The Case for Stepped Payments
© 2002 by Bill Broadbent & George Rosenberg

Why aren't stepped payments used more often?
Most real estate agents are not familiar with seller financing in any form. They have been taught to list property, look for a buyer with a down payment, then send the buyer to Insecurity Bank to apply for a new loan for the balance of the purchase price. Unfortunately this simplistic formula doesn't always work. Sometimes the buyer fails to qualify; sometimes the property fails to qualify. Property owners who will carry the financing find that more buyers are takers. Their property sells faster than if they waited for that elusive "all cash" buyer. Some buyers with reasonable credit still don't qualify, or, they just don't want to put up with Insecurity Bank's "picky policies."

The biggest obstacle to stepped payments may be that it has been difficult to produce an amortization schedule. T-Value, a computer software program used frequently by accountants, can produce such a schedule. The program is a bit expensive and the procedure for setting up the stepped payment calculation is cumbersome. Recently a simple (PC) program was produced that calculates stepped payments either by a flat dollar increase (periodically) in the regular payment or by a percentage increase (periodically) in the regular payment. It also computes any future balloon payment and produces an amortization schedule. It includes a column of boxes called "Date Paid" which the note holder can use to record the payments as they are received. This payment history is valuable in the event the note holder ever decides to sell the note.

In the event the note holder decides to sell his note this program will produce a schedule that discounts the note to the investor's desired yield. It will then amortize the discount over the life of the note and print a schedule that assists the note investor in reporting taxable income from his note investment.

Now that these mechanical problems have been solved more real estate agents and note brokers should learn how to properly structure seller carried notes and use stepped payments where applicable.

Application of the stepped payment concept

Arthur Agent has just listed Sam Seller's house. They have priced it at $110,000. Sam owns it free and clear of any loans.

Arthur: Sam, would you accept a cash down payment and carry a note for the balance secured by this property?

Sam: I'm not a bank! I'm not in the business of making loans!

Arthur: That's right, Sam, you don't have any cash to loan. You have some equity and a property to sell. If you were to accept a cash down payment and carry a note and mortgage you would facilitate the sale of your property.

Sam: I want cash!

Arthur: O.K., Sam. But what will you do with the cash?

Sam: I need the money to live on, to supplement my Social Security.

Arthur: How much more income do you need on a monthly basis?

Sam: About $750 to $800/month should do it.

Arthur: Suppose a buyer bought your house and after all transaction costs you had $100,000 left. What could you do with the money? Here are some alternatives.

1) If you put it under your mattress and withdrew $800/month, it would last you 10.4 years.
2) If you put it in the bank and they paid you 3% interest, and you withdrew $800/month, it would last you 12.5 years.
3) If you carried back a mortgage at 6% interest and you received payments of $800/month, your income would last 16.4 years.
4) If you carried back a mortgage at 9%, your income would last 31 years.

Sam: But I'm 68 years old and I won't be around for 31 years.

Arthur: You're probably right. In the years to come you'll need more dollars to spend to maintain the purchasing power of the current $800/month. If inflation during the next 15 years averages the same as the last 15 years, you will need about 3% annual increases in income to keep pace. We could structure a carryback note with stepped payment increases of 3% each and every year. Your note would last about 17 years. (The life expectancy of a 68 year old man is about 15 years)

Where else could you put cash to work and achieve comparable results?

In alternative #2 if you deposit $100,000 cash in the bank they will pay you 3% interest. What do they do with your money? They may loan it out to someone as a Mortgage at 7% to 9% interest and they keep the profit spread. If you carry your own mortgage, you don't need them and you can keep the profit spread. There are both risks and responsibilities in carrying a mortgage that are explained in a book I want you to read. It's called Owner Will Carry, How to take back a note or mortgage without being taken. I'll loan you my copy.

Sam: What if my note gets paid off early?

Arthur: You will have received a higher return on your note during the time it was in effect. You can always put the payoff funds in a bank or if you were comfortable holding a mortgage, then you could make a loan secured by real property. You could buy a note secured by real estate (at a discount) and still have a better yield than you can get at Insecurity Bank.

Sam: I see your point. Carrying my own mortgage can be a win-win situation. I get a good return secured by a property I know and understand. My income would increase annually, and the buyer gets his mortgage paid off much sooner.