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Financing Residential Real Estate

Lesson 13:

Seller Financing

Introduction

In this lesson we will cover:

lhow seller financing works,

lwhy seller financing is used,

lforms of seller financing,

lalternatives to seller financing, and

lagent’s responsibilities in a seller-financed transaction.

How Seller Financing Works

Two ways for seller to finance buyer’s purchase:

lPurchase money loan

lLand contract


For a purchase money loan, seller uses promissory note with mortgage or deed of trust.

Purchase money loan



�Buyer makes installment payments to seller.

Purchase money loan




�Seller is mortgagee or beneficiary, withright to foreclose in case of default.

Purchase money loan




�Seller is mortgagee or beneficiary, withright to foreclose in case of default.

lUnlike institutional lender, seller is just extending credit to buyer, not providing loan funds.

Purchase money loan


A land contract is an alternative to a purchase money loan.

Land contract



�As with purchase money loan, buyer takes possession of property, paysseller in installments.

Land contract



�As with purchase money loan, buyer takes possession of property, paysseller in installments.

�But with land contract, seller doesn’tconvey title until contract price paid in full.

Land contract


Seller financing may be:

lPrimary financing

�Seller is buyer’s main or only source offinancing for purchase.

Primary or secondary financing



lPrimary financing


lSecondary financing – seller second

�Supplements primary loan from institutional lender.




lPrimary financing


lSecondary financing – seller second

�Supplements primary loan from institutional lender.

�Covers part of downpayment or closingcosts required for primary loan.



Seller generally decides which type of finance instrument to use.

�Should be prepared and/or reviewed byreal estate lawyer.

�If using a deed of trust, trustee must beappointed.

Choosing finance instrument


Seller generally decides which type of finance instrument to use.

�Should be prepared and/or reviewed byreal estate lawyer.

�If using a deed of trust, trustee must beappointed.

lIf transaction also involves institutional financing, lender probably won’t allowseller to use land contract.

Choosing finance instrument

Why Seller Financing is Used

Seller financing can:

¡Attract buyers when interest rates are high.




¡Help buyer qualify for institutional loan.





¡Enable seller to charge higher price.






¡Provide tax benefits to seller.






¡Provide tax benefits to seller.

¡Offer payment plan not available from institutional lenders.


Seller isn’t bound by institutional policies regarding yields, loan-to-value ratios, or qualifying standards.


Seller financing isn’t an option for seller who needs to be fully cashed out right away.

But for some sellers, buyer’s downpayment is enough cash at closing.

Seller Seconds

Seller second can supplement new institutional loan or assumption.

Seller accepts second mortgage for remainder of purchase price not covered by first mortgage.

Seller Seconds

Seller second supplementing new institutional loan must meet lender’s standards.

¡Many kinds of seller seconds can comply with lender rules.

Supplementing a new loan

Seller Seconds

Seller second supplementing new institutional loan must meet lender’s standards.

¡Many kinds of seller seconds can comply with lender rules.

¡Seller second can help buyer qualify for institutional loan.

Supplementing a new loan

Supplementing a New Loan

Three factors in buyer’s financial situation shape design of seller second:

Buyer’s situation



¡How much money buyer has for downpayment.

Buyer’s situation




¡Total monthly payment buyer qualifies for.

Buyer’s situation




¡Total monthly payment buyer qualifies for.

¡Balloon payment.

Buyer’s situation


When seller second involves balloon payment, it may be easy to refinance if:

çLow interest rates

çProperty has appreciated substantially

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

Buyer’s situation


Seller’s evaluation of second:

¡Cash at closing

Seller’s situation



¡Cash at closing

¡Monthly income




¡Cash at closing

¡Monthly income

¡Timing of payoff (balloon payment)




¡Cash at closing

¡Monthly income


¡Yield on investment




¡Cash at closing

¡Monthly income



¡Tax consequences




¡Cash at closing

¡Monthly income



¡Tax consequences

¡Lien priority


Seller Seconds

Seller second can also be used to supplement buyer’s assumption of seller’s existing mortgage.

