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Investing | Real Estate

What Is a Straight Note in Real Estate?

A straight note in real estate is a type of loan agreement where you are required to pay only interest during the note’s term. Once the term ends, the entire balance of the debt is supposed to be paid in a single balloon payment.

Types of notes in real estate

When a borrower signs the promissory note (a note that forms the debt), they have to pay the promised money off. For this reason, there are many ways to pay the borrowed money off. One such note is called a straight note, where the borrower only pays interest. This type of note is usually suitable for a short-term construction loan that lasts for a few months.

Another method of payment is a partially amortized note, where payments go towards both principal and interest. The principal amount of a loan is the original loan balance, and in a partially amortized loan, the borrower only pays the loan down partly. This means there is still some balance left over at the end of the term. The remaining balance is then paid off using a balloon payment. It works as a final payment, paying the loan amount off completely.

Another type of payment plan is a fully amortized note, which is usually considered for something as huge as a 20-year home loan. This type of note implies that the payments include the principal and interest, and that the loan is paid off entirely throughout the term. This means the borrower can own the home once those 20 years are over and the payments have been made.

Graduated payment notes are another type of note, but they’re not as commonly used as the other types. This type of note is where the payments are initially lower but gradually go up every year. It typically happens for five years consistently, after which they are expected to level off.

Last, we have the adjustable-rate mortgage, where your interest rate changes every year based on several economic indexes. With this type of mortgage, you can expect the interest rate, payments, and everything related to change. The most important thing to remember here is that if a borrower wishes to pay the loan off faster without paying as much interest. The borrower can then make extra payments toward the principal. This results in the reduction of the loan balance and total number of payments that should be made over the loan term.

What is a balloon payment?

When you pay a large sum as soon as the terms of your loan are ending and the amount is comparatively larger than any amount you may have paid before, it’s called a balloon payment. If there are any loans you come across without the option of a balloon payment, you can pay a fixed amount in a certain sequence to get done with the loan’s remaining balance. This type of payment helps borrowers reduce their fixed payment amount when they decide to pay a larger amount once their terms end.

Generally, such loans are well-suited to borrowers with a good income and excellent credit. However, they happen to be riskier than any other loan even though the initial payments are low because there is a large amount still pending at the end. Hence, lenders prefer providing these loans only to businesses or consumers with sufficient credit, an adequate amount of cash, and a stable source of income.

Due to the nature of this type of payment, several states have banned mortgages related to balloon payments or put limitations on auto loans of similar nature. For mortgages and auto loans, borrowers are supposed to pay a large amount as a down payment to be eligible.

Balloon mortgages

If you’re a qualified buyer looking for low monthly mortgage payments, you can consider the option of balloon mortgages to finance your home. One of the most common example of this type of mortgage is the home loan with an interest-only agreement where homeowners can defer paying the principal down for up to 10 years. Instead, they can solely pay interest.

Mortgages of this nature, along with other types of balloon mortgages, usually get used by home-buyers who don’t have financial issues when dealing with a large payment (principal) on a regular schedule of amortization. Most prospective clients of this type of mortgage don’t pay the amount at the end of the reduced payment period. Instead, it’s common to consider refinancing or selling the house to avoid making a large, lump sum payment.

Costs and benefits of balloon payment loans

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It is recommended people with stable incomes use balloon loans. For instance, it may be a good idea for investors who wish to minimize loan costs and free up capital. Moreover, many businesses with an immediate financing nature and predictable income utilize such loans. However, it’s not that great of a choice for an average borrower, especially if there is no income security.

Average borrowers take out balloon payment loans only to hope that their financial situation may improve in the near future. Therefore, if you do consider getting one for purchasing a car or a house, create a budget on a monthly basis before applying for a loan. This will help you decide on the basis that you can afford to pay for it with your income right now. On the other hand, if you do not want to make a purchase in a rush, you can save the amount for a down payment later. This way, you’ll be able to get a more valuable asset with reasonable monthly payments.

Pros

  • The initial payments are low
  • Borrowers can have access to a reasonable amount of capital
  • It can help in covering any financing gaps

Cons

  • Loan costs can increase later down the line
  • There are more risks involved than a traditional loan because of the payment schedule
  • There are fewer chances of you getting a refinance later

Basics of notes

The dictionary meaning of a note varies, and you may find a lot more definitions of this four-letter word than needed. However, in terms of real estate, it is a written promise to pay a debt. Typically, certain parties can request the Escrow Holder to prepare the Note in an escrow transaction, especially where a private lender does not have the expertise to do it. Regardless, it is recommended to consult a legal counsel after the forms are prepared.

Typically, two types of notes outline debt – a secured or an unsecured note. A rather common example of an unsecured note is our everyday check that we draw from our checking account. Generally speaking, there are three parties involved in a secured note and two involved in an unsecured note. Here are some basic terms involved in the process.

  • The “payee” or lender is the person who receives the payment
  • The “payer” or borrower is the person who pays the money
  • The “trustee” is generally a third party in a secured note who issues the loan release once the amount is paid off

No matter what type of note is involved, there are some elements that one must incorporate into this instrument. For starters, it must be in writing and have an amount. There must be a date on the instrument and also a date for payment.

Third, there should be a payee, payer, and both of them should be legal entities. Last, the payor must sign the instrument. If you’re wondering what a legal entity is, it’s something recognized under Federal and State laws. For example, an incorporated organization or a natural person.

What else should you put on the note?

Here are some additional items you can put on the note depending on the conditions: Interest rate (only if it’s charged), starting off the interest, the method of payments, the starting and ending dates, and the term of the note.

Secured and unsecured notes

An unsecured note is similar to a check in a way that it isn’t backed by any security except the ’payer’s ability to pay. In circumstances where the payer is unable to pay, the payee may have to go to the court for collection, but an unsecured note can attach to anything owned by the payer.

