Same buyer and same house, so does the bigger down payment or the bigger coupon win

Question

Here is a structuring question that comes up on nearly every seller carry, laid out with numbers so the tradeoff is visible. Take a 1970s three bedroom in a decent second-ring suburb, priced at 400k. The buyer is self-employed with two years of returns that no bank will read charitably, and he has roughly 80k of real cash plus a little reserve he does not want to touch. First shape: 80k down, 320k note at 7.25%, 30 year amortization, 5 year balloon. LTV at creation is 80%, the coupon is unremarkable, and if the paper is ever sold, the buyer of it is looking at a modest yield behind a thick equity cushion. Second shape: 45k down, 355k note at 9.5%, same amortization and balloon, and the borrower keeps 35k in the bank. LTV lands near 89%. Cash yield on the 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 in a bad year. The argument for the second is that coupon is what a capital provider actually gets paid for, and a borrower with liquid reserves survives a broken furnace better than a borrower who wired everything at closing. Note buyers price the first one much closer to par, though that only matters to a holder who intends to sell. Which constraint would the room optimize against here?

raj_mehta14 · Answer

Down payment and interest rate do trade off against each other, and not just because a buyer is cash constrained. A larger down payment lowers the lender's risk and usually earns a better coupon, but the mechanism only holds when the buyer's cash is genuinely limited. On reserves, the instinct is correct. Cash the buyer holds outside the transaction isn't pledged to the note holder unless the note specifically says so. A buyer can spend reserve cash on a truck in month three and there is nothing in an ordinary note preventing it. The down payment behaves differently because it is embedded in the collateral and lost on default. So reserves only protect a note holder if the buyer still has them when something breaks, which is a behavioral bet, not a contractual one. Some notes do carry reserve covenants requiring a minimum balance be maintained and verified periodically, with a cure period or default trigger if it drops below the floor. It is not universal, but a seller carrying paper who wants that protection should write it into the note rather than assume it.

tylerbrooks9 · Answer

80 percent and the boring coupon. Getting paid slightly less by someone who keeps paying beats the alternative.

Same buyer and same house, so does the bigger down payment or the bigger coupon win

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