Supplementing an assumption

Seller Seconds

Seller second can also be used to supplement buyer’s assumption of seller’s existing mortgage.

¡Buyer makes payments to seller on the seller second.

¡Buyer takes over monthly payments on the existing mortgage.


Seller Seconds

Assumption is only possible if existing mortgage doesn’t have due-on-sale clause, or lender agrees to assumption.

¡Even without due-on-sale clause, need lender’s agreement to release seller from liability.

¡Lender generally applies its usual underwriting standards to evaluate buyer assuming loan.


Summary

Seller Seconds

ÄPurchase money loanÄLand contractÄSeller second

ÄAssumption

Seller Financing as Primary Loan

Seller financing is most flexible when seller has clear title to property.

Unencumbered property


Seller financing is most flexible when seller has clear title to property.

Buyer and seller negotiate price and terms.

�Buyer needs less cash for seller financing.

�No discount points or origination fee.

�Lower closing costs.

Unencumbered property

Unencumbered Property

If finance instruments are recorded at closing, seller is assured of first lien position.

Protecting the seller’s security


If finance instruments are recorded at closing, seller is assured of first lien position.

Seller should be concerned with:

¡property taxes,

¡special assessment liens, and

¡hazard insurance.



Seller can prevent default by requiring impound account to protect security interest.

�Failure to pay taxes or insure property is default under most finance instruments.



Buyer might want to supplement seller financing with secondary financing from a lender.

lSeller should investigate terms of proposed second loan before agreeing to transaction.

Institutional second


Buyer might want to supplement seller financing with secondary financing from a lender.

lSeller should investigate terms of proposed second loan before agreeing to transaction.

�Can buyer afford monthly payments onboth loans?

�Does second have any provisions thatmake default likely?

Institutional second


Seller may choose to use land contract instead of mortgage or deed of trust. Also known as:

çcontract for deed,

çbond for deed,

çconditional sales contract,

ç installment sales contract,

ç installment land contract, or

çreal estate contract.

Land contracts

Land Contracts

Only a seller can use a land contract.

¡Works differently than mortgage ordeed of trust.

Only for seller financing

Land Contracts

Seller (vendor) keeps title to property until buyer (vendee) pays off entire purchase price in installments.

How contract sale works

Land Contracts


¡Vendor’s title during contract term is called legal title.


Land Contracts



¡Vendee has equitable title: right to possess and enjoy property.


Land Contracts



¡Vendee has equitable title: right to possess and enjoy property.

¡Contract should always be recordedto protect vendee.


Land Contracts

Land contract document generally not accompanied by a promissory note.

Contract states all terms of sale and financing arrangement between vendor and vendee.


Land Contracts

Some contracts provide that if vendee defaults:

Remedies for breach of contract

Land Contracts


¡vendee’s rights in property are terminated,


Land Contracts



¡payments may be kept by vendor as liquidated damages, and


Land Contracts




¡vendor may retake possession of property immediately.


Land Contracts




¡vendor may retake possession of property immediately.

This penalty is called forfeiture.


Land Contracts

However, if vendee refuses to leave, vendor usually must take legal action to clear title and remove vendee from property.


Land Contracts

However, if vendee refuses to leave, vendor usually must take legal action to clear title and remove vendee from property.

Major drawback for vendor: may have to wait for months to go to trial.


Land Contracts

Depending on state law, judge may be able to:

lenforce contract as written, allowing seller to keep payments received, and terminating vendee’s rights;


Land Contracts



lgive vendee time to pay off contract balance;


Land Contracts




lallow vendee to reinstate contract by paying delinquent payments plus interest; or


Land Contracts




lallow vendee to reinstate contract by paying delinquent payments plus interest; or

lorder sheriff’s sale of property.


Land Contracts

In some states, vendee’s rights depend on how far into contract term it is when vendee defaults.

¡State law may not allow forfeiture if contract’s remaining unpaid balance is comparatively small.


Land Contracts

Advantages for vendor:

�Remains legal owner until contractpaid in full.

�If forfeiture allowed, vendor mayreacquire property.

¡Doesn’t have to sell it and give surplusto debtor, as required in mortgage foreclosure.

