Same buyer, same house: bigger down payment or bigger coupon?

Question

I'm about to carry on a 1970s three bedroom in a decent second-ring suburb, priced at 400k. Buyer is self-employed, two years of returns that no bank will read charitably, and he has roughly 80k of real cash plus a little reserve he doesn't want to touch.

So there are two shapes I keep sketching. First: 80k down, 320k note at 7.25%, 30 year amortization, 5 year balloon. LTV at creation is 80%, coupon is unremarkable, and if I ever sell the paper the buyer of it is looking at a modest yield and a thick equity cushion.

Second: 45k down, 355k note at 9.5%, same amortization and balloon, and he keeps 35k in the bank. LTV lands near 89%. Cash yield on my carried balance is materially better and the note throws off maybe 900 more a month in interest early on.

The argument for the first is that equity in the borrower's hands is the only thing that has ever kept anyone paying me in a bad year. The argument for the second is that coupon is what I actually get paid for, and a borrower with liquid reserves survives a broken furnace better than a borrower who wired everything at closing.

Note buyers I've talked to price the first one much closer to par. But I don't have to sell it.

Which constraint would you optimize against here?

raj_mehta14 · Answer

A couple of months into reading about this, I still can't tell whether down payment and interest rate are supposed to trade off against each other at all, or whether that's just something people do because the buyer only has so much cash. In your version they clearly do, because he can't fund both.

What I don't follow is the reserves point. If he keeps 35k liquid, that money isn't pledged to you in any way, right? He can spend it on a truck in month three. Whereas the 80k down is locked into the house and he loses it if he stops paying. So the reserves only help you if he happens to still have them when something breaks.

Or does the note usually have language about maintaining reserves? I haven't seen a real one yet.

tylerbrooks9 · Answer

80% and the boring coupon. I'd rather get paid slightly less by someone who keeps paying.

Same buyer, same house: bigger down payment or bigger coupon?

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