered, because I had a note with a favorable LTV. These people, if they could help it, were not about to jeopardize their hard-earned equity by defaulting on the monthly payments. With each passing month, their equity grew, and so, too, did the odds improve that they would continue to pay. This improved the value and quality of my investment even more.

Put another way, if these people were to default, my "financial exposure" compared to the value of security would be relatively small. If they owe $25,000, but the value of the home is $45,000, then my "exposure" is $25,000. Therefore, when I foreclose, my acquisition cost would be $25,000, plus any costs which I must incur to obtain possession of the real estate.

When you sell real estate and provide seller financing with a small down payment, you are creating a high exposure risk for yourself. If you try to sell your carry-back contract, any investor worth his/her salt will immediately detect this danger. This does not mean that he/she will not want to buy your contract. It only means that if you want to interest him/her in your paper, you must improve the "exposure", which is usually accomplished by discounting.

This brings us to the proverbial question, how much will the discount be? In a low down-payment situation, it's all based on exposure. In other words, if the deal goes south, how much money will the investor actually have in the property? Investor yield or return has nothing at all to do with discounting. In other words, if the borrower defaults, the investor is going to end up owning the real estate for whatever is still owed (plus foreclosure costs). This depends on how much the investor paid for the paper. If the property sold for $45,000 with only $3,000 down, the carry-back contract would have been $42,000. If an investor wants to limit his exposure to 70% of the property value, then he will pay no more than $31,500 for the paper ($45,000 x 70%). This means the note holder would have to discount $10,500 ($42,000 less $31,500) from his mortgage, if he is going to sell to this investor.

At this point any sane person would condemn any investor wanting such a discount, however, consider his/her fate should there be a default. First, the investor usually must wait a fixed amount of time before he/she can commence a foreclosure. Then there is another time to wait during the reinstatement period while the foreclosure is in progress. If a bankruptcy ensues, there is another waiting period. Once the investor finally gains title to the property, he/she must still wait for any money while attempting to sell. All together, these waiting times can add up to well over a year, and in extreme cases as long as five years.

Not only that, all these waiting times cost money. Not only can the investor lose all interest income while waiting, but he must pay out huge costs for professional and legal fees, as well as real estate sales commissions. All these costs, plus the original investment, must be recovered in order for the investor to be made whole.

In the meantime, the borrowers, Joe and Sally six-pack, continue to live at the expense of others, and with absolute impunity, because the law is on their side. They do not make any repairs. They do not maintain the landscaping. They do not do anything, except create distressed property, which at best might bring 80%, or $36,000 on the open market. To add insult to injury, Joe and Sally six-pack are not even the ones who are losing their equity. Remember, they only put $3,000 down when they purchased the home.

Who would wish such a fate for any investor paying only $31,500 for the discounted mortgage in this situation, where the exposure, due to costs, may well exceed $40,000? So much for a society which rewards scofflaws and then punishes the thrifty who direct their savings to an investment instead of to an affluent lifestyle of self indulgence.

To summarize this subject of LTV, remember that the greater the down payment, the better are the odds that a borrower will be a good payor. For this reason, any investor will pay more for a note which has good equity behind it, because the payors stand to lose a substantial stake in their property should they decide to default.

Never overlook this very important element, which you can do to enhance the value of your seller financing: negotiate the largest down payment possible!

TERM is the second most critical factor which goes into creating a good carry-back contract. When you sell real estate and provide seller financing to the new owners with a 30 year term, you own a piece of paper which at best can be described in the trade as a "dog". This is true even when you get a substantial down payment.

I am still holding "paper" today which I carried from a property I sold long before I ever knew what this business was all about. The Realtor who closed the deal talked me into seller financing because he could not find a buyer who could qualify for a new mortgage. I was very hesitant to participate in his creative-financing scheme because I knew I would need a large sum of money a year or two down the road. "No problem", he told me while producing a list of note buyers from the classified advertising section of the local newspaper. "People sell contracts all the time. It's just like selling property, only it's paper, you see?", I remember him telling me. So I went along with his proposal, confident that I was liquid, however, totally oblivious of the consequences which I would have to face two years later.

When the time approached for me to cash in my deed of trust, I began calling note buyers. To my dismay, I learned that my paper was worth less than 50 cents on the dollar -- max. In others words, I owned a "dog". All of the explanations which I received, for such a low price quote, all sounded like a broken record, "your term is too long".

I blamed my Realtor for the predicament he put me in. He was totally oblivious of any factors which would have had an impact on the health of my carry-back paper. Needless to say, I did not sell my note, because I did not want to discount my note 50%. I'm still receiving payments today.

Had my "gas-station owner to Realtor" known just one factor--term, I could have been spared a great deal of financial catastrophe. Anyone who can comprehend that "adding air to car tires increases mileage", surely can learn a few things that will add mileage to the value of a note, too.

If you carry a note with plans to someday sell it, don't do as I did. Had my Realtor, for example, structured my note with a 5 year term instead, I could have sold that note for more than eighty-five cents on the dollar, instead of the less than 50 cents which I was offered. That would have translated into many thousands of dollars more in my case.

The reason "note term" is so critical to an investor is based on the fact that no one has yet been able to predict the future. If interest rates today are 8%, what will they be in 30 years? Nobody knows. Therefore, why would an investor buy a 30 year note written at 8% today when the possibility exists for high interests rates, say 16%, in the future? He wouldn't, unless of course you were willing to discount your paper so that he would realize, say, a 16% yield on his investment. Of course this would mean giving away your paper because such a situation would require about a 50% discount of the note.

On the other hand, when paper has a short term, an investor is less concerned about future interests rates because they will have less effect on his/her portfolio. For example, when you discount a 5 year note to yield 11% in an 8% market today, an investor will more than likely want to bet on the future in order to take advantage of the opportunity to own a good note. In other words, he may conclude that even if interests rates rise to 11% after four years, he will then have to wait only one more year to get out with all of his money, and then back into something else that will yield a higher rate. Otherwise, his alternative would be to stay right were he is, probably in a bank account yielding a lower rate of return.

With long-term paper, however, if you offer an investor a higher yield (a larger discount), say a 13% yield, an investor will more than likely want to bet for a longer time into the future. How long? Each investor is different. This is the question that only can be answered when an investor places money in escrow to purchase a note. Only then will you know for sure how long into the future he/she will bet based on a given yield.

There is another reason, aside from the fact that no one has yet been able to predict the future, why "note term" is so critical when it comes to how much money you can obtain from the sale of a note. It has nothing to do with hedging on the future or greed of an investor. It has to do with simple mathematics.

For example, let's say you own a $10,000 note, written at 12%, payable monthly with interest only payments, and all due and payable in one year. The monthly payments are $100 ($10,000 times 12% divided by 12 months). When you keep this note until paid, you will earn $1,200 in interest ($100 x 12 months).

Now let's say you want to sell your paper, and you find an investor willing to buy it, but only if he can get a 15% yield. In other words, he is not satisfied with the $1,200 of interest which your note will earn. Instead he wants $1,500 ($10,000 x 15%). This means you would have to discount your note $300, so that the investor would realize a profit of $1,500 ($1,200 in interest plus $300 of discount).

[Note! For purposes of clarity and simplicity, I purposefully avoided taking this example into extreme technical discussion. Even so, in that absence, the result on my conclusion is not appreciably different. In actuality, the discount would be less than $300 because the 15% return is based on the investors real cash outlay of $9,723--not $10,000. This means that the investor will be looking for a 15% return on his cash outlay, and not on the face value of the note. Consequently, the investor wants to earn $1,477, not $1,500, and accordingly, you will not have to give him/her a $300 discount, but only a $277 discount.]

So far, understanding the principles of discounting have been quite elementary. Even when we complicate things a little bit, the concept remains easy to understand.

For example, let's change the equation by only one factor. Assume your $10,000 paper does not have a one year term, but instead has a two year term. The interest rate is still 12%, and the payment is $100 each month. This means when you hold it to maturity, you will realize a return of $2,400 in interest ($100 x 24).

Now, when you want to sell this note to the investor, how much will you have to discount it? Since the investor wants a 15% yield, this means he wants $3,000 for a return on his investment ($10,000 times 15% times 2 years). In other words, you will have to discount your note $600 in order that the investor can realize the same yield ($2,400 in interest plus $600 of discount equals $3,000).

[Note! In reality the discount in this example is $516, because the investor wants to earn $2,916 to achieve a yield of 15% on his actual investment of $9,484--not $10,000.]

Curiously, this just happens to be about twice the discount percentage of your one year note.

By now you've probably gotten ahead of me and concluded that if you change the example to a 3 year note, then the discount rate will approach three times the one year rate. You are right. The longer the term, the more the discount bite will be, even when all other things remain the same.

Let's say that your note has a 10 year term. Already you can guess that you would have to take a steep discount in order that an investor might realize a 15% yield. That is if he would be comfortable with a 15% yield on such a long contract. Because of the 10 year time factor, he may now want a 16% or 17% yield to hedge against higher interest rates further into the future. This now means that your discount will be even steeper so that the higher yield can be realized for the investor who is hedging on the future.

Here lies the critical problem wherein "note term" becomes a double edged sword. Not only is the value of a long term note eroded by simple mathematics, but it is also eroded by the higher yields which investors demand to hedge against unknown interest rates in the distant future.

Never overlook this very important element which you can do to enhance the value of your seller financing: negotiate the term to be as short as possible!

The INTEREST RATE is the third most critical factor which goes into creating good carry-back paper. Remember the previous example where you own a $10,000 note, written at 12%, payable monthly with interest only payments, and all due and payable in one year? What if the note rate were 15 percent? In other words, your annual return would be $1,500 ($10,000 times 15%), $300 more than before. When you sell your note to the investor who demands a 15% yield, you can sell without any discount and realize full face value from the sale of your note.

On the other hand, if you have a 10 year note written at 14%, you will only need to discount your paper about 5% (1% for each of the five years) in order to satisfy an investor who demands a yield of 15%.

Never overlook this very important element which you can do to enhance the value of your seller financing: negotiate the highest interest rate possible!

To summarize, there are three things you can do to enhance safety, price and salability of carry-back paper.

  • Negotiate the largest down payment possible.
  • Negotiate the shortest term possible.
  • Negotiate the highest interest rate possible.

If you follow these three principles, you will create a good carry-back contract, which will perform flawlessly to maturity, or when the day arrives and you want to liquidate your holding, your chances of realizing full face value are greatly enhanced.

Moreover, if you are a real estate professional, at the very least you will avoid alienating a valuable client, as well as demonstrating that you have a good working knowledge of the factors, which contribute to the safety and value of seller financing. Once a note is dangerously cast, it is difficult, if not impossible, to go back and restructure it.

Many other factors contribute to establishing the safety and value of paper such as seasoning; credit rating and income of the payor; occupancy by owner or tenant; type and location of property; and payment promptness. None of these, however, play a role as crucial as the down payment, the term, and the note interest rate.

Finally, understanding these critical factors will emphasize that note discounting is not a function of investor demands, but rather a function of critical components which enhance the safety and value of carry-back financing.

More money to you.

Copyright © 1995, Ron Kilber. All rights reserved.

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