Advantages and disadvantages

Land Contracts

Disadvantages for vendor:

�Delay and expense of court proceedings.

�Uncertainty of trial results.


Land Contracts

Advantages for vendee:

�Slow court proceedings.


Land Contracts

Disadvantages for vendee:

�Vendor remains legal owner.

�Judgments against vendor might cloudvendee’s interest in property.

�Uncertainty of court decision.


Land Contracts

Lenders generally don’t permit seller to use land contract if there is institutional secondary financing.

Two possible solutions to this problem.

Using a land contract

Land Contracts

First, vendor could agree to have property stand as security for institutional loan to vendee.


Land Contracts

First, vendor could agree to have property stand as security for institutional loan to vendee.

¡Vendor wouldn’t assume personal responsibility for repayment.

¡Lender can foreclose on property but can’t sue vendor for deficiency.


Land Contracts

Second, vendee could mortgage her equitable interest in property.


Land Contracts

Second, vendee could mortgage her equitable interest in property.

¡Lender acquires vendee’s contract rights, but has to pay contract price to have title.

¡Few lenders find equitable interest acceptable as collateral.


Summary

Financing Unencumbered Property

ÄInstitutional secondÄLand contractÄVendor

ÄVendeeÄForfeiture


Sellers of encumbered property generally can’t afford to offer primary financing to buyer and pay off existing mortgage at closing.

Encumbered property


Sellers of encumbered property generally can’t afford to offer primary financing to buyer and pay off existing mortgage at closing.

¡Wraparound financing is alternative.

Encumbered property

Encumbered Property

With wraparound financing:

lProperty remains subject to seller’s existing mortgage (underlying loan).

Wraparound financing

Encumbered Property



lBuyer does not assume underlying loan;seller remains responsible for payments.


Encumbered Property



lBuyer does not assume underlying loan; seller remains responsible for payments.

lBuyer makes monthly payments to seller on wraparound loan.


Encumbered Property



lBuyer does not assume underlying loan; seller remains responsible for payments.

lBuyer makes monthly payments to seller on wraparound loan.

lSeller uses part of buyer’s payment to make payment on underlying loan.


Wraparound Financing

For wraparound, seller can use:

çmortgage,

çdeed of trust, or

ç land contract.

When deed of trust used for wrap: called an all-inclusive trust deed.

Choice of finance instrument


Wraparound financing only works if underlying loan doesn’t have due-on-sale clause.

�Even contract sale triggers due-on-saleclause.

�Lender won’t consent to wraparound.

No due-on-sale clause in underlying loan


Wraparound financing only works if underlying loan doesn’t have due-on-sale clause.

�Even contract sale triggers due-on-saleclause.

�Lender won’t consent to wraparound.

lSilent wrap: without lender’s consent.

�If lender finds out about silent wrapand accelerates underlying loan,both seller and buyer in trouble.

No due-on-sale clause in underlying loan


If seller’s existing loan has no due-on-sale clause, parties can choose between:

lAssumption plus seller second

lWraparound

Comparison with assumption + second




�Buyer gets benefit of existing loan with below -market interest rate.

lWraparound





�Buyer gets benefit of existing loan with below -market interest rate.

lWraparound

�May give buyer below -market rateand seller above-market yield.



On wraparound, seller may charge buyer an interest rate that is:

�below current market rate for financing(benefits buyer);

�yet also higher than rate on underlyingloan (benefits seller).

Can benefit both buyer and seller


On wraparound, seller may charge buyer an interest rate that is:

�below current market rate for financing(benefits buyer);

�yet also higher than rate on underlyingloan (benefits seller).

lEven if seller charges market rate, wrap may still offer buyer greater flexibility and lower closing costs than institutional loan.

Can benefit both buyer and seller


Seller’s yield from wraparound transaction depends on:

�amount of credit extended to buyer, and

�difference between interest rate on wrapand rate on underlying loan.

Seller’s yield


Seller’s yield from wraparound transaction depends on:

�amount of credit extended to buyer, and

�difference between interest rate on wrapand rate on underlying loan.

lCredit extended is:

�only the difference between wrap amountand balance on underlying loan,

�not the full amount of the wrap.

