Unlike a few years ago, most banks now require a large down payment, even for good credit buyers. The problem is that many good credit buyers on the market today are cash-strapped. One solution to this problem is for the seller to offer financing to the buyer. In fact, it is estimated that in the near future 1 in 10 transactions may require seller financing.
Selling finance is a time-tested solution for tight credit markets, and it’s easy to understand: part or all of the purchase price is financed by the seller in the form of a promissory note. Deciding whether to have finances, however, is not so easy. The seller has a lot of questions – How to structure, cover and document it? What happens if the buyer fails to pay? What are the tax implications? If you are going to try this type of deal, first make sure you have 1) a good real estate calculator; and 2) experienced real estate attorney and tax advisor. Then follow these Steps:
- Step 1: Purchase price – You and the buyer must agree on the purchase price;
- Step 2: Amount Funded – Determine the amount you are willing to finance. Consider a) how much you owe on your current mortgage; b) the loan amount agreed by the buyer; c) the maximum amount the buyer’s lender will allow in the seller’s financing.
- Step 3: Loan Terms – Determine the interest rate, loan duration and amortization. There are many factors to consider. Interest payments only? Balloon? High default interest rate?
- Step 4: Guarantee – It’s more art than science. Consider the “4-C” of underwriting: a) Credit; b) Capacity to repay loans; c) Guarantee (house value); d) Character from the buyer. Unlike large banks, you will be able to create your own approval standards.
- Step 5: Documentation – DO NOT try to do it yourself. Get an experienced real estate attorney to compile the necessary documentation.
- Step 6: Closing – Go to settlement in properties as usual. Have your newly created mortgage recorded by the title company in the proper County land records. You can even get title insurance to protect your interests in the property.
But before you dive into owner financing, consider the following:
Guarantee: This may be difficult for beginners. If you don’t know the buyer, how do you determine his character and will he pay you back? One such tool is a credit report. Analyze each derogatory sign and dig deeper into why these things are happening. Maybe a spouse died or someone lost their job. Remember – you have underwriting flexibility that banks don’t have, so use common sense.
Existing loans: If you financed the entire purchase price of your home and you have an existing mortgage on the property, you must retain those mortgage payments even after you sell your home. This is called a “wrap”. However, you may be violating the lender’s “due-on-sale” clause contained in your mortgage documents. This shouldn’t be fatal to your deal, but it should be addressed.
Tax: If this is your primary residence or investment property? You should address any capital gains/tax liability issues you may have. For example, if you sell an investment property and finance the entire amount, you can still owe taxes at the end of the year – even if you don’t get any money at closing!
Default: Even with the best borrowers there is always a risk that payments will not be made as promised. If that’s the case, you should consider several options – from foreclosure to loan modifications to “replacement deeds”. Your local real estate attorney can properly address this issue.
Selling Notes: The business of buying paper money is booming. Many sellers trade long-term note payments for immediate cash. You can build long-term notes with buyers and then sell them at a discount, while still spending all the cash you want.
Seller financing will no doubt be the “lubricant” that keeps the real estate wheels turning until the credit market returns, but be sure to have the right professionals to help you. This will ensure that the agreement is structured fairly and that there is a legally binding contract between all parties.
