The closing of a note transaction is like a funnel for problems. It can gather all the little oversights from your negotiations into one big lump that delays, or stops, the money flow.
Perhaps the most common oversight that grows into a lump is the next payment due: the transition payment. Who gets it, you or the note seller?
Why the next payment causes disputes
Most notes have monthly payments, so it’s important to settle which payment is the last to go to the note seller and which is the first to go to you, the note buyer.
Note closings can take longer than you expect. If they run past a month, you’re into the next payment period, and both you and the note seller may think that month’s payment is yours. That can turn into a frazzling dispute that kills a deal.
It’s easy to neglect the question. By the time you negotiate a preliminary agreement, do your due diligence, prepare the final documents and close, the payor may have made another payment. You have to think ahead.
Put the payment split in writing
There is no single way to handle the transition payment, but a few pointers can help you avoid upsets that could sink your deal.
First, have a clear written agreement with the note seller in advance. It should say exactly which payment is the last one the seller receives and which is the first one you receive.
Example: You’re buying a note balance of $30,000 with monthly payments of $400. You’ve agreed with the note seller to buy the December 1 balance of $30,000. You sign a written agreement that the seller gets the December 1 payment of $400 as their last payment, and you receive every payment beginning January 1.
Next, be aware of two special situations that come up often enough to mention. They can’t always be foreseen clearly enough to settle in writing beforehand, and this is where you’ll test your negotiating skills.
Handling sophisticated note sellers
The first situation is the sophisticated note seller, most often someone experienced in real estate or lending, who may insist on part of the transition payment. They’re used to calculating the time value of money by the day, not the month. Even though the note pays monthly, they want to be paid by the day.
Some will simply ask you to split the transition payment down the middle, half for them and half for you, without fine calculations.
Very sophisticated note sellers will do the calculation a day at a time, but they usually want only their share of the interest down to the day. As far as they’re concerned, the principal is yours. It’s a habit they probably picked up figuring loan payback schedules.
This seller tests your poker skills as well as your negotiating skills. Like the Kenny Rogers song says, “You’ve got to know when to hold ’em, know when to fold ’em.” Try to keep as much of the payment as you can, but being too inflexible may cause the seller to walk away. It’s better to give up part of a payment than lose the whole deal.
Whatever split you agree on, figuring each person’s share is routine with a business calculator and interest tables. Daily prorating is increasingly common as note sellers become more sophisticated.
When the closing runs late
The second situation is an unexpected delay. If the closing goes well past the planned date, who gets the payment becomes a matter of fairness, not just negotiation.
Example: Your planned closing date is mid-August, and you’ve agreed in writing to split the September payment fifty-fifty. Then you learn that someone who must sign documents is out of the country and out of reach of FedEx. The closing drags on an extra month, and the seller wants the whole September payment. You negotiate to keep part of it, and the seller reluctantly agrees. Then the closing drags on another month, and the seller insists on the whole September payment and part of October’s.
Now you really have no choice about the September payment. It’s a matter of business ethics, and your integrity and reputation matter more than a note payment. If the seller squawks, give it to them.
But you would be justified in renegotiating your price, since you’ll get a lower balance and fewer payments than you originally agreed to pay for. The fairness issue cuts both ways.
Making sure the payment reaches you
Once these matters are settled, make sure you actually get the transition payment as agreed. It won’t happen by itself. The payor, or the servicing agent if there is one, can’t read minds and will keep sending payments to the old payee. It’s up to you to notify the payor or servicing agent that you’re buying the note and make sure the transition payment and every later payment come to you.
There are two common approaches:
- Freeze payments. During negotiations, ask the payor or servicing agent to hold all payments until the seller notifies them in writing that your purchase has closed. Get the seller’s permission first, because you don’t own the note yet and have no real authority over the payor. This gives you control over when your first payment arrives and avoids bookkeeping messes and payments crossing in the mail.
- Hold back one payment. Agree with the seller that you’ll pay for the note at closing minus one payment, which you hold out (often in escrow) until the transition payment is made. If the seller receives it, the seller keeps it as part of the proceeds. If you receive it, you send the hold-out to the seller. Either way you get the transition payment.
Keep in mind that because you didn’t notify the payor before you bought the note, this might be the month the payor decides to pay extra, or less than usual. Holding out a payment isn’t foolproof, but it often works.
Protecting your holder-in-due-course status
When you buy a note, make sure you have the legal protection known as being a “holder in due course.” It gives you valuable immunity from certain later complaints by other parties, especially the payor. But the rules for gaining this status are strict, and one of them cancels the protection if you buy a delinquent note.
That can raise technical questions:
- If the closing drags into a new payment period, say May 9, and you haven’t received the May 1 payment and the note has no grace period, is the note overdue and delinquent?
- If you’ve held out a payment or put it in escrow after its due date, is the note delinquent?
The rules say that if you have notice that a note is overdue and you buy it anyway, you may not be a holder in due course.
You can protect your status by putting off the closing until the transition payment is actually paid and the note is current. Or you can take your chances and close without that payment in hand. That’s a judgment call to make with the risks clearly in mind.
All these little things, if neglected until closing, can turn into that lump in the funnel. Pay careful attention to them and keep the money flowing smoothly.
