So, you have decided to use Seller Financing to sell your property. Next, you must find the right buyer. But how do you do this? You are not a bank and so many people are interested. How do you select the right borrower to ensure the success of your new Note?
INTRODUCTION
Many sellers accept buyers without vetting the borrower to determine credit worthiness and how much they can afford to pay. The last thing a seller wants is to stress over receiving monthly payments or worse, getting the property back through foreclosure. The key in setting up a successful new Note is to make sure you follow these steps in selecting, choosing, or accepting the correct Borrower!
REVIEW THE BUYER’S CREDIT
How buyers have paid bills in the past is a good indicator of how timely they will make future payments. Always review the buyer’s credit prior to accepting a promise to pay.
Sellers can obtain a signed authorization from the buyer to pull credit through a reporting agency or simply ask the buyer to obtain a copy of his or her report for review. Most note investors prefer credit scores above 675. If the scores are lower, it will likely reduce any offers to purchase the note after closing if a time arises in which you may wish to sell.
VERIFY AFFORDABILITY
If a buyer can’t afford the monthly payments, it soon results in late payments or worse, no payments. Buyers should be willing to share their job history along with how much money they make each month. Paycheck stubs or tax returns can help verify the income.
3 Ways to Calculate Payment Affordability Before Accepting Seller Financing
The amount a buyer can afford to spend on a house depends on their income, overall debt, cash they can put down, credit rating, and the mortgage terms.
There are three different calculations that are traditionally used by mortgage companies to determine how much house a buyer can afford. These are known as the Income Rule, the Debt Rule, and the Cash Rule. While owner financing does not require the strict use of these rules, it makes sense to utilize the standard as a guideline.
1. Income Rule
If you ask a real estate agent or lender for an estimate of how much a house a buyer can afford, they’ll typically use a version of the Income rule. The Income Rule says that the monthly housing expense — which is the sum of the mortgage payment, property taxes, and homeowner insurance premium — cannot exceed a percentage of income.
This is often referred to as the front-end ratio and ranges from 27 percent to 30 percent for most lenders.
For example, if the maximum percentage is 28 percent and the monthly income is $4,000, the monthly housing expense can’t exceed $1,120 (4,000 x .28 = 1,120). If taxes and insurance on the home are $200 per month, the maximum monthly mortgage payment is $920. At 7 percent interest for a 30-year loan, that payment will support a loan of $138,282. Assuming a 5 percent down payment, the maximum price of the home this buyer can afford would then be $145,561.
2. Debt Rule
The Debt Rule says that the total debt expense – which is the sum of the total mortgage payment plus monthly payments on existing debt like cars, credit cards, etc. – cannot exceed a percentage of income.
This is often referred to as the back-end ratio and ranges from 36 percent to 43 percent.
For example, if this maximum is 36 percent and the monthly income is $4,000, the monthly payment can’t exceed $1,440 ($4,000 x .36 = 1,440). If taxes and insurance are $200 a month, and existing debt service is $240, the maximum mortgage payment the buyer can afford is $1,000. At 7 percent interest and a 30-year loan, this payment will support a loan of $150,308. Assuming a 5 percent down payment, the maximum price of the home would then be $158,218. You’ll notice that’s higher than what we calculated using the Income rule.
3.Cash Rule
The Cash Rule says that the buyer must have sufficient cash to meet the down payment requirement plus other settlement costs.
If the buyer has $12,000 and the sum of the down payment requirement and other settlement costs are 10 percent of the sale price, then the maximum sale price using the cash rule is $120,000 (12,000 divided by .10 = 120,000).
Since this is the lowest of the three maximums in this example, it would be the affordability estimate that is safest to use for determining the correct borrower.
SUMMARY
When selling a home with owner financing, an important step is to qualify your Buyer! Often, once a deal is agreed to with a buyer, the seller will jump to closing instead of verifying credit worthiness and affordability. This is a very common mistake. Understanding your buyer and their ability to pay is a key step to ensure long-term success of your new Note.
Back in the early 2000’s, many banks started to loosen up review of the borrower’s ability to pay. In 2008, during the real estate meltdown, a significant number of unqualified borrowers could not make their monthly payments, and subsequently many banks and financial institutions went bankrupt. There are no federal bailout programs for sellers accepting owner financing. Play it safe and make sure the buyer is qualified before closing on your new Note!
CONNECT WITH PEAK NOTES
MEETING
Why not set up a meeting with a Peak Notes specialist to discuss the steps to follow to determine if your Borrower will be successful for your new Note! Meetings are brief, cost nothing and can give you more insight into how you can maximize your investment potential!
If you live in Florida or have a Note in Florida, click on the button below
If you live outside Florida or have a Note outside Florida, click on the button below!
NEWSLETTER
Want to stay informed on everything about Notes? Peak-Notes produces a monthly newsletter that covers information about Notes. The focus is on education and information, really focusing on getting the most out of your investment in Notes. The Newsletter also covers topical news stories, market updates and conference summaries.
If interested, click on the button below!
Have a question about Notes or just want to inquire about Notes?
Click on the button below and send your message or question!