by Walt Harvey, Real Estate Broker, ABR, CRS, GRI, SRES, e-PRO, QSC
Seller financing or "seller carry-back" is simply a situation in which the seller/owner of the property acts as the lender for the buyer. The seller leaves a portion of their equity in the property and receives payments from the buyer. It can be beneficial to both buyer and seller and it can also be hazardous to a seller if not properly structured.
Caution: many real estate agents today have never been involved in a seller- financed transaction. Before making a decision to sell your property using this technique, please make sure you fully understand the terms, the risks and the ramifications.
Each situation is unique and must be evaluated to determine benefits and risks, but here are some basic concepts of seller financing.
Seller financing was popular back in the early 1980’s when conventional lender financing was in the 19% range. That’s NINETEEN PERCENT for a traditional 30-year fixed rate mortgage! In addition, many loans were assumable by the buyer at their existing lower interest rate. Not many buyers could buy so not many sellers could sell unless the seller acted as the lender. The real estate market was stagnant (as was much of the economy) and those of us in the business had to get creative to help buyers and sellers. Hence the birth of "creative financing".
In many scenarios, the buyer made their down payment, assumed the seller’s existing fixed-rate, low interest rate mortgage and the seller provided or "carried" a second or junior mortgage. The buyer took over payments to the seller’s existing lender in addition to making payments to the seller. In some cases, the seller provided the entire financing for the buyer
In those days, most loans were 30 year amortized, fixed rate mortgages and were assumable or they were taken "subject to" the existing interest rate and terms. This practice was eliminated by the Garn legislation in the mid-80’s and about that time the adjustable rate mortgages increased in popularity.
Gratefully, interest rates came down, traditional methods of financing became viable again and seller provided financing became less necessary.
Let’s examine some benefits and risks of seller financing.
One benefit to the seller is income. If the seller doesn’t need the proceeds of the sale of the home to purchase another home or to make specific investments, financing the sale may be a good option. The seller may be able to get a higher interest rate than currently available with other investments. Keep in mind that the payments received from the buyer are income and are taxable.
Another benefit is that the sale may qualify as an installment sale, thus deferring tax on the proceeds of the sale. To qualify, the seller must receive at least one payment in a tax year after the year of sale. The gain is prorated and recognized over the years in which the principal payments are received. This method may save taxes if the seller is in a lower tax bracket in a year subsequent to the year of sale. Check with your tax consultant to see how this may apply in your circumstances.
A third benefit may be a higher price for your property. Offering to "carry-back" a mortgage for the buyer is worth a premium on your price.
Remember, if carrying a note for the buyer, be sure to get enough cash down payment to cover the closing costs and commissions as well as any tax on the gain from the sale.
The risks must be evaluated as well. The most obvious: The buyer fails to keep the promise to pay! The seller’s remedy in California is to foreclose on the note under the terms of the deed of trust and take back the property. Sounds simple enough but let’s look at the process.
In California, the seller will notify the trustee (or a substituted trustee) named in the deed of trust that the buyer is in default. At this point, the buyer has missed their payment, usually is 30 or more days late. The trustee files and publishes a Notice of Default and the buyer has 3 months to cure the default and bring the loan current and pay any trustee fees. If the buyer fails to do so, then the trustee files and publishes a Notice of Trustee Sale. If the buyer still has not brought the loan current, approximately 3 weeks later, the property is sold at the Trustee’s Sale on the courthouse steps to the highest bidder over the outstanding loans. In many cases, the highest bidder is the lender that initiated the process and that could be the seller!
So, if everything goes as planned (and many times it doesn’t), the seller gets back the property in approximately 5 months from the date of the past due payment. The seller has had to pay for the process and will probably have to pay back property taxes (the buyer may not have paid the taxes if they weren’t paying on the note), as well as any payments on an underlying loan.
Even worse, the seller may have to start an eviction process (unlawful detainer action) to get the buyer out of the property in order to sell it again. There may even be rehab costs to restore the property before marketing it again.
Yes, you may get the property back but after 6 or more months and many expenses. That’s still not the worst-case scenario. At any time in the above process, the buyer (now owner or tenant) may file bankruptcy and cause even further delays.
So you see that "getting the property back" is not so simple and the time and costs involved must be considered when seller financing is involved.
Given the hazards of seller carry-back financing, what can you do to minimize or eliminate them.
