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Pitfalls of Seller Financing

Seller financing historically hasn’t been very common. When a property owner wants or needs to sell a home, the sellers typically want to get their proceeds at the settlement table rather than collect monthly payments from the buyers. However, over recent years since 2008, seller financing has become a bit more frequent as lending guidelines returned to traditional approval methods. Sometimes otherwise very qualified buyers couldn’t get an approval from a bank or a mortgage company and seller financing was one of the few options available.

For example, a conventional loan program using Fannie Mae underwriting requirements ask that a self-employed borrower be so employed for at least the past two consecutive years with income considered stable and likely to continue into the future. Yet take the instance of a physician leaving a practice and starting out on her own. She essentially takes most of her patients with her and for the first year, she’s done very well. Her credit is excellent and she has plenty of cash available for a down payment and closing costs. Yet she doesn’t meet the two-year self-employment history as she has only been on her own for just over a year but an individual who offers seller-financing might be an option.

Seller financing can help bail out potential buyers who, for whatever reason, don’t qualify for a traditional mortgage. Instead, the buyers accept seller financing with an eye toward refinancing in the future. Yet while this approach can make sense in some instances, there are some things buyers need to be wary of.

home loan application for condos

Legally Constructed

The loan documents must be properly drawn, adhering to the city, county and state regulation. If not, it’s very possible the note would not be recognized as a legally binding agreement and the seller could end up collecting the monthly payments each month but the payments end up being treated as rent and not mortgage payments.

The property must legally be transferred and recorded with ownership changing heads with a properly executed deed and note. The seller will still have an interest in the property and can foreclose on the home should the buyers not make the payments on the mortgage and default.

There may also be existing, so-called “superior” liens against the property that must be paid off before the home is sold. If not, unsuspecting buyers who are financed by the seller could discover a forced sale of the property to settle a previously recorded, superior lien. This can happen with delinquent federal income or property taxes. Delinquent child and spousal support payments must also be settled.

More Cash

Sellers know that when buyers need or want seller financing it’s because the buyers don’t yet qualify for a standard mortgage. That means sellers can require a greater down payment from such buyers. How much? That’s completely between the buyer and seller but it can be anything they agree to or the seller requires. The down payment might be as much as 50 percent of the sales price for example. In the same manner, interest rates on seller financed transactions will also be much higher than current market rates.

The strategy with a seller financed note is to make the payments on time and wait until whatever situation is prohibiting traditional financing is resolved. Remember the physician? After two years of a successful practice along with copies of filed federal income tax returns, she can later apply for a conventional mortgage, retiring the seller financed note and obtaining more favorable terms. If she wants, she can also pull some additional cash out during the transaction and put some of the original down payment money back in a bank account.

Is This a Wrap?

You may have run across the term called a “wraparound” mortgage. A wraparound, or simply a “wrap” is a transaction where the seller sells the home, finances it while there is still an existing mortgage. The buyers make the payments to the seller and the seller uses some or all of those same funds to pay the existing loan on the property. However, wraps are not allowed, regardless of what you may have heard or have been told. If you take seller financing and discover there’s an existing mortgage on the home that will remain there after you close, you could run into a big problem.

Somewhere in the middle of all mortgage loan papers, there is an acceleration clause. This clause describes under what conditions the seller can take back the property and demand the mortgage money back. One of the most common events that trigger acceleration is a default on the note. The borrowers fall behind on the mortgage payments and can no longer afford the home. The lender forecloses and takes back the property and sells it. Another way to trigger an acceleration is a Due on Sale clause. This means if the home is ever sold, the outstanding note must be paid. There can be no wrap if the home is in fact sold because of the due on sale clause.

Now let’s say you’re told not to worry because wraps are really not that uncommon of a transaction and if you make your payments to the seller on time each month there won’t be a problem and the existing lender will never know. That is unless the seller runs into some financial problems. The seller loses his job and can’t find work or falls ill or some other unfortunate event. The seller could very well then take your monthly payment and keep it to help pay his bills. You did everything right but the seller didn’t.

The previous mortgage goes into default and the lender forecloses only to further discover the seller illegally transferred ownership. The previous lender doesn’t care about your agreement, forecloses on the mortgage and you lose not only all the payments you made along with your down payment.

How to Finance Non-Arm’s Length Transaction

The Alternative

If you’re considering seller financing, you first must determine that in fact, you do not qualify for a mortgage from a mortgage company. There are niche products in the industry today that address certain issues that keep many from qualifying. That means talk to a lender like us who has multiple options, many more than standard conventional fare.

Second, consider a lease-option agreement instead of an outright sale. This is an agreement that you can exercise the option to buy the property from the seller at a future date. Many choose this method when needed because there is no down payment for a lease-option agreement and the future buyers can take the necessary steps to correct whatever is keeping them from a standard mortgage.

Seller financing can certainly be an option under the right circumstances but buyers do need to be made keenly aware of the legal issues involved, more down payment and higher rates and title problems. In most cases, it’s better just to wait.