The interest rate a seller agrees to accept when seller-financing a property to a buyer can have a dramatic impact on the note’s future value to investors. Unfortunately, many sellers don’t give this important decision proper consideration.

The fact is that the note’s “face” (interest) rate is a very big deal … here are a few reasons why!

Inflation Hedge

Each year it seems the cost to buy the necessities of life just keeps going up. It’s not your imagination; it’s inflation. Though the official inflation rate has been hovering around 2.5 percent annually, those who look deeper into the numbers paint a much more grim picture of the rate at which our currency is devalued. Add to basic inflation ever-increasing property taxes, skyrocketing energy costs, and it’s clear that a dollar tomorrow is worth significantly less than a dollar today.

You might ask, “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 true inflation rate just to break even! Beware of doing the buyer any favors by accepting a low interest rate when negotiating a sale.

Return on Investment

Most sellers offering seller-financing are looking for a positive return on investment. It’s not enough to just break even when factoring in the negative effects of inflation. By accepting payments from the buyer, the seller’s money is tied up for a considerable time. Benefits like home appreciation and depreciation can no longer be claimed by the seller once the property has been sold.

The seller now assumes the role of the bank and should expect a rate of return at least equivalent to the interest rate a bank is charging for a similar loan. In fact, there are good arguments to support an interest rate significantly higher than the going rate at the local bank.

For example, the seller doesn’t have the protection of private mortgage insurance (PMI) that many banks require when originating a mortgage loan. Not having the benefit of PMI adds another level of risk to the seller-financier that should be rewarded by an increased interest rate.

Consider as well that the buyer is saving the costs a traditional bank might charge for a loan (points, underwriting fees, origination fees, etc.). As such, it’s reasonable to expect the buyer to pay an interest rate above what a bank would charge. On average, it is recommended that a seller financed note carry an interest rate of at least 2% to 4% higher than bank rates to compensate for these benefits. In some cases, the benefits of offering seller-financing can command an even larger interest rate premium. Seller financing should be considered an amenity just like granite counter tops or an in-ground swimming pool.

Improves Resale Value

It’s not uncommon for a seller to believe they’ll continue to collect payments for the life of the seller-financed loan. Then at some point in the future life happens and they realize that cash now would be pretty nice. It’s at that point many sellers quickly realize how important the note interest rate is to investors.

A handful of factors work together to determine the price a note investor will pay for a seller-financed note. However, all other things being equal, there’s no doubt that a higher interest rate will result in a higher purchase offer from the investor.

For example, let’s say a seller holds a note with a balance of $100,000.00, an interest rate of 6 percent, and 120 months remaining. If the note investor wants a 9 percent yield, all other factors being ideal, then their offer would be $87,641.52 (a 12 percent discount). Now, if the note interest rate was only 4 percent, then the offer would decrease to $79,924.72 (a 20 percent discount). However, if the original note rate was 8 percent, then the offer would increase to $95,778.08 (only a 4 percent discount).

Hopefully, it’s clear from this simplified example that the higher the interest rate the more valuable the note. One word of caution … Always know and abide by federal and state lending laws which will set the maximum allowable interest rate. The main point in this section is to discourage sellers from setting the interest rate too low and later paying the price for that decision.

Do-Overs Aren’t Allowed!

As a seller, you get only one chance at the time the note is created to decide what interest rate you’ll offer. There are no do-overs or take-backs once the closing occurs. The rate you agree upon will stay the interest rate for the life of the note. The only exception would be to execute a formal note modification which requires both the seller’s and buyer’s consent. It’s highly unlikely the buyer is going to agree to an interest rate increase at a later date (unless there is some other incentive offered to them).

So, a word to the wise seller … Be sure to weigh carefully the interest rate offered to your seller-financed buyer since that rate will have a lifetime impact on the value of your note.

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