One solution to avoid the above nightmare is to sell the seller carry-back note to a company that buys such notes. One such company is NoteWorld.com. These companies will "discount" the note and you’ll receive a portion of the amount based on the company’s criteria. You won’t get 100%. Keep in mind, however, that you should receive a higher sales price on your home when you provide financing for the buyer and that higher price should cover the "discount" if you intend to sell the note.
Suggestion: Allow adequate time to analyze the true value of a note you’re asked to carry before agreeing to that note. Call a couple of companies and ask what they will be willing to pay you for the note. If you agree to sell the note, this can be done in escrow and you’ll get the proceeds from the "discounted note" at the close of escrow.
Another way to minimize the risk of the nightmare scenario is to provide the primary financing (you carry a 1st mortgage) and the buyer gets a 2nd mortgage from an institutional lender. That way, if the buyer defaults, the 2nd mortgage holder will usually keep your note current while they do their own foreclosure at their expense. You have a degree of protection, assuming the 2nd mortgage holder believes there is sufficient equity in the property to pursue the process.
Of course, the larger the down payment the buyer makes, the less likely they are to default on a loan. Circumstances change however, and it bears repeating: Anyone considering carrying a note must be aware of the risks.
There are some protections that should be in any seller-financing instrument:
Insist on a copy of the buyer’s credit report and review it. You are extending credit and have a right to see how the buyer has handled credit in the past.
Request for Notice of delinquency on any junior (or senior) mortgage: This means that you must me notified if the buyer is late on any other loans on the property. This is a wake-up call that a foreclosure may follow if action isn’t taken soon.
Request for Notice of Default on any junior (or senior) mortgage: This will alert you that the junior (or senior) mortgage holder has actually started a foreclosure action on the property and that you may need to move quickly to protect your equity interest in the property. You may have to cure the default and start your own foreclosure action if your note is junior to the foreclosing note.
Tax Service: You want to be notified if the property taxes are not paid on time. This may trigger a foreclosure action by an institutional lender so you need to be aware of delinquent property taxes.
Insurance: The buyer should name you as an additional insured on their fire insurance policy. The institutional lenders require it and you should too.
Late charge: Specify the date the payment is due as well as the grace period and the amount of the late charge.
Interest: Be sure the note has the interest rate and remember to consider "imputed interest rates" set by the government and the IRS. You may be taxed on interest income you didn’t actually receive if the rate you charge is lower than the imputed rate. Consult your tax preparer.
There is yet another technique to minimize your risk over the life of the seller carry-back note: Periodic lump-sum principal payments. This depends on the buyer’s income and/or bonus situation and on the seller’s income needs and/or tax situation. The note may have monthly or yearly payments, it may be interest only or include principal or it may provide for periodic principal payments.
You can even have more than one note with different terms, interest rates and due dates. This can work well if the buyer receives annual bonuses and can make a lump sum payment to reduce the loan amount. Seller carry-back notes usually do not have pre-payment penalties and may even have an inducement to an early payoff.
Most seller carry-back notes are interest only and have a "balloon payment" requiring a payoff at a specified point in the future. The buyer may have to refinance the property to make the balloon payment and there needs to be sufficient equity in the property to do this. Allow reasonable time for this to occur and as the due date approaches, communicate with the buyer and determine what plans are being made.
If the buyer has made the payments on time and you don’t have another immediate use for the money, you may even offer to extend the note. You and the buyer may even modify the terms or interest rate as well as the due date if both parties agree. You get to continue the income stream and the buyer saves on refinancing costs. You could ask for a partial principal payment as well. Always consult with your financial advisor or tax-preparer before entering into a new financial arrangement.
You have probably noticed another benefit of seller financing: You can structure a seller carry-back note almost any way you want; just be careful and consider your future situation as well as the present.
That covers the basics or seller financing. When I entered the real estate profession in 1981, seller financing was a very popular alternative to the prohibitive interest rates the institutional lenders were charging. Real estate prices were declining here in California because buyers couldn’t or wouldn’t pay 19% interest for a mortgage. In San Jose, where I got started in the business, membership in the local board of Realtorsâ dropped from over 12,000 to around 3,000. Those of us that survived and continued to assist buyers and sellers in selling real property did so by becoming proficient in seller financing techniques. The knowledge we gained in those challenging days can benefit sellers today when seller financing is being considered.
ã Walt Harvey, ABR, CRS, GRI, SRES, e-PRO, QSC, Real Estate Broker