Seller’s yield


Example:

Sales price: $200,000 Downpayment: $20,000

Underlying loan: $150,000 balance at 6% interest

Wraparound: $180,000 at 7.5% interest

$180,000 Wrap financing for buyer– 150,000 Seller’s underlying loan balance

$30,000 Credit extended to buyer by seller

Seller’s yield


Example, cont.

In first year:

lSeller collects $13,500 in interest from buyer.

lSeller pays $9,000 in interest on underlying loan.

lNet interest to seller: $4,500

Net Interest ÷ Credit Extended = Seller’s Yield

$4,500 ÷ $30,000 = 15%

Seller’s yield


Obvious problem with wraparound is how to make sure seller makes payments on underlying loan.

Protecting wraparound buyer


Solutions:

1. Include provision in finance instrument requiring seller to make timely payments, and allowing buyer to pay lender directly if seller fails to.



Solutions:


2. Buyer can send lender a “Request for Notice of Delinquency.”



Solutions:


2. Buyer can send lender a “Request for Notice of Delinquency.”

3. Set up escrow account, with third party appointed to manage wraparound.



Example of escrow instructions:

1. Buyer shall make all payments into escrow account.

2. Upon receipt of each payment from buyer, escrow agent shall promptly make payment due on seller’s underlying mortgage.

3. Escrow agent shall maintain balance in account equal to two monthly payments; all funds in excess of minimum balanceshall be disbursed to seller.


Summary

Financing Encumbered Property

ÄWraparound financingÄAll-inclusive trust deedÄUnderlying loan

ÄSilent wrapÄCredit extendedÄSeller’s yield

Alternatives to Seller Financing

Seller can help buyer purchase property without financing transaction.



Seller can help with:

¡Buydown




¡Buydown

¡Contribution to closing costs




¡Buydown


¡Equity exchange




¡Buydown


¡Equity exchange

¡Lease/option




¡Buydown


¡Equity exchange

¡Lease/option

¡Lease/purchase


Seller pays to reduce buyer’s interest rate on loan, but doesn’t actually pay lender lump sum at closing.

�Seller proceeds are reduced by amountof buydown.

Buydowns


Seller sometimes willing to make up shortfall when buyer doesn’t have enough money for closing costs.

Contributions to closing costs


Seller sometimes willing to make up shortfall when buyer doesn’t have enough money for closing costs.

�Lenders impose limits on how much sellercan contribute.

Contributions to closing costs


Seller may be willing to accept other assets from buyer and reduce cash sales price.

lBuyer may have equity in vacant land or in personal property such as a boat or recreational vehicle.

Equity exchanges


Sometimes buyer wants to lease home before actually buying it.

¡Needs more time to get cash for closing or downpayment.

¡Not currently able to qualify for loan.

Lease arrangements


Seller can lease property to prospective buyer in one of two ways:

¡Lease/option arrangement

¡Lease/purchase arrangement

Lease arrangements

Lease Arrangements

Lease/Option

Lease agreement that includes option to purchase.

Lease Arrangements

Lease/Option

Lease agreement that includes option to purchase.

Lease/Purchase

Purchase contract that allows buyer to lease property for extended period before closing.

Lease Arrangements

In lease/option, seller leases property to buyer for a term and grants buyer option to purchase property at certain price during lease term.

Lease/options

Lease Arrangements

In lease/option, seller leases property to buyer for a term and grants buyer option to purchase property at certain price during lease term.

Seller = Landlord / Optionor

Buyer = Tenant / Optionee

Lease/options

Lease Arrangements

Buyer under no obligation to buy, but seller can’t sell property during option period.

�Often, buyer opts not to purchase.

Lease/option can be used even if seller’s loan has due-on-sale clause.

�Clause not triggered until option is exercised.

Lease/options

Lease/Options

1. Buyer pays seller sum of money (option money) in exchange for option.

� Makes option binding on seller.

