The term Seller Finance is thrown around a lot and means different thing to different people. Some people think of Seller Financing as a “lease option” or lease with the option to buy, other think of someone who owns their home free and clear and they sell their home on contract and the buyer makes payments to them for a pre determined period. True all of these could be considered to be seller finance deals, but my definition of Seller Finance is when the seller transfers title to the buyer and records a note on the property and the buyer makes payments either directly or indirectly to the seller or the sellers’ lender. First