Reasons for Seller Financing:
A Seller may be interested in selling a property and carrying back a Promissory Note & Deed of Trust for a number of reasons. The Seller may feel the property will sell quicker, the property type may make it difficult to find conventional bank financing, or the Seller is interested in the interest income generated from the Seller carry-back Note & Deed of Trust (or Note & Mortgage or Contract For Deed).
A Buyer may be interested in buying a property where the Seller will carry back a Note & Deed of Trust for a number of reasons. The Buyer may have credit issues, the property type may make it difficult to find bank financing, or the Buyer may have relationship with the Seller and they’ve mutually agreed on a reasonable transaction.
The reasons for seller financed transactions are as varied as the Sellers and Buyers. Oftentimes the idea of owner financing is overlooked simply because the parties are unfamiliar with the pros and cons.
What is Owner Financing?
When part or most of the purchase price is paid not by a cash sale or bank financing, then the Seller is providing owner financing. The Seller is not lending the Buyer money, but rather part of the purchase price is carried by the Seller and secured by a Promissory Note and Deed of Trust (or other real estate lien instrument). The property sale price is often determined by comparing similar properties in the area or obtaining an appraisal. Depending on the property type, the Buyer is encouraged to obtain a home inspection. After a price is agreed upon, the terms of the Note are discussed and agreed upon. Often when the Seller and Buyer aren’t negotiating directly, it will be an offer and counter offer as to terms. Most Sellers require the Buyer to make a cash down payment equivalent to 20%-30% of the sale price with the balance of the price carried back on a Note. The interest rate often will be determined by the strength of the Buyer, property type, and the going conventional rates. The Seller carry-back rate may be higher than bank financing due to the Seller’s less stringent buyer requirements. The benefit to the Buyer is the transaction is greatly simplified and more do-able because they are not having to spend hours providing seemingly endless information to the lender, only to find one more item is missing. The length of the note can be negotiated. It might be largely determined by the size of the monthly payment the Buyer feels comfortable with, along with the required annual property taxes and estimated property insurance. Depending on the particular transaction, a balloon payment is encouraged (not less than three years).
After the Buy-Sale is executed, including the terms of the down payment and carry-back note, a closing is scheduled. The parties are very strongly encouraged to employ a Title Insurance Company (and possibly an attorney) to assist in the details of the closing. The Title company will provide to the Buyer an “Owner’s Policy” which will show the condition of the property title, insuring that the Buyer will be the owner. The Title Company should simultaneously give the Seller a “Lender’s Policy” which will insure their first lien on the property. The Title Company (or attorney) will have the Deed and Note & Deed of Trust documents prepared. The Title Company will be responsible for assuring that all parties get what they have bargained for. It is strongly suggested that the Buyer and Seller, going forward, have a long-term escrow company service the Note. That may be a Title Company’s own long-term escrow agent, or it could be a respected independent long-term escrow agent. The Long-Term Escrow agent will hold the original documents for safe keeping, service the payments, provide payment coupon book and balance statements, as well as provide end of year interest reporting.
Contract For Deed (or Land Contract): A Contract For Deed does not pass property title to the Buyer, but the Buyer’s interest is perfected by a recorded Notice of Purchaser’s Interest (or Abstract of Contract). The Buyer makes the required payments per the terms of the Contract, and when the Contract has been paid in full, the Buyer then receives the Deed to the property (to be recorded with the County Clerk & Recorder). Most attorneys are now steering their clients to other security instruments because of perceived uncertainties associated with Contracts for Deed.
Promissory Note and Deed of Trust (or Trust Indenture): At the closing, the Seller passes property title to the Buyer, and a lien in favor of the Seller is recorded. At the time of the closing, the Buyer’s interest is perfected as well as the Seller’s lien. In some States the lien will be known as a Mortgage.
Wrap (or Junior Lien): Occasionally, in a Seller Financing situation, the Seller may still have a bank loan or lien which may stay in place. The Seller Carry-Back transaction would then be considered a “wrap”, where the Buyer’s payments will go to pay his Note with his Seller, who then passes that payment (or most of it) to his current Lender (a long-term escrow agent with clear servicing instructions is strongly recommended). Many Lenders have a “due on sale” trigger. Oftentimes, if the loan is in good standing and payments are always on time, the first-position Lender will not have any real motivation to call the note due. The Seller should fully disclose all the details of the existing lien to the Buyer if there is to be a wrap. Some states and some Lenders require particular disclosures or compliances and an attorney may be required.
Seller Financing Limitations:
The following limitations refer ONLY to seller-carryback transactions on properties that have a dwelling which the Buyer will use as their primary residence. Vacant land is exempt (even if the Buyers plan on building a home). Homes being purchased as investment properties, commercial properties and multifamily of 5 or more units are all exempt from the restrictions. A Seller must be an individual, a trust or an estate. A Company or an LLC does not have any exemptions and are subject to substantial regulations.
Within the past few years certain regulations and agencies have imposed some limitations on the type and terms of seller financing transactions. The Safe Act, Dodd-Frank Act, and the Consumer Financial Protection Bureau all have participated in implementing certain seller financing restrictions, which largely became effective January 10, 2014.
The One-Per Year Category: Generally, if a Seller is selling a home to a Buyer who will be occupying the property and that is the only home that Seller will be selling in one year to an owner-occupied Buyer; there are no restrictions on the terms of that transaction. We want to emphasize again that the one-per-year allows a Buyer/Seller to negotiate whatever terms they prefer. Currently the only limitation is that the Note must have a fixed interest rate for the first five years. The Buyer and Seller are free to determine the terms that work best for each of them.
However, if in a year’s time, that Seller will be selling more than one home to more than one Buyer who will be occupying that home, there are significant limitations (no balloon payments, and other rules). If a Seller sells more than one home in a year to a Buyer who will be occupying the residence using seller financing, the Seller’s ability to sell his note may be encumbered in that any note buyer will also be taking on any liability as far as regulations.
If a home Seller is selling more than one home but less than four in a year’s time to a Buyer who will be occupying that home, we encourage the Seller to contact an attorney, or do further research, to determine up-to-date regulations regarding seller carry-back rules. Some of those rules currently (as of 2014) include: no balloon payments allowed, fixed interest rate for first five years, Buyer’s ability to repay must be established. If a Seller does more than three owner financing transactions for the sale of a home to a Buyer who will be occupying that home, the Seller must become a Mortgage Loan Originator (MLO), licensed with the National Mortgage Licensing System, or must use a MLO who is willing to handle the compliance and disclosures.
We here at Creative Finance & Investments LLC encourage any Seller considering carrying the financing for a Buyer do some sort of investigation into the Buyer’s creditworthiness and/or ability to pay.
Call us at 406-721-1444 if you have questions with a specific transaction as well as seek other competent advice.