How lease/option works

Lease/Options



2. Option money not refundable; may be applied to purchase price if buyer exercises option.


Lease/Options



2. Option money not refundable; may be applied to purchase price if buyer exercises option.

3. Rental payments may be applied to purchase (rent credit provision).


Lease/Options

Rent charged on lease/option is often much higher than rent under ordinary lease.

¡Gives optionee incentive to exercise option quickly.

¡Provides compensation to optionor for uncertainty of outcome.

Rental payments

Lease/Options

Two ways rent credit can be applied to purchase:

1. deducted from sales price; or

2. applied to downpayment.

Rent credit

Lease/Options

Most lenders will accept rent credit as part of downpayment, but not for whole downpayment.

�Buyer must also invest some cash.

Rent credit

Lease/Options

Most lenders will accept rent credit as part of downpayment, but not for whole downpayment.

�Buyer must also invest some cash.

Often, amount in excess of fair market rent can be applied to downpayment:

¡Fair market rent: $1,500

¡Lease/option rent: $1,800

¡$300 out of each rent payment applies to downpayment

Rent credit

Lease/Options

Lease/option document generally includes:

¡all terms of lease, and

¡all terms of potential purchase contract.

Provisions of lease/option agreement

Lease/Options

Agreement should state that option money is not security deposit.

�Seller can require security deposit, but it must be separate from option money.


Lease/Options

Agreement should state that option money is not security deposit.

�Seller can require security deposit, but it must be separate from option money.

Agreement should also state that if tenant defaults on lease, option rights are forfeited.

�Seller should review tenant’s credit report.


Lease/Options

Prospective buyer should beware of lease/option if housing prices are likely to go down.

Could be faced with choice between buying property for more than market value or losing:

�option money, and

�rent credit (difference between lease/optionrent and fair market rent).

Declining market

Lease Arrangements

With lease/purchase arrangement:

�Parties sign purchase agreement, notoption, along with lease.

Lease/purchase

Lease Arrangements



�Tenant/buyer provides good faith depositinstead of option money.

Lease/purchase

Lease Arrangements



�Tenant/buyer provides good faith depositinstead of option money.

�Closing date set quite far off; buyer rentsproperty in meantime.

Lease/purchase

Lease Arrangements

If tenant/buyer decides not to buy property, good faith deposit is forfeited.

Lease/purchase

Lease Arrangements

If tenant/buyer decides not to buy property, good faith deposit is forfeited.

lTenant/buyer tends to feel more committed with lease/purchase contract than with lease/option.

lEventual sale more likely.

Lease/purchase

Lease Arrangements

Agreement should have many of the same provisions as lease/option, including rent credit provision.

Lease/purchase

The Agent’s Responsibilities

No matter how well-planned, any seller financing arrangement holds risks.



Real estate agent should:

�make sure both parties understand sellerfinancing arrangement; and





�encourage both to consult lawyers or CPAs.





�encourage both to consult lawyers or CPAs.

lAgents should never prepare seller financing documents.


Some states require special disclosure forms to be used when third party (agent) helps arrange seller financing.

Disclosures


Some states require special disclosure forms to be used when third party (agent) helps arrange seller financing.

Seller financing disclosure statement generally:

¡discloses all financing terms; and

¡ informs seller of buyer’s financial situation.

Disclosures


Good idea to use disclosure statement even if not required by state law.

�Provides information to parties, and

�Protects agent by documenting that certaininformation was provided to them.

Disclosures


Disclosure statement does not completely shield agent from liability, however.

Liability



lIf transaction turns out badly, agent’s client could claim agent breached fiduciary duties.

Liability



lIf transaction turns out badly, agent’s client could claim agent breached fiduciary duties.

lCourt might also hold that agent was inadvertent dual agent, with fiduciary duties to both parties.

