Financing Residential Real Estate

Financing Residential Real EstateLesson 13:Seller Financing

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IntroductionThis lesson will cover:how seller financing workswhy seller financing is usedforms of seller financing alternatives to seller financingagents responsibilities in seller-financed transactions

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How Seller Financing WorksTwo ways for seller to finance buyers purchase:purchase money loanland contract

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How Seller Financing WorksMortgage or deed of trustSeller is extending credit to buyer, not providing loan funds.Buyer makes installment payments to seller.Seller is mortgagee or beneficiary, with right to foreclose in case of default.

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How Seller Financing WorksContract for DeedBuyer (vendee) takes possession of property, but seller (vendor) retains title until contract price paid in full.Alternative to a lien.Seller extends credit to buyer.

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How Seller Financing WorksSeller financing may be:primary financingseller is buyers main or only source offinancing for purchasesecondary financing (seller second)supplements primary loan from institutional lendercovers part of downpayment or closing costs required for primary loan

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How Seller Financing WorksSeller generally decides which type of finance instrumentReal estate lawyer should prepare/review.Deed of trust: trustee must be appointed.Choosing finance instrument

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Why Seller Financing is UsedSeller financing can: attract buyers when interest rates are highhelp buyer qualify for institutional loanenable seller to charge higher priceprovide tax benefits to seller

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Why Seller Financing is UsedSeller financing:seller isnt bound by institutional policies regarding yields, loan-to-value ratios, or qualifying standardsnot an option for seller who needs to be cashed out quickly

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Seller SecondsSeller second: buyer paying most of purchase price with institutional loanseller accepts second mortgage for remainder

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Seller SecondsSeller second supplementing new institutional loan must meet institutional lenders standards.Combined loan to value (CLTV)CreditIncome and debt ratiosAssets (including reserves)TermsSupplementing a new loan

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Supplementing New LoanFactors in buyers financial situation may shape design of seller second:funds available for down paymentbuyers qualifying for total monthly paymentinterest rateballoon paymentBuyers situation

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Supplementing New LoanMay be easy to refinance seller second with balloon payment if: property has appreciated substantiallyinterest rates are low

But if interest rates are high or property has lost value, refinancing could be difficult.Buyers situation

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Supplementing New LoanSellers evaluation of second:cash at closingmonthly incometiming of payoff (balloon payment)yield on investmenttax consequenceslien prioritySellers situation

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Seller SecondsSeller second can supplement buyers assumption of sellers existing mortgage. Buyer makes payments on seller second to seller.Buyer takes over monthly payments on sellers existing mortgage.Supplementing an assumption

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Seller SecondsAssumption only possible if:existing mortgage doesnt have due-on-sale clause, orlender agrees to assumption.Needed to release seller from liability.Usual underwriting standards to evaluate buyer assuming loan. Supplementing an assumption

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Seller Financing as Primary LoanSeller financing is most flexible when seller has clear title to property.Buyer and seller negotiate price and termsBuyer may need less cashMay not have discount points or origination feesLower closing costsUnencumbered property

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Unencumbered PropertyFirst lien position if finance instruments are recorded.

Seller should still be concerned with:property taxesspecial assessment lienshazard insuranceProtecting sellers security

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Unencumbered PropertyFailure to pay taxes or insure property should be grounds for default under the finance instrument.Seller can require impound account.If not, seller should require proof be sent to him.Protecting sellers security

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Unencumbered PropertyBuyer might want to supplement seller financing with secondary financing from lender.Seller should investigate terms of proposed second loan before agreeing to transaction.Can buyer afford monthly payments on both loans?Does second have provisions thatmake default likely?Institutional second

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Unencumbered PropertySeller may choose to use a contract for deed instead of mortgage or deed of trust. Also known as:land contractbond for deedconditional sales contractinstallment sales contractinstallment land contractreal estate contractContract for deed

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Contract for deedSeller (vendor) keeps title to property until buyer (vendee) pays off entire purchase price in installments.Legal title: vendors title during contract term.Equitable title: right of vendee to possess and enjoy property.How contract for deed works

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Contract for deedContract:not accompanied by promissory note states all terms of sale and financing arrangement between vendor and vendeeshould always be recorded

How contract for deed works

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Contract for deedForfeiture: penalty if vendee breaches contract.Vendees rights in property are terminated.Payments may be kept by vendor as liquidated damages.Vendor may retake possession of property immediately.Remedies for breach of contract

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Contract for deedIn Texas, repossession not allowed40% of the amount owed OR has made 48 monthly paymentsTrustee must be used to sell property insteadRemedies for breach of contract

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Contract for deedVendee refusing to leave means legal action to clear title and remove vendee from property.Drawback for vendor: may take months.Remedies for breach of contract

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Contract for deedJudge may:enforce contract as writtengive vendee time to pay off contract balanceallow vendee to reinstate contract by paying delinquent payments plus interestorder sheriffs sale of propertyRemedies for breach of contract

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Contract for deedAdvantages for vendor:legal owner until contract paid in fullmay reacquire property in event of defaultAdvantages and disadvantages

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Contract for deedDisadvantages for vendor:delay and expense of court proceedingsuncertainty of trial resultsAdvantages and disadvantages

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Contract for deedAdvantages for vendee:slow court proceedingsAdvantages and disadvantages

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Contract for deedDisadvantages for vendee:vendor remains legal ownerjudgments against vendor might cloud interestuncertainty of court decisionAdvantages and disadvantages

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Contract for deedLenders generally dont permit financing to vendees due to the nature of the ownership

Two possible solutions:Vendor agrees to have property stand as security for institutional loan.Vendee could mortgage his equitable interest in property.Using a contract for deed

