How to Structure a Seller-Financed Loan to Maximize Profit

Selling a house with seller financing gives you great flexibility in structuring a loan based on the goals of each party to the transaction. The goal of the buyer is to have a monthly payment they can afford. The goals of the seller often are more complex. Certainly, the seller wants the best price they can get for the house, but other factors may be involved. They may be concerned with the monthly cash flow, the length of the loan, the interest rate, and the tax implications. All of these factors affect the value of the note if the seller later wants to sell the note.

Suppose you purchase a house as an investor with the intention of creating a seller-financed note which you can then sell to other investors to get your money back and do the next deal. Start with the end goal in mind and work backwards to achieve the best results.

Let’s analyze a case where an investor believes that a house would rent for $1,500 per month. He is willing to pay cash for the property, and he intends to flip the property at a higher price with seller financing. To meet the goal of a payment the buyer of the property can afford, the investor wants to keep the monthly payment to the buyer a similar or lesser amount than how much the buyer could rent the property for.

The trick to analyzing the deal is to understand the relationship between the price of the house, the interest rate charged, the loan term, and the monthly payment. In a standard amortization calculator, there are five fields –

- Principal Amount
- Interest Rate
- Loan Term
- Number of Payments Per Year
- Payment Amount

If you know four of the five fields, you can solve for the fifth field. Most people simply fill in the first four factors and solve for the payment amount. But what’s the fun in that? Assume that in this case taxes and insurance will cost $600 per month. The monthly principal and interest payment must be around $900 per month to meet the goal of a $1,500 PITI (Principal, Interest, Taxes, and Insurance) for the ultimate buyer. How many ways can get you to your goal?

- Monthly Payment: $900.00
- Interest Rate: 10%
- Total Number of Regular Payments (Loan Term): 180
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $83,751.69
- Monthly Payment: $900.00
- Interest Rate: 8%
- Total Number of Regular Payments (Loan Term): 180
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $94,176.53
- Monthly Payment: $900.00
- Interest Rate: 6%
- Total Number of Regular Payments (Loan Term): 180
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $106,653.16

As you can see, fixing the monthly P&I payment at $900 and keeping the length of the loan at 180 months gives you a range of values for the property between $83,751.69 and $106,653.13 at interest rates between 10% and 6%. A lower interest rate on the loan increases the value of the property.

You can also vary the length of the loan. What would happen at each interest rate if you changed the length of the loan?

- Monthly Payment: $900.00
- Interest Rate: 10%
- Total Number of Regular Payments (Loan Term): 120
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $68,104.05
- Monthly Payment: $900.00
- Interest Rate: 8%
- Total Number of Regular Payments (Loan Term): 120
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $74,179.33
- Monthly Payment: $900.00
- Interest Rate: 6%
- Total Number of Regular Payments (Loan Term): 120
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $81,066.11

The value of the property with a loan term of 120 months and a fixed P&I payment of $900 gives you a range of values between $68,104.05 and $81,066.11 at interest rates between 10% and 6%. The range of values for the property is less with a shorter loan term. What if you extended the loan term out to 240 months?

- Monthly Payment: $900.00
- Interest Rate: 10%
- Total Number of Regular Payments (Loan Term): 240
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $93,262.16
- Monthly Payment: $900.00
- Interest Rate: 8%
- Total Number of Regular Payments (Loan Term): 240
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $107,598.86
- Monthly Payment: $900.00
- Interest Rate: 6%
- Total Number of Regular Payments (Loan Term): 240
- Number of Payments Per Year: 12
- Solve for Principal Amount (Value of the Property): $125,622.69

The value of the property with a loan term of 240 months and a fixed P&I payment of $900 gives you a range of values between $93,262.16 and $125,622.69 at interest rates between 10% and 6%. It is important to note that the amount of money coming back to the lender is *exactly the same* over the course of the loan with each choice of interest rate. The only difference is the ratio between principal and interest. A loan of $93,262.16 at 10% interest will have the same payment amount and loan term as a loan of $125,622.69 at 6%.

Why does that matter? If you’re selling a property you have owned for more than a year outside of a tax-free IRA, then it has an affect on the taxability of the income. Long-term capital gains are typically taxed at a lower rate than interest, which is taxed as ordinary income. If it is done within the tax-free environment of a Self-Directed IRA, you don’t need to worry about the tax implications.

The market will limit the range of prices and interest rates you can realistically get for your house, but you still have tremendous flexibility in how you structure transactions. If you need to get a higher sales price to set comparables in the neighborhood, lower your interest rate on the seller-financed loan. If you believe the loan will be paid off sooner than the full loan term, then it makes sense to have a lower interest rate with a higher sales price. The loan balance will be higher if the house is paid off early.

Armed with the information on how much you can sell the property for, you can negotiate a better deal with the current property owner. Knowledge is power, and you have a significant advantage if you have knowledge that the other party doesn’t. If you want to make a 50% return on your money, then you know what you can afford to pay for the house. For example, if you believe that you can get $75,000 for the property with seller financing, then you must negotiate a price of $50,000 or less.

Now let’s take it a step further. Remember, your goal is to create a seller-financed note that you can sell to another investor to get your money back and do the next deal. Let’s say that you need $50,000 to do the deal with the property owner. How much of the note do you have to give up to get the $50,000 needed? Suppose you could find an investor who requires an 8% yield on his investment.

- Monthly Payment: $896.20 (this adjusts when you solve for Number of Payments)
- Interest Rate (yield): 8%
- Principal Amount: $50,000
- Number of Payments Per Year: 12
- Solve for Number of Regular Payments (Loan Term): 70

Since nothing changes for the borrower, you have to put the payment back to $900.00 and solve for the interest rate.

- Monthly Payment: $900.00
- Number of Regular Payments (Loan Term): 70
- Principal Amount: $50,000
- Number of Payments Per Year: 12
- Solve for Interest Rate (yield): 8.1558%

Your investor will be pleased to receive a slightly higher yield than he wanted. Now that you know what you have to give the note investor, how is that affected by interest rate and the price of the house? The answer is that *it is not affected at all!* You still have to give up 70 payments of $900.00 regardless of the interest rate and balance of the loan, and you still have the same number of payments remaining. The only difference is how much of the remaining payments is interest and how much is principal.

The lesson is to keep the end goal in mind when structuring transactions or purchasing property. By thinking about the end goal and working backwards you will focus on how to structure the transaction in the best way possible. You will become a more successful investor as a result.

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