An important element of any Note is the interest rate…so what interest rate should you select for your new Note? Should I pick a rate to match current bank rates? Since you are selling to a friend, should you give them a discount? What is the highest interest rate you can charge? With Seller Financed Notes, setting the interest rate correctly on day 1 is key to ensuring the success of your investment!
INTRODUCTION
When negotiating terms for your new Note, a key item will be the interest rate. You could argue this is the most important element of the terms after the price. By picking too low, you can severely hurt future values of the Note and lower your return. By picking too high, you risk exceeding state usuary laws bringing significant legal peril. The key is to pick the right interest, not too low or too high!
KEY ELEMENTS IN INTEREST RATE SELECTION
There Are No Takebacks!
The time to give serious consideration to the note interest rate is at the time of creation. There are no takebacks or do-overs. The rate you agree to accept at closing stays the interest rate for the life of the note. The only way to change it later is to get the buyer to agree and execute a formal note modification. It’s highly unlikely a buyer or note payer is going to agree to have their interest rate increased later (unless there is some advantage to them).
Return on Investment
Rather than just breaking even, a seller desires a return on their investment which is based on the terms you negotiate in the Note. By completing a Seller Finance Note, you will receive a monthly payment, but your lump sum will be tied up for the duration of the term, and the new owner will be the only one to directly benefit from any increase in property value.
The seller is now acting as the bank and should expect a return at least equivalent to the interest rate a bank is charging for a similar loan. The seller does not have the protection of private mortgage insurance that many banks require, adding another level of risk that should be rewarded by an increased rate.
Since the buyer is saving the costs a traditional bank might charge for a loan (points, underwriting fees, origination fees, etc.) it is reasonable to expect them to pay an interest rate above what a bank would charge.
Improve Resale Value to Note Buyers
If a note holder ever desires to sell their future note payments for a lump sum of cash, they will quickly realize how important the note interest rate is to investors. While investors look to a variety of factors to determine their pricing, all things being equal, a higher interest rate results in a higher purchase price from a note investor.
To highlight the benefit of having the appropriate interest rate, refer to the following table. For each case, all terms are the same except the interest rate. In case 1, the interest rate is 4% and the expected offer price is $59,334. In case 2, the interest rate is 6% and the offer price rises to $74,513. In case 3, the interest rate is 8% and the offer rises to $91,193! So, the higher the initial interest rate, the more valuable the note!
Inflation Fighter
Each year it seems the cost of buying the basics just keeps going up. It’s not your imagination; it’s inflation. So, what does inflation have to do with seller-financed notes? Well, a seller would need to at least charge an interest rate equivalent to the inflation rate just to break even!
Usury Laws
Usuary laws are designed to protect borrowers from predatory lending practices and financial exploitation. These laws are set up state by state so when creating your Note, it is critical that you understand your specific state limitations. As shown above, the higher interest rate, the move valuable the Note. Usury laws provide the upper limits for lending as a protection to the borrower. Before setting your interest rate, make sure you know your state’s limitations!
SUMMARY
As shown in this article, choosing the correct interest rate selection is extremely important and should not be done on the fly! Be sure to give the amount of interest charged on a seller financed note serious thought. It will affect the value of your note not only today, but also far into the future. Setting up your Note on day 1 with an appropriate Interest rate will maximize future value of your Note and get the most out of your investment.
Remember, you are providing a service just like a bank (without the onerous regulations and federal protections), do not sell yourself short by choosing the wrong interest rate!
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MEETING
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