Interest Rate Risks of Owner Financing
Both buyer and seller involved in an owner financed transaction are exposed to risk and reward resulting from interest rate changes. Adjustable rate mortgages are common in conventional home financing, but rare in owner financed transactions. If nothing else, the legal documents required to define how the adjustments are made are so complex they could not be drafted by the usual general practice attorney. Most seller financing will have a fixed rate of interest.
What happens if the interest rates increase?
The buyer is happy because their rate stays the same and may even be below market. The higher rates go, the better their deal looks.
The seller may be unhappy. However, in most cases the note was written at 3-5% above the bank rate for savings, so the seller may still be making more money than they could on their savings.
Where the seller will really suffer is if they are forced to sell the contract into the seconday note market after there has been an interest rate increase. Depending on a lot of factors the cash value of the contract may be reduced by 1/3 or more. Not a happy situation.
What happens if interest rates go down?
The buyers gets more and more unhappy and feel like they are paying to much. It their credit has improved since they bought the house, they are making more money or some other facet of their financial condition has changed, they will probably start shopping for a conventional loan at market rates and pay off the seller.
If the seller needs the money, getting paid off early is a good thing. However, if the sellers were counting on the extra interest for income, they will be less pleased. If overall interest rates are going down they probably can’t find any place to invest the note payoff funds at the rate they were getting. If large amounts of money were involved, this can mean a large drop in income for the sellers.
{ 7 comments… read them below or add one }
What do you suggest as a fair way to establish an interest rate to charge someone for owner financing? The specific piece of property I am selling is 3 acres of land with an old mining cabin on it that is not a legal residence.
Thank you,
Lillian
That’s a hard question to answer.
Interest rate frequently makes a good negotiating point because it may have a lot more importance to one party than the other. Thus, the party that doesn’t care can make a “concession” which has value to the other side but costs them little or nothing.
What do you earn on other investments? Since there is no property to damage, this should be a low risk loan. That would mean you could set the rate low and still double your return on investment. On the other hand I believe bank loans to buy property like this are VERY hard to find, have high fees, and a lot of paperwork and other requirements. My daughter actually had to have property re-platted when they paid off the owner financing on a property with bank financing. That would suggest you could ask for a high rate and still be cheaper than the buyers other choices.
Interest is taxed as current interest income. Profit from the sale is taxed at capital gains rates. You can play with the amount of each you receive by raising the price and lowering the interest or lowering the price and raising the interest rate. The payment can stay the same; it just changes how the money is allocated.
It all comes down to what you and the buyers agree is “fair”.
I am looking at buying a property. The agent is telling me there is a minimum rate of interest allowed by federal law. Is this true?
Thank You!
What do you think about an interest only, three year note at 4 points over prime adjustable in conjunction with purchasing a commercial property? From the bank, the rough terms I have been getting are 15 year am w/ 3 year balloon at 6.0-6.5%. Can you help me analyze the two options. Thank you in advance.
Do either of the notes allow the lender to do anything besides take back the property in the event of default? In other words, what do you loose if you can’t refinance in three years? Your credit rating? Your down payment? Control of your business?
What do you expect to happen over the next three years which will make paying the balloon or refinancing with terms which make sense to you possible?
With a bank loan I think you are vulnerable to more issues which are outside your control. For example, even if you are making your payments on time and your numbers are good the bank may decide to leave the area, etc.
Have you considered a lease/option with the seller. That would give you the right to perform but not the requirement.
I think the interest rate and/or payment amounts on the two alternatives you describe are the least important factors in your decision.
Good luck with it.
Thank you for your response. The reason we are considering owner financing is that the current tenant has only a little over a year left on its lease, and in my conversations with the bank, it appears that there may be some concerns because of the short term nature of the lease. The tenant is a department of the city government, and my due diligence points to the fact that they will not be leaving any time soon. In addition, I do not think there would be any major differences if we did default on the loan.
Our thought process was to get owner financing for now, and then refinance with the bank if and when the tenant renews its lease. We are putting over 60% in equity, so we have sufficient cash flow and cash reserves to handle an unforeseen problem. That being said, I have never used owner financing and was a little unsure about the tentative terms. In order to figure out our payments, would I just use 3 years as the length of amortization (instead of 15 with the bank)? If this is correct, then it seems as though our payments would be lower with the owner financing. Also, why would the seller offer an interest only loan and not have us pay principal as well? Thank you again for your help.
That all makes sense.
If it is an interest only loan there is no amortization. Your payment would be the monthly interest on the outstanding balance at whatever rate it had adjusted to.
In the current economic times many people are worried about inflation. Many are also having a difficult time finding “safe” investments with decent returns. From your description you are a solid buyer and I presume the seller is comfortable with you. That being the case, the proposed terms let him lock in a return that is probably higher than he might get elsewhere and which will adjust for inflation. Your loan might very well be one of his highest yielding investments so keeping as much invested as he can (no principle reduction) would make sense.