Seller Financing....Is it For You?
One of our biggest financing issues is finding sources that will take a mortgage on a condo. For years, condos have been the most desired property here to purchase because there is always someone there to maintain it when you are absent.
If we are working with sellers who have seen offers collapse because buyers can’t get a mortgage loan, we 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 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 a few 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 occasionally linked to the buyer’s performance. If the buyer defaults, the seller may 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 or have the buyer provide the reports. 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. 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 the sellers' original mortgage, 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 we can help protect your interests.