UNDERSTANDING SELLER FINANCING
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 identify the pro’s and con’s of Seller Finance.
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 So Great with 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 – Seller Financing offers distinct benefits and risks that should be considered when such an opportunity arises. This Article is intended to introduce you to these issues but, of course, is limited in its scope. Entire books have been written on this subject but neither can specifically address your situation and the unique circumstances of your transaction. Before signing any Seller Financing agreement or any Contract providing for such financing, be certain to obtain the advice from legal and tax counsel of your own choosing.
If you or someone you know is considering using Seller Financing in a real estate transaction or is facing a legal or financial challenge and don’t know what to do, our BPE Law flat fee Consultation Program can offer knowledge of what to expect and form strategies to achieve your best overall resolution. To schedule a Consultation, please contact our office at (916) 966-2260 or e-mail me at email@example.com
The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are upside-down on your loan, especially if you’re facing a real estate or lender dispute, get competent legal advice in your State immediately so that you can determine your best options.