A secured note, on the other hand, comes with the backing of payer-owned real estate. Here, if the note is not paid, the payee has the option of foreclosing on the real estate. However, in some states, specifically California, there are certain conditions required when it comes to this type of note.

  • There should be a deed of trust that puts the loan on the ’payer’s property, and it must be with the note.
  • The deed of trust and note should have a “trustee”- a neutral or disinterested third party who can be called upon for re-conveyance issuance after the loan is paid completely.
  • There must be some agreed-upon clauses in the deed of trust as well as the note.
  • If the payer is unable to pay at any point, the payee can choose to foreclose both judicially or non-judicially.

Since there are many different types of secured notes, here are the most commonly used ones:

  • Straight note: Both interest and principal payments are due in one lump sum at one time.
  • Installment Note – This is the most common one where there are set amounts for principal and interest throughout the note term.
  • Interest-only Note – Here the monthly payments are based on interest-only, and you’re required to pay principal only at maturity.

Apart from the loan term and interest rate, additional conditions can be incorporated into the note after negotiation between parties. Some of them are:

  • Prepayment penalty- This type of penalty is applied if you pay the loan off earlier than the due date.
  • Due on sale clause- This implies the loan has to be paid in full in property transfers ownership.
  • Late charge- It’s a certain part of your monthly payment that you have to pay in case you made a late payment.
  • Subordination clause – This clause allows your loan to be subordinated and made into a new loan in the future.

You may have to consider several conditions and requirements for each note because even a small error may invalidate some or all of your note. Interestingly, you may not be able to catch it even after years at a crucial moment. Therefore, preparing a note requires expertise and knowledge of the laws that govern it.

Moreover, depending on the property and type of transaction, you can find the laws in your state’s relevant business and professions code or the civil code. While escrow officers are there to prepare the note, it is up to you to obtain legal counsel as a client. A legal counsel will help you review the note and ensure the property reflects the same agreement.

Pros and cons of secured notes

There are important costs and benefits associated with this type of loan you must consider before deciding if this is the right funding source for you.

Pros

Here are some of the benefits:

  • Smaller loan payments allow you to have money in your business.
  • Since there’s collateral involved to secure the loan, you have better chances of finding good rates than an unsecured loan.
  • Making timely loan payments will help make your credit score better. A good credit score enables you to find refinancing opportunities before addressing the balloon payment.

Cons

On the other hand, there are also some drawbacks of secured notes. Some of them are:

  • The lender may seize the collateral if the payments are not timely.
  • There may be difficulty coming up with the funds to pay for a big balloon payment once the loan ends and if you weren’t careful enough during the planning.
  • If you plan to refinance the loan before getting to the balloon payment and your credit rating is not up to par, it may not be possible to refinance immediately.
  • The loan can also be challenging to pay off because you are not building equity in the loan.

Straight notes for short-term debt

Typically, straight notes are used by carry-back sellers or lenders to act as evidence for short-term debt. However, they are not used enough in real estate transactions because most mortgages aren’t short-term. It is possible to use straight notes as evidence for temporary real estate matters. One example is bridge loans you can use to buy a certain property when the required funds for closing are unavailable.

Using interest-only calculators

One way to determine whether straight notes are the right choice for a loan agreement is to use interest-only calculators. Since interest-only mortgages have become popular recently, it’s only fair to find out if the settlement suits your affordability. For many borrowers, this type of mortgage offers a great deal to lower their mortgage payments while also preserving the choice to pay against loan principal whenever they wish.

Interest-only calculators are hence designed to help you understand the payments and costs associated with an interest-only mortgage. It also helps you figure out how much loan balance you can reduce by making extra payments and how much interest you can save.

How to use this calculator

Here are some steps you can follow to arrive at monthly payments using a mortgage calculator.

  1. Find out the slider where you can put the intended mortgage amount or type it into the box manually.
  2. Select the number of years you require to pay the mortgage off from the drop-down box.
  3. Select the number of years you need to make up the interest-only time of the repayment plan and the interest rate.
  4. Click on the prepayments option to input any extra payments you wish to make within the interest-only phase.

As soon as you’ve input the required calculations, click the calculate option. You will be able to see an estimate of your monthly payments and interest-only phase of the loan. You can also click the View Report option to see what your repayment plan looks like in the duration of your mortgage. This may also give you an idea of the projected increase during the mortgage amortization phase once you start paying the principal amount down.

Who should use this calculator?

The calculator can be used by people who may be interested in this type of mortgage but wish to see if the costs play out in their favor. It can also be used to figure out what your payments would be like at different stages as the loan proceeds. Moreover, you can also use it to see the prepayment effects on the amount of interest you’ll pay through the life of the loan and to calculate how the period of interest-only payments impacts the loan later on.

If you’re wondering why the total interest is higher than a standard mortgage, it’s because you’re not reducing the loan principal during the first phase of the loan. Since you’re not paying the principal down, you’re making interest payments on the full loan amount each month. This means that 5% of $200,000 is the same in the first year of the term as it is in the fourth, unless you make prepayments.

Once the results of your calculation are there, start looking for quotes from lenders to see the type of rates they’re offering. This way, you’ll be able to see if you pre-qualify.

Wrapping up

In conclusion, to determine whether a straight note is well-suited to your needs, it’s important to get a professional’s opinion. Weigh out the pros and cons, and don’t hesitate to look into other types of notes before placing your final bet. Don’t forget to consider small but trivial factors such as your credit score, as it highly determines your refinancing options. Become familiar with terms used in a typical real estate situation. Additionally, use resources such as interest-only calculators to determine whether getting loans of this caliber are worth it.