This article considers the use of an adjustable rate note (ARM) by a carryback seller during periods of low interest rates when it is foreseeable interest rates will rise.

Editor’s note — This article does not apply to private lender loans or carryback notes secured by one-to-four unit residential properties. 

Adjustable rate loans originated by institutional and private lenders or carryback sellers which are secured by one-to-four unit residential properties are heavily regulated by state law and federal agencies. [Calif. Civil Code §1916.7] 

The bargain increasing interest rates


A seller of a parcel of real estate, other than one-to-four residential units, agrees to carry back a note secured by the property. The sale will take place at a time during the current business cycle when real estate related interest rates are rising or are likely to rise. 

The seller and his listing agent have indications that both short- term and long-term interest rates are going to maintain (or begin) an upward swing over the next few years of national economic or inflationary upturn. 

The resale value of a fixed-rate note arranged before the rise in rates will be decreased by any future rise in interest rates, resulting in a future loss of value in the note which the seller wants to avoid. The seller wants to be able to sell or pledge the note in the future without a loss in its value caused by rising interest rates. 

Can the carryback seller receive both the current interest rate charged for fixed-rate loans and any future increase in interest rates without renegotiating the interest rate on his carryback note every year or two based on due-dates or call options? 

Yes! A carryback seller and his perspective buyer can agree to an adjustable rate mortgage (ARM) note. ARM provisions give the carryback seller both the current market rate for fixed-rate loans and a rate adjustment for any future increase in short-term interest rates. Thus, he reduces his risk of a loss in the value of his note. 

For the carryback seller to benefit from any future increases in short-term interest rates, the terms negotiated for the note will include a periodic adjustment of interest, based on: 

·     a rise in the index selected for interest rates on short-term treasury bills; and


·     an agreed-to margin representing the spread between the current figure in the index and the market rate charged by private lenders for fixed-rate loans.


Negotiating a carryback ARM


An agent solicits a seller of income producing property, other than one-to-four residential units to list the property for sale on terms which include a carryback of short-term junior financing by the seller. The carryback will assist a buyer in financing the purchase of the property. The current market rate for a comparable fixed-rate loan made by a second trust deed lender is 10%. 

The seller wants to offset the financial risk of what he believes will be a future market of rising interest rates driven by inflation fears, an excess demand for mortgage funds, growing corporate equity financing and massive government borrowing. 

To hedge against rising rates, the seller wants an adjustable rate of interest on any note he agrees to carry. The initial interest rate sought by the seller for the first six months will be the current market rate for private loans. When the initial interest period runs out, the note rate will be adjusted upward every six months to match any periodic increase in rates as reflected by an index tied to short-term interest rates for government bills. 

The carryback seller wants his interest rate adjustments to be set by figures from an index based on short-term rates since he believes short-term rates will be driven upward more rapidly than long-term rates, and remain up for many months after the decline of long-term rates. 

In addition to an index figure, an interest rate margin must be set to make the periodic adjustment in the interest rate on the carryback note. The amount of the margin will be added to the adjustable rate mortgage (ARM) index figure to establish the periodic interest rate on the carryback note. 

Consider negotiating a margin based on the percentage spread between: 

·     the interest rate currently charged by private lenders on comparable fixed-rate second trust deed loans; and


·     the current figure from an index for short-term treasury rates (one-year T-Bills) or lender cost-of-funds (11th District cost-of- funds).


Thus, with the amount of the margin set for the life of the carryback note, the carryback seller’s yield on the note will change every sixth months as the index figures issued by the government change, reflecting any increase or decrease in short- term interest rates. 

In our example, the current market rate for comparable fixed-rate loans originated by private lenders is 10%. 

The index agreed to is the one-year constant maturity treasury index, which is currently at 4%. The margin agreed to is 6%, the difference between the current market rate on fixed-rate loans made by private lenders (10%) and the index figure (4%). 

Thus, when short-term interest rates increase as the economy or inflation picks up, and the index figure rises as a result, the interest rate on the note will be adjusted accordingly. 

Editor’s note — In periods when interest rates are in decline, as occurred in the mid-1980s and again in the mid-1990s, it is advantageous for buyers to finance their purchases by using an ARM. ARM financing allows their payments to drift downward with short- term interest rates. Later, when the note rates on the ARM and fixed rate loans are at the same reduced level, the buyer then converts or refinances the loan with a fixed-rate loan to provide permanent long-term financing. 

Conversely, the moment ARM rates benefit buyers, carryback sellers should arrange fixed-rate notes with prepayment penalties to cover losses of future earnings due to an early payoff during a period of reduced rates. 

However, when short-term interest rates begin to rise, as they did in the late 1980s and to some extent at the turn of the century and again in the mid 2000s, the advantage of using an ARM shifts to carryback sellers. Sellers with adjustable rate carryback notes can ride short-term interest rates upward as a hedge against inflation and the increased demand for funds. 

Carryback seller


A seller seeks to carry back paper on the sale of real estate, other than a one-to-four unit residential property. The carryback note will provide the seller with a steady stream of relatively management-free future income. 

The carryback seller understands an adjustable rate mortgage (ARM) note would help maintain a positive real rate of return by adjusting his yield to keep up with any increase in inflation. He also knows potential buyers are unlikely to make offers containing terms for a carryback ARM when fixed-rate loans are plentiful and cheap. Also, arranging regular carryback financing, especially an ARM, is foreign to most brokers and agents who began selling real estate after the mid 1990s. 

What can the seller do to encourage buyers to make an offer containing a provision for a carryback ARM? 

The seller and his listing agent should release information on the seller’s willingness to carry back an ARM as detailed in the listing agreement, making the carryback information available to the public and other brokers. Publishing listing information is accomplished primarily through multiple listing services (MLS), electronic networks, flyers and newspapers. 

However, if an offer submitted to the seller by a buyer does not include a carryback ARM, the seller can include the carryback ARM in the terms of a counteroffer by preparing and attaching an ARM agreement as an addendum referenced in the counteroffer. [See first tuesday Form 263] 

ARMing the AITD


A carryback seller includes an all-inclusive provision in an adjustable rate mortgage (ARM) note to create an all-inclusive ARM. 

If an all-inclusive trust deed (AITD) wraps an underlying loan which contains a variable interest rate provision, structuring the carryback note as an ARM with an all-inclusive provision must be considered as nearly imperative. The ARM provision in an AITD note protects the dollar amount of the equity in the AITD note from shrinking during a rise in short-term rates. Further, ARM provisions in the AITD maintain the amount of the payment override in AITD installments when market rates rise and drive up the interest rate and the amount of the installment payments on the underlying ARM. 

Thus, as the interest rate on the underlying note varies, the AITD’s note rate and payment schedule will increase or decrease parallel to the changing interest rate. Tying the AITD note rate and payment schedule to variations in the underlying ARM provides the seller with a constant yield and cash flow over the life of the AITD, equal to the override margin set in the ARM note provision. 

Converting the ARM to an all-inclusive ARM only requires adding an all-inclusive provision from a fixed-rate AITD note to the ARM note. The added provision references the inclusion of the underlying loan balance in the principal amount of the AITD note. 

The all-inclusive provision is added to the ARM note by entering the provision on the face of the ARM note. If there is insufficient space on the face of the note, attach an addendum which includes the provision and reference the addendum on the face of the note. [See first tuesday Form 250]