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Contract for deedVendor agrees to have property stand as security for institutional loan. Vendor doesnt assume personal responsibility for repayment.Lender can foreclose on property but cant sue vendor for deficiency.Using a contract for deed

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Seller Financing as Primary LoanSeller of encumbered property cant afford to pay off existing mortgage at closing.Seller second was one alternative.Wraparound financing is another alternative.Encumbered property

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Encumbered PropertyWraparound financing:property remains subject to underlying loanbuyer does not assume underlying loanseller remains responsible for paymentsbuyer makes monthly payments to sellerseller uses part of buyers payment to make payment on underlying loanWraparound financing

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Wraparound FinancingFor wraparound, seller can use:mortgagedeed of trustcontract for deed

Deed of trust used for wrap: all-inclusive trust deed.Choice of finance instrument

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Wraparound FinancingWraparound financing is only proper if underlying loan doesnt have due-on-sale clause and lender approves of it.Silent wrap: without lenders consent.Underlying loan: no due-on-sale clause

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Wraparound FinancingIf sellers existing loan has no due-on-sale clause, parties can choose between:assumption plus seller secondbuyer gets benefit of existing loan with below-market interest ratewraparoundmay give buyer below-market rate and seller above-market yieldCompared with assumption + second

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Wraparound FinancingSellers yield depends on:amount of credit extended to buyer, anddifference between interest rate on wrap and rate on underlying loan.Credit extended is:difference between wrap amount and balance on underlying loannot full amount of wrap

Sellers yield

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Wraparound FinancingExample:Sales price: $200,000 Downpayment: $20,000Underlying loan: $150,000, balance at 6% interestWraparound: $180,000 at 7.5% interest $180,000 Wrap financing for buyer 150,000 Sellers underlying loan balance $30,000 Credit extended to buyer

Sellers yield

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Wraparound FinancingExample, cont.In first year:Seller collects $13,500 in interest from buyer.Seller pays $9,000 in interest on underlying loan.Net interest to seller: $4,500.

Net Interest Credit Extended = Sellers Yield$4,500 $30,000 = 15%Sellers yield

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Wraparound FinancingTo ensure seller makes payments on underlying loan:provision in finance instrument requiring seller to make timely payments, and allowing buyer to pay lender directly if seller defaultsRequest for Notice of Delinquencyescrow account managed by third party

Protecting wraparound buyer

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Alternatives to Seller FinancingSeller can help with:buydowncontribution to closing costsequity exchangelease/optionlease/purchase

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Alternatives to Seller FinancingBuydown: seller pays to reduce buyers interest rate on loan.Seller proceeds are reduced by amount of buydown.Buyer more easily affords lower payment and/or qualifies easier with lower DTIBuydowns

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Alternatives to Seller FinancingSeller sometimes willing to make up shortfall when buyer doesnt have enough money for closing costs.Lenders impose limits on amounts.Contributions to closing costs

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Alternatives to Seller FinancingSeller may be willing to accept other assets from buyer and reduce cash sales price.Equity in vacant land or personal property.Equity exchanges

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Alternatives to Seller FinancingSometimes buyer wants to lease home before actually buying it. Time to get cash for closing or downpayment.Cannot currently qualify for loan.Lease arrangements

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Alternatives to Seller FinancingSeller can lease property to prospective buyer in one of two ways: lease/option arrangementlease/purchase arrangementLease arrangements

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Lease ArrangementsLease/Option: lease agreement includes option to purchase.Seller leases property to buyer for term.Buyer granted option to purchase property at certain price during lease term.Seller = Landlord/OptionorBuyer = Tenant/OptioneeLease/options

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Lease ArrangementsLease/option:buyer has no obligation to buyseller cant sell property during option periodcan be used even if sellers loan has due-on-sale clause

Lease/options

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Lease/OptionsLease/option:buyer pays seller option money to make option binding on selleroption money not refundableoption money may be applied to purchase price if buyer exercises optionrental payments may be applied to purchase (rent credit)How lease/option works

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Lease/OptionsRent charged on lease/option is often higher than rent under ordinary lease.Gives optionee incentive to exercise option quickly.Provides compensation to optionor for uncertainty of outcome.Permits a lender at the exercise of the option to credit excess toward down payment.Rental payments

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Lease/OptionsThree ways rent credit can be applied to purchase:applied to down paymentdeducted from sales priceapplied toward closing costs/prepaids

Rent credit

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Lease/OptionsLease/option should: include all terms of leaseinclude all terms of potential purchase contractstate that option money is not security depositstate that option rights are forfeited if tenant defaults on leasestate that option money is forfeited if purchase is not consummated by buyer

Provisions of lease/option agreement

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Lease ArrangementsLease/Purchase: purchase contract allows buyer to lease property for extended period before closing.Parties sign purchase agreement (not option) along with lease.Tenant/buyer provides good faith deposit instead of option money.Closing date set quite far off; buyer rents property in meantime.Lease/purchase

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Lease ArrangementsIf tenant/buyer decides not to buy property, good faith deposit is forfeited.Tenant/buyer probably more committed with lease/purchase contract than with lease/option.Eventual sale more likely.Lease/purchase

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Agent ResponsibilitiesReal estate agent should:make sure both parties understand sellerfinancing arrangementencourage both to consult lawyers or CPAsnever prepare seller financing documents

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Agent ResponsibilitiesSeller financing disclosure: required in some states when agent helps arrange seller financingdiscloses all financing termsinforms seller of buyers financial situationDisclosures

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Agent ResponsibilitiesGood idea to use disclosure statement even if not required by state law.Provides information to parties.Protects agent by documenting that certain information was provided.

Disclosures

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Agent ResponsibilitiesDisclosure statement does not completely shield agent from liability.Breach of fiduciary duties.Inadvertent dual agency.Liability

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