Friday, August 13, 2004

Promissory Note An Instrument of Investment

There are plenty of ways to invest in real estate and one of the cleanest ways is to loan money to homeowners/buyers who need cash to purchase a property. For most individual investors, this loan would be based on a promissory note – an instrument by which you loan someone money and they promise to pay it back in certain terms and at a certain interest rate.

It sounds easy – and the process actually is pretty simple. There are plenty of sample notes on the Web and even Microsoft has some templates for this type of document at its documents site – I’ve used it several times. The tough part comes in the risk factor. After all, you’re handing over thousands of dollars to someone and hoping, praying they’ll pay it back. If they do – great – you’re making more than market interest on your money. However, if they don’t, you may have to foreclose on the property, which can get pretty messy.

If the person signing the note (the borrower) is a trustworthy person – then there’s no fear. That’s why you want to complete a financial background check on anyone to whom you would consider issuing a promissory note. Assuming you’ve completed this process, then your next task is looking at the terms of the note.

This will include these basic points:
Start date and finish date
Loan amount
Length of loan
Interest rate
Payment plan
Recourse for non-payment
Location payments are to be sent
Name of who will receive payment
Name, address of borrower…just to name a few.

There are several ways to figure repayment. If this note is a family member and you’re just loaning them the money, but don’t really care when it’s paid back, then you can be a bit more flexible on the payback requirements. Let me mention something here – it you are receiving a loan from a family member, you definitely want to use a promissory note. It removes any question as to the intentions of both the borrower (son/daughter/nephew/niece/grandchild) and the lender (mom/dad/uncle/aunt/grandparent).

I’ve seen plenty of bad blood boil over because “My grandson never paid back that $15,000 I loaned them to buy a house.” If the borrower gets into further financial stress, it gets more uncomfortable and distressing at between the family members and can ruin what should be a nurturing relationship. However, a promissory note takes away the flexibility of “just pay it back when you can.”

The payback can occur several ways:

Amortized – This is how most loans are paid off. A payment that includes interest and principal over the term of the loan. For a $10,000 loan over 5 years at 7 percent, the amortized payment would be $198.01 per month and the payments would be spread over 60 months.

Balloon Payment - Let’s say you can only afford $100 per month, but you still want to pay off the mortgage in 5 years. Then you would be looking at a monthly payment of $100, but then a final large payment at month 60 of $7,016.96.

Interest Only – There’s a lot of talk about interest only loans these days. On a simple plan, the above loan would cost the borrower $58.33 per month for 59 months (7 percent per year divided by 12 monthly payments) and then a balloon payment of $10,058.33 on month 60.

Single Payment – This is how many promissory notes are structured – “Here, Johnny, take this $10,000 and pay me back with interest in five years.” Johnny, then would pay back the $10,000, plus accrued interest totaling $3,500 (7 percent per year). It could even be compounded interested, which is a great deal for the borrower – because Johnny is paying interest on interest and principal and the loan amount grows each year.

There’s a lot of information out there about promissory notes. Before you either issue one or take one, read up on the risks and benefits. Next week, I’ll talk about how to get cash for a note you may already be holding.

1 comment:

Anonymous said...

Does anyone have a website, or a quick and dirty outline of the Lease to own process, i.e. contracts, negotiation issues, average rent above payment, amount down, etc.?