Unless the buyer is paying all cash, notes are an integral part of every real estate transaction. If the buyer is borrowing money—whether it is from an institutional lender or directly from the seller—he or she has to sign a note. This is the promise to repay the money. The note tells you how much is being borrowed, how it will be paid back, what the interest rate will be, and what security, if any, the lender will have in case the borrower defaults. Like contracts, notes come in different forms.
As note brokers know, there are periodic payment notes, where the borrower makes payments to the lender at predetermined intervals, i.e. once a month, twice a year, once a year, etc. Periodic payment notes can be fully amortized, i.e. principal and interest are both completely paid up by the end of the loan term; interest-only notes where the entire principal balance is due in one lump sum at the end of the loan term, or partially amortized. They can even be set up with less than the interest-only payments where the borrower would wind up at the end of the loan term owing more than he or she borrowed.
There are also straight notes, where principal and interest are all due in one lump sum at the end of the loan term and the borrower makes no payments in the meantime. These are quite useful for borrowers who want to keep their monthly payments down, but they can be trouble for lenders.
Notes Can be Secured By Real Estate or Something Else
As you may know, notes can be secured by real estate or some other specific property, or they can be unsecured, guaranteed only by the borrower’s word and his good credit.
Once you get into creative financing, which usually involves the seller carrying some sort of loan for at least part of the purchase price, note terms can make or break a deal. The is why clauses are important for both the buyer and the seller. These are the little zingers you want to put into every note you write. Clauses that will allow you to pay off the note at any time when you borrow money, or skip one payment a year without penalty. Clauses that prevent the borrower from passing the loan on to anyone else when you lend money and prevent the borrower from substituting a different property as security for the loan without your prior permission.
You can often slip things into a note that would never be accepted in the main contract. Once you understand the types of notes available and the different clauses you can use, you can make up your own notes to use when you are borrowing money and notes to use when you are lending money. Print them on your laser printer to look like any ordinary note from a title company. The only difference is that they will have your special clauses inserted in the fine print.
Is this unethical or illegal? Absolutely not! You are not trying to defraud or deceive anyone. You have a right to create the best kind of note for yourself. They will be printed there on the page along with the other terms of the note. If the other party reads the note he or she will see them.
If you, the buyer, are buying real estate and have asked the seller to take back a note (as you should do), here are some clauses you can add to the note which will benefit you, the buyer, and won’t cost the seller much.
1. The Substitution of Collateral Agreement allows the buyer to substitute other collateral instead of the property he or she is buying as security for any notes he asks the seller to carry back. He can substitute other real estate or some other type of property, such as gold or jewelry, with the seller’s approval. This gives you, the buyer, instant equity in the property you are buying.
POSSIBLE CLAUSE: “The note holder hereby agrees to accept a substitution of collateral for the amount of this note by moving the mortgage (or trust deed) to another piece of property which the borrower shall designate. The holder shall have the right to inspect such property to insure the security of the collateral and shall give his or her approval to make the substitution of collateral, which approval shall not be unreasonably denied.”
“Borrower is given the right to substitute collateral from time to time, being subject to borrower’s approval, but said approval shall not be unreasonably or arbitrarily withheld.”
2. Prepayment Privilege Clause: “This note may be prepaid at any time before maturity, in whole or in part, without penalty. A discount will be awarded to the payor of ___% of the remaining balance if this note is paid off prior to the maturation date stated in the note.”
3. The Subordination Agreement is the seller’s promise that he will subordinate any notes he is carrying to any new note the buyer may create. Normally, notes are given priority according to the order in which they were recorded. The first note recorded must be paid off in case of any foreclosure. The other notes, known as junior notes, get paid off only if there is any money left after the first note is paid.
If the property does not fetch a high enough price at the foreclosure auction, the junior note holders may get only part of their money back or none at all. For this reason, most lenders do not want to go beyond second position. If you already have two loans against a property, it will be very difficult to borrow any more money against it unless you can get the seller to subordinate.
That way, he or she goes into a third position and the new lender goes into a second position. The wording for a subordination agreement will require an attorney, but the benefits to you, the payor, will more than compensate for this additional cost.
4. Exculpatory Clause: “The liability on the part of the borrower to satisfy the terms and conditions of this note shall be limited to the property securing the subject loan and shall not extend beyond the subject property.”
5. Roll over Clauses/Balloon Payment Due: “Borrower shall have the right to extend the balloon payment, at his option, for an additional (12) twelve months, provided a principal payment of $___________ is made to the holder on or before the original due date of the balloon payment.”
“In the even debtor is unable to find reasonable refinancing for this loan prior to the due date, the debtor may pay ______ of the principal due as a penalty and renew the loan note at the above rate for ____ years.”
6. Attorney or Court Fee: “It is understood and agreed that in any proceedings for the enforcement of the debt evidenced hereby the legal holder hereof waives any right of collection beyond the proceed of security for said debt.”
“Any cost of collection, including an attorney’s fee not to exceed $500 will be divided equally between the maker and the payee.”
7. Assignment Clause: “Borrower has the right to assign this note and deed of trust (or mortgage) without penalty.”
“Said note and Deed of Trust to be fully assumable, with no due on sale clause.”
8. First Right of Refusal: “Should payee decide to sell their interest in this note to anyone prior to receiving full payment, borrower, or assignee, will have first right of refusal to purchase, upon the same terms and conditions as set forth herein, any such offer with thirty (30) days.
Written notice must be made to borrower of the intent to sell said interest and borrower must reply in writing.”
“The holder of this note reserves the first right of refusal to purchase note it is ever to be sold.”
WE HOPE YOU WILL EXPLORE THESE AND OTHER CREATIVE WAYS TO BUY REAL ESTATE. PLEASE, PLEASE NOTE YOU SHOULD ALWAYS CONSULT WITH AN ATTORNEY WHEN DRAWING ANY CONTRACTS. THESE PURCHASE AGREEMENT CLAUSES ARE FOR ILLUSTRATION ONLY. NO INDICATION IS INTENDED TO APPEAR LEGAL OR ILLEGAL. WE ALWAYS ADVISE EVERYONE TO CONTACT A PROFESSIONAL WHEN ENTERING INTO ANY WRITTEN AGREEMENT.