Seller’s Risks with Owner Financing
1. The buyers may not pay. This is the only risk novice buyers
and sellers really think about. Participants in a owner financed
transaction need to realize they are going into the banking business
in a small way. Everyone knows banks have large buildings
and make a lot of money. They sort of forget banks also take some
heavy losses. However, banks get to play the odds. They
try to make more loans on which they profit than loans on which they
take a loss. For the seller trying to unload his house the news
on the day the monthly payment is due is either all good or all bad. Sellers
frequently insist on terms that actually increase the chances the loan
will get into trouble.
2. The sellers may need their cash faster than the contract pays. This
can be a subtle trap.The sale is done and some time later something happens
in the sellers life which causes them to need a chunk of cash. The obvious source of funds would seem to be selling the contract for cash. After all, the buyer has been paying every month and the interest rate on the
note is well over what banks are paying on CD’s.
A few calls to the note brokers advertising in the paper will spoil
that illusion. In the United States home ownership is reguarded
as a sacred right and governmental systems are in place to make sure
cheap money for home buyers is always available. The government
backs the bonds that get issued to provide the money so loans can be
made at the lowest possible rates. When you try to sell a privately
held note the buyers of the note will expect much higher rates. The
way they do this is to discount the value of the note.
Note discount calculations are complicated and depend on a lot of factors. However,
even a short term note, with market interest rate, and a good payment
history may be discounted by 25% or more. One of the difficult
parts of being a note broker is educating consumers about the true value
of their note on the open market. Successful note brokers typically
do that by proposing terms which help the note seller feel like they
are getting more for their note than they really are. This works
because few people really understand the mathematics of notes.
3. There may be unintended tax consequences. As
long as the seller continues to hold the note and reports the interest
as income the tax situation remains simple. For the buyer the interest
is deductible and the tax results are obvious. The tax situation
is more complex if the note gets sold to a third party at a discount. It
will also be more complicated if seller financing was used in the sale
of an income property. In that case the sellers “basis” in
the property comes into play and the allocation of the money from the
payments is more complex.
4. There may be title/ownership issues. Title
issues are rare in the residential home market. Subdivisions have
to on the books for years so there are few boundary issues. Title
insurance is a almost always used so potential problems are found and
corrected early. With land and income property title related problems are more likely. Owners
get sued, make bad business decisions, fail to pay their taxes, get divorced
and do other things that result in clouds on the title. Even with
residential property, sellers may “forget” to mention they
deeded an interest in their home to their kids who then will have to
sign the deed as part of the sale. Even though it is expensive,
I would strongly suggest title insurance.
5. Poorly drawn paperwork puts sellers at risk
of not being able to enforce the contract. Serious problems
will require a trip to court to resolve. THis is expensive and
takes a long time. In the
meantime the buyer may live the the property for months without making
payments. The seller is stuck making payments on the underlying
loan(s) to protect his equity without any income. I have known
sellers who would drive buy “their” property and watch it being
destroyed without being able to do anything about it. In court
the only thing which will really matter is the paperwork. Things
that were said or promised are not considered. This is the time
when the seller may realize the generic document they got at the stationary
store really doesn’t protect their interests well. In other words,
the parties to a seller financed sale should do everything with the idea
that they may eventually be in court and the documents they are signing
will determine what happens.
{ 40 comments… read them below or add one }
I am selling my house to a friend who can borrow three fourths of the money and wants me to finance the remainder.My house is paid for and I think this is a good deal? How many years should I ask for and what interest rate ? Do I need a lawyer? What happens if he dies?
Your note will be behind the banks, so if anything goes wrong your equity goes away first. In some parts of the country home values are declining so the house may be worth less if you have to take it back. Do you need the money? Would you be happy with 3/4’s of the sale price? If you do get it back the next buyer will have to qualify for a new loan. Assuming the note is properly drawn and recorded it will still be attached to the property in the event of the buyers death. Depending on the situation with heirs, you might find yourself making payments on the first to protect your note until things get finalized.
Terms can be whatever you want. You might look at your tax situation and see if capital gains or interest income is best for you. In any case I would avoid a balloon payment. They frequently cause problems.
A lawyer is a good idea, but look for one with experience doing non-standard real estate deals.
Good luck.
We have an offer 160k with 130k cash and 30k owner financing @5% for 6 years. He wants to use his atty. and no disclosure on his credit. We owe 150k on the house so we would be negative 20k on mortgage. We want to keep the mortgage until paid off. He does not..
The original price on the house was 185k and now 179k in a robust college town. We cannot pay the 20k left on mortgage. We want more close to our price, keep deed, finance 30k @10%. Would this seem more like it?
If the buyer is actually going to put down 130K and the note he is giving you is in first position you should be able to sell it to an investor at closing and get most or all of your 20K. My guess is that he plans to put a new mortgage on the property and put you in second position behind that. Not a place you want to be.
