Note Professor Newsletter

How To Structure a Note To Sell at Closing Continued

The most common question I receive from sellers is, "How should I structure a note to sell at closing?" There is no cookie cutter answer. Usually, each note is taken on its own merit, and different note buyers will have different parameters. As a rule, there are three factors which will decide the value of note, or determine if the note is marketable at all. J.P. Morgan said the most important factors in lending were the three "Cs"… character, capacity, and capital. In the note industry, we refer to the most important note factors as the three "Ps"…the people, the paper, and the property. "The people" refers to the credit worthiness and ability of the buyer to pay. "The paper" refers to the terms and conditions of the note. Lastly, but what I consider most important is "the property", or the collateral. It is the property where the ultimate security of a note lies. I will be discussing all three factors. In this issue, I will emphasize the people factor. At the same time, I will give you a step-by-step approach, that will quickly weed out unmarketable notes.

Remember that when you take back a note, you are going to be lending someone ten's, if not hundred's of thousands of dollars. Wouldn't you want to know a little about the people you are lending this money? So would a note buyer. We will get into how to structure the note later. Now we are concerned only with the people. As the cartoon on the front page indicates, due diligence must be done to check out the people we are going to loan thousands.

When the buyer submits the contract, have them fill out a Fannie Mae Form 1003. This is the loan application form lenders use. You can obtain it from the Fannie Mae website, or if you email me, I will send you one. The Form 1003 will give you an idea of income, assets, job history, and liabilities. Sometimes merely by glancing at the credit application, you will be able to see assets that will make the deal workable, that was not even considered, like cash value of life insurance. Remember to look for any notes they might have also. These notes can be converted to cash for the down payment. More importantly, you will have a thumbnail view of the buyer, and with their signature, you are now given the authority to pull their credit report.

From the Form 1003, you can get a grasp of factors affecting the value of the note, such as debt to income ratios. The lower the ratio, the better. I wish I could give another cookie cutter answer on what is the maximum acceptable, but some note buyers are more strict than others. However, the closer you get to the 50% range of debt to income, the less warm and fuzzy a note buyer becomes. Likewise someone who has a job history of 6 months, is not the same quality as someone who has been working in the same job or industry for a year or more. Are you starting to get a picture of what a note buyer looks for? We note buyers are not as stringent as conventional lenders, but at the same time, we do not shut our eyes to reality.

Next comes the credit report. Many wise sellers will have the buyers get a copy of their own tri merge credit report, and furnish it to the sellers. Once you have the buyers' credit reports, you now have a good idea as to what the credit worthiness is of buyers. If you see the buyers have a credit score in the lower 500s, you know your note is not going to bring the same price as a credit score in the upper 500s or greater. A low credit score does not necessarily mean the note is not marketable, only that it is not as valuable from "the people" standpoint. Often you can offset a low credit report with a more sizeable down payment. For example, I purchased a note where the buyer had a terrible credit report. Nevertheless, because he put over 30% down, this made the note very marketable. I will get more into this aspect when we discuss "the property. A axiom you can go by is the lower the score, the more the down payment. A rule of thumb, (whose thumb? Mine of, course) if the buyers' have a credit score in the low 500s, at least 20% down is needed to satisfy a note buyer. On the other end, a 600 score or above, only 5% down is needed. Usually somewhere in between is reality.

If the buyers do not want to furnish you with a credit report, relax, it is not the end of the world. It merely makes it easier for the note buyer to make a firm offer if we know the credit worthiness of the buyers. Some note buyers will not pull the credit scores of the buyers until there is an agreement on the price of the note. If the credit scores are already available, then there will not be factors come up in the buyers' credit history that will effect the original offer on the note. The reason some note buyers will not look up the scores prior to having an offer accepted is because if the note holder is not going to accept an offer based on good credit, it is a waste of the note buyers money to pay for a credit search. Many note holders will approach a note buyer with the intent just wanting "to shop", but have no desire to sell their note. This is fine, it is part of the business, but do not expect for the note buyer to start paying for expenses until there is a firm deal. It would be like your paying for an inspection for a house before you even have a contract. Remember our time and money are valuable, also.

There are numerous ways to purchase a note with the buyers' having less than perfect credit. In the EDUCATION section, there are several methods on how to sell a partial of a note, or perhaps a split payment, or even split funding might solve everybody's problem.

Basically, that is it in a nutshell. In selling a note at closing:

First, get the buyers to fill out a Form 1003.

Next, have them obtain their own credit report, and furnish you with a copy.
Then fill out your contract specifying the sales price, down payment, and the terms of the note.

Finally, fax me the contract, Form 1003, and credit report. If I am in the office, I will let you know within hours what your note is worth. If I am not in, I will be back with you within 24 hours. You will know then whether you have a potential deal, or if you should move on with another buyer.

But, Professor, how do we structure the note for maximum value. This is exactly what we will discuss in the next issue, when we discuss "the paper".

As with anything you read in THE NOTE PROFESSOR NEWSLETTER, always consult and attorney and CPA before dealing in notes.

Be sure to CONTACT the Professor, and give him you comments or suggestions.