Seller
Financing has been used in real estate and other transactions for
thousands of years and still possesses the dual capacity to provide
unique investment opportunities with equally unique risks for all
parties. This Article is intended to introduce you to the benefits and
detriments of Seller Finance. Of course, every transaction is unique as
are the circumstances of every Seller and Buyer/Borrower. Before making
your decision concerning Seller Financing, be sure to consult with
legal and tax professionals.
What's Great About Seller Financing
1. No Lender Required
- When institutional lenders tighten-up credit and loans become harder
to get, Sellers with equity in their property can get their property
sold by providing some or all of the purchase financing, also called
"carrying back paper".
2. Better Pricing
- Unlike institutional lenders that must package sales commissions and
other funding costs into the financing, Seller Financing generally
avoids these added costs and can offer lower cost financing for which
Buyers will pay more.
3. Better Return on Investment
- When a Seller carries back financing, they are acting in the place of
an institutional lender by converting the cash that they would normally
receive in sale proceeds (liquid assets) and converting it into a
secured cash stream (hard assets). Cash in a bank today is earning less
than 1% interest. Interest on loans is typically earning from 3-6%.
4. Security
- Seller Financing is generally secured by the real estate. If the
Buyer/Borrower doesn't pay, the Seller can foreclose and either get paid
or take the property back to rent or resell.
What's Not Great About Seller Financing
1. Seller is the Lender
- Normal loans are hard to get because lenders examine credit, and
jobs, and income stability, and financial capacity. Seller financiers
often lack the sophistication and access to provide the same level of
"due diligence" as to the borrower's credit-worthiness. So Seller
Financing may carry a higher risk of default.
2. Loss of other investment opportunities
- Because a Seller's sale proceeds are being loaned to the Borrower,
those funds are not available to the Seller to make other investments
which may be more lucrative.
3. Income is at risk
- If the Borrower defaults in repaying the Seller Financing, the
Seller's income stream is cut-off and will stay cut-off until the Seller
either forecloses or reaches some other agreement with the borrower.
Foreclosure could take more than a year. Buyers sometimes seek to avoid
paying Seller Finance by claiming that the Seller failed to disclose
some defect that has cost the Buyer property value... often equal to the
amount of the Seller Financing.
4. Limited Recourse
- If the Borrower fails to pay, the Seller must foreclose. In many
States including California, Seller Financers are barred from suing the
Borrower if they are not paid back in full. If the real property pledged
as security has deteriorated or market conditions have fallen, the
foreclosing Seller Financer may suffer the loss of their investment.
What Seller Financing Looks Like
In
most cases, real estate agents may be involved representing the Seller
and the Buyer. They will provide the necessary Contract documents which
explain the financing terms and, if required, will assist the Seller to
provide any Seller Financing Disclosure. An escrow or title company will
process the sale documents and may provide the Seller Finance loan
documents for the Borrower to sign including: 1) a Promissory Note promising to repay the Loan to the Seller based on the terms set forth in the Note; and 2) a Deed of Trust
(or Mortgage) giving the Seller a security interest in the real
property which can be foreclosed if the Borrower defaults. The Deed of
Trust would then be recorded establishing a lien on the Buyer's title
for the amount of the Loan.
Alternatives to Seller Financing
While
Seller Financing has a well-established place in real estate finance
and investment, there are other alternatives when the Buyer cannot
qualify for normal lender financing. The most common of these are:
1. Contract for Deed (also called Land Sale Contract)
This
is very similar to typical Seller Financing except that the legal
ownership of the real estate does not change from Seller to Buyer. There
is no Grant Deed. Instead, Title to the property remains in the
Seller's name until the Buyer performs some obligation. Typically, the
Buyer signs a Contract to buy the real estate and pays the Seller a
certain amount of money each month which the Seller then uses to pay any
existing financing or other costs of ownership. When the Buyer obtains
their own Loan, or pays off the Contract purchase price, or possibly
even sells the Property, then the Contract amount is paid off and the
Title transfer to the Buyer. Under current legal decisions, these
arrangements are also considered to be a sale with Seller Financing.
a. Pro's: This is fast and cheap and Seller retains ownership. Foreclosure is not needed.
b. Con's:
Although the Legal Title stays with the Seller, with each payment the
Buyer gains "Equitable" Title, ie: they become a partial owner and
cannot be evicted if they default in a payment. An expensive legal
action must be brought. Further, this arrangement is typically a
violation of any "Due on Sale Clause" which may be in any existing
financing. If that Lender finds out, they could possibly start their own
foreclosure which could wipe out the Seller's interest in the real
estate and the Contract.
2. Lease with Purchase Option
This
too may sound very similar to typical Seller Financing or Contract for
Deed except there are major differences. The Seller actually leases
(rents) the real property to the Tenant who pays the Seller a certain
amount of money each month. The Seller and Tenant/Buyer also enter into
an Option Agreement which provides a right (but not an obligation) for
the Buyer to purchase the property at a future date on terms set forth
in the Agreement and related documents.
a. Pro's:
The Buyer remains only a Tenant until the Buyer performs the
obligations required to exercise their Purchase Option. If they default
in paying, they may be evicted under Landlord-Tenant law which is fast
(often 4-6 weeks). For a Buyer, the Option period may allow them to
qualify for a purchase loan and even make improvements to the real
property to increase it's value and gain the Buyer immediate equity.
b. Con's:
The Seller has not sold their real property and does not receive any
money from the Property other than the promise of monthly rent payment
which may not cover all of the Seller's costs in owning the property.
Managing a rental property is not easy.
THE BOTTOM-LINE