Liability

Summary


ÄBuydownÄEquity exchangeÄContribution to closing costs

ÄLease/optionÄOption moneyÄRent credit

ÄLease/purchase contract

Real Estate Finance Lesson 13 Cumulative Quiz

1. Rather than using an institutional loan, a seller extends credit to a buyer and the buyer gives the seller a deed of trust. This would be known as a/an:

A. assumption B. land contract C. purchase money loan D. wraparound loan

2. Which of the following would NOT be a reason for a seller to use seller financing?

A. It can help attract a buyer at times when interest rates are very high B. It may allow the seller to charge a higher price for the house, in exchange for other benefits C. It provides a large lump sum to a seller who needs to be cashed out D. It provides tax benefits

3. Seller financing can provide significant tax benefits for a seller because it involves:

A. an installment sale B. casualty loss C. depreciation D. recapture

4. A seller second is used to supplement:

A. a land contract B. a new institutional loan C. an assumption D. Either B or C

5. Which of the following is NOT a consideration when structuring the combination of a first mortgage and a seller second?

A. How large a balloon payment the buyer is comfortable with B. How large a combined monthly payment the buyer can afford C. How large a downpayment the buyer can make D. The buyer's credit history

6. A seller might be affected by the IRS's imputed interest rule if:

A. the seller finances too large a portion of the total sales price B. the seller second includes a balloon payment C. the seller second is for too long a loan term D. the seller second uses an interest rate that is too far below market rates

© 2009 Rockwell Publishing 1

7. To be able to use a seller second in conjunction with an assumption:

A. the buyer must be able to afford the payments on both loans B. the lender's consent is necessary for the seller to be released from liability C. the mortgage may not include a due-on-sale clause (unless the lender agrees) D. All of the above

8. If a seller is willing to finance most of the purchase price but needs some cash at closing, a possible solution is:

A. a land contract B. a wraparound loan C. an institutional loan plus a seller second D. primary seller financing plus an institutional second

9. In a land contract, the seller is also known as the:

A. trustee B. trustor C. vendee D. vendor

10. Who holds legal title during the repayment period of a land contract?

A. trustee B. trustor C. vendee D. vendor

11. The penalty for breach of a land contract is known as:

A. forfeiture B. garnishment C. liquidated damages D. relinquishment

12. Which of the following is an advantage of a land contract for a seller?

A. Court proceedings are usually delayed when there is a breach B. It's difficult to obtain financing that would be secured by a property subject to a land contract C. It's possible that a cloud would remain on the title after a breach D. The seller may be able to reacquire a property in case of default rather than having to sell it and

give the surplus to the buyer


13. How does wraparound financing work?

A. An existing loan wraps around the seller financing B. The buyer assumes an existing loan and receives supplemental financing C. The buyer retains legal title to the property while the underlying institutional lender repays the

purchase price D. The seller financing wraps around the underlying loan

14. A deed of trust used in a wraparound arrangement may be known as a/an:

A. all-inclusive trust deed B. blanket mortgage C. package mortgage D. underlying loan

15. A 'silent wrap' is:

A. a commonly accepted practice B. a failure to notify the underlying lender of the wraparound arrangement C. an arrangement where the buyer assumes the underlying loan D. used when the underlying loan is larger than the planned seller financing

16. A possible advantage of using a wraparound loan is:

A. a below-market interest rate for the buyer B. an above-market yield for the seller C. an above-market yield for the underlying lender D. Both A and B

17. A common way for a seller to assist a buyer is to use a/an ____, in which the seller's proceeds will be reduced by a certain amount at closing, in exchange for a lower interest rate for the buyer.

A. assumption B. buydown C. equity exchange D. lease/option

18. A buyer doesn't have adequate cash to close a proposed transaction, but the seller agrees to accept a sailboat owned by the buyer in exchange for a $20,000 reduction in the purchase price. This is a/an:

A. buydown B. equity exchange C. lease/purchase D. Section 1031 exchange


19. In a lease/option:

A. the buyer gives a non-cash asset to the seller in exchange for a reduced sales price B. the buyer leases the property for a period of time and may choose to buy the property at a

specified price during the lease term C. the buyer leases the property but is committed to buying the property at the end of the lease term D. the seller pays discount points on behalf of the buyer

20. A lease/option agreement should contain:

A. all terms of the purchase agreement B. all terms of the lease C. an agreement that the option money is not a security deposit D. All of the above


Documents

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