Due to the amount of short sales and foreclosures we have endured over the past two years, it has been my prediction that there will be a lot of well incomed homeowners that need housing that cannot get a mortgage due to these losses. Therefore, owning houses and selling them to consumers through seller financing instead of with regular mortgage loans will be very lucrative in the coming years. I predict it will be the new trendy way to generate income instead of flipping real estate or holding onto rentals. That is just my opinion, of course, but that is what I am predicting. Below is an article from last month’s Realtor Magazine that explains Seller Financing Pros and Cons that I think every potential seller financing buyer or seller should be aware of.
When traditional lending avenues fail, seller financing can help seal the deal. But watch out for pitfalls.
If you’re working with sellers who have seen offers collapse
because buyers can’t get a mortgage loan, you might want to suggest they
consider offering some variation of seller financing. If structured carefully, seller financing not
only makes deals possible but also can typically help transactions close
quickly, as less due diligence is required.
After all, who knows the property better than the sellers?
There are other perks, too:
Sellers can often negotiate an interest rate that’s more favorable than
would be available for other sorts of investments. And they might also get a higher selling
price as compensation for assisting the buyers.
Finally, there can be some tax benefits; if the seller structures the
loan as an installment sale, for example, there can be tax advantages based on
how recognition of the capital gain is timed.
But against these benefits is the big downside of seller
financing: the potential for buyer
default. This risk is compounded if the
deal is structured as a wrap-around deed of trust, as many are. With a wrap-around deed of trust, the seller
issues a promissory note and deed of trust for the dollar gap between the
amount of the first mortgage and the buyer’s down payment. When structured this way, the seller’s
performance on the underlying first mortgage is linked to the buyer’s
performance. If the buyer defaults, the
seller will likely default, too.
Here are some ways to help sellers minimize such pitfalls,
no matter how the transaction is structured:
- Request a
credit report and credit references.
Sellers can get a credit report from any credit reporting agency, but
they’ll want to get a signed consent letter from the buyer first. For credit references, one place to go is the
buyer’s landlord, if they’re renting.
Sellers should also ask for independently audited financial statements.
- Consider
loan assumption. In many cases, the
seller’s existing mortgage loan has a due-on-sale clause that requires the
principal to be paid upon sale of the property.
Having to settle their own financing makes it hard for many sellers to
offer financing, especially if they’re buying a house themselves and need their
sale proceeds to make their own down payment.
In these cases, it might be better to simply have the buyer assume the
seller’s existing loan. The buyer still
must submit to the lender’s underwriting analysis and get the lender to approve
a modification, but the process should be less time-consuming than if they were
applying for new financing.
- Provide
expanded remedies. For many sellers,
the only remedy for buyer default included in their loan documents is
foreclosure. But it’s best to include
lower-level remedies so foreclosure doesn’t have to be the only option. Suggest that sellers set rules for imposing
late charges or default interest. Or
suggest that sellers hire a property manager to keep track of incoming payments
and to spearhead collection efforts, because these activities can be
time-consuming.
- Understand
the risks to buyers, too. Although
it might seem like most risks are on the sellers’ side since they’re putting
their resources on the line, there are risks to buyers as well—and if you’re
working with buyers, you’ll want to be aware of them. First, buyers could pay the loan in full but
still not receive title if there are encumbrances that were never divulged by
the seller. Second, if the transaction
is structured as a wrap-around deed of trust and the sellers are supposed to be
making payments on senior debt, the buyers could be at risk if the sellers fail
to make their loan payments, even if the buyers are scrupulous in holding up
their end of the deal. Third, buyers might
not have the protection of a home inspection, mortgage insurance, or an
appraisal to ensure they’re not paying too much.
These are challenging times in credit markets, so there’s a
role for seller financing. But be aware
of risks so you can help protect your clients.