With the state of the economy these days what you paid for the house is NOT a relevant issue.
I have a question about owner financing: My house is paid for and a investor wants to purchase it with 10,000 down @ 7% for 30 years with a callout of 7 years. The purchase price is 45,000. I’m 56 years old and I don’t think this is a good deal. Please advise.
What don’t your like about the offer?
$10,000 is 22% down which seems good these days. There is no way for me to know if the price is high, low, or about right. I do know many economic forecasters do not think home prices are likely to increase much in the next few years. Bank CD’s are paying around 1% these days, so 7% seems good. Balloons are dangerous; it’s amazing how fast seven years goes by. So, would you be happy to get the house back if they can’t refinance to pay the balloon?
We have the chance to buy a house with owner financing but they still owe the bank the majority of the loan and it has a subject to existing loan and said loan has the due on sell clause. This worries me then she mentioned after the sale she could sell the loan to an investor. So if the bank enforced the due on sale clause I would be in trouble or if she defaulted in payments or even worse died I could lose my down payment and because it is a fixer upper I would lose any of the work I have done. Any advice to help a first time home buyer please?!?!
You are correct to be concerned. If you decide to go forward with the purchase you will want your own attorney closely involved. That said, there are arrangements which can reduce the risk from these issues.
In many parts of the country any home purchased since 2005 is worth less today than it was then. Are you certain this house will be worth enough more after fixup to repay your investment, your time and a profit?
I don’t know any investors who would be willing to buy a small second position note which is behind a large first. I think the sellers chances of selling the note to an investor range from slim to none.
Escrow companies are designed to handle these situations. As part of the purchase buyer and seller (their attorneys actually) will prepare instructions for the escrow agent. The seller would put a deed to you into escrow, you would put in a deed back to the seller. You make your payments to the escrow company. They use those funds to pay the first mortgage and send the balance to the seller. If you quit paying the seller, after proper notice, gets the deed you placed in escrow, records it, and evicts you. If something happens to the seller your payments, via the escrow company, go to her heirs/creditors. Her deed to you is released when the loan is paid off.
My first thought was this is the perfect situation for a lease with option to buy. You lease the property from the seller using a lease that includes the improvements you plan and a schedule for their completion. Since it is a lease, due on sale is not an issue. When the improvements are done you have the house appraised and buy it for the option price. If you can’t finance it yourself at that point you should have the right to renew the lease and option until you can. At some point a long term lease could be considered the equivalent of a sale, but my guess is that five years or less wouldn’t be a problem.
If you are planning to use the first time homebuyers credit to buy the place that isn’t going to work with a lease option. I don’t know enough about the exact requirements of that program to offer any suggestions. My impression is there are some “gotch ya’s” which kick in when you want to sell or move that may make it look less like “free money” than it seems.
My impression from lurking on some of the financial blogs is that due on sale is seldom, if ever enforced, especially in these “interesting” economic times. You may decide the risk is small and that you would have time to sell before it could be enforced. Selling a property with a due on sale clause is not illegal, it means the lender can make the entire outstanding balance due immediately and foreclose if it isn’t paid. I believe you would have at least ninety days, probably more, to sell, refinance, or make other arrangements before such a foreclosure could happen.
You do not have to record all the documents for the transaction. Doing so would make all the details such as purchase price and terms a matter of public record. Investors I know record a memorandum of understanding that simply states there is an agreement in place. This clouds the title so the seller can’t sell the property again but keeps the details of the transaction private.
Good luck with whatever you decide to do.
I have no idea what to do….I am hoping you can help! My husband and I purchased our home just about 3 yrs ago. The seller held part of our mortgage. That mortgage balloons this December. In the begining of this year we tried to refinace the 2 mortgages into one. In the course of the 3 years, our home’s value decreased. We could not combine the two. Now….we are struggling to figure out how to pay this note off. What are my options? We have applied for loans and have been unsucessful! Are we going to lose our home?
The first thing you need to determine is the actual market value of the home now. This needs to be a hard nosed, quick sale price with no wishful thinking. If there are some homes in your area that have actually sold recently they would be the best comparables. Is the quick sale price less than your total mortgage debt? Is the quick sale price less than the first mortgage?
I don’t know where you live, but in many parts of the country current home values have dropped a lot. If your home is now worth substantially less then you owe on it, you will have to decide if it is worth continuing to make payments. If you do a Google search for “ruthless default” you will find a lot of discussion of the pros/cons of the choices available to you.
If your decision is to try and keep the house and the balloon is the problem, I think your first action should be to contact the note holder and ask for the terms to be changed. That’s one of the advantages of owner financing after all. If the house value has gone down the seller may be very happy if all you do is keep making payments, never mind the balloon.
Most of all I would encourage you to make the stay/leave decision quickly before you burn through your financial resources trying to save an impossible situation. If the house is worth less than you owe and the seller won’t negotiate then make other arrangements quickly.
Good luck