Most private loan originators are savvy real estate professionals who know how to structure a loan. However, some may not think long-term, in the form of an exit strategy such as selling to an investor, when creating their mortgage note.
Here are some tips to consider when crafting mortgage notes.
Put yourself in the mind of a mortgage note buyer when you create your note. A primary factor in determining the value of a note is the leverage of the asset. A potential buyer 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.
A smaller 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%, 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.
While a 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. Most individual buyers will 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.
If you are looking to sell 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.
When creating a mortgage note with the intention of selling, loan terms become extremely important. Consider the following when structuring your deal:
Keep the Loan Term 5 to 7 years
Typical 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.
Charge a 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 3 to 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.
No Balloons or Interest Only Loans
Although borrowers would love to get a business loan with a balloon payment, they are not practical for the lender and would only serve to devalue your note on the secondary market. On a balloon loan, a note buyer would only be able to realize a return on their investment after, and only if, the borrower pays the balloon payment as scheduled. Also, consider staying away from interest-only loans, as they defer principal payments that a note buyer would need to factor the yield into their buying price.
If the borrower is a business, and especially true for newly-formed entities, require a personal guarantee from the individual borrower or borrowers. While a personal guaranty is not required of a private loan, and may not seem warranted for a deal with a lot of equity, if you are planning on selling the note later, not having a personal guarantee could negatively affect the note’s value to the tune of thousands of dollars.
A personal guarantee keeps the borrower on the hook for meeting the financial obligations of the note. If there were no personal guarantee for a business entity loan, the managers could close the company, and a note holder would have no recourse but to foreclose. This situation could drag out in bankruptcy court for many months, tying up the investor’s capital for an extended period. So, if there is no personal guarantee, your note would not only become less interesting to most investors but may make it nearly unsellable on the secondary market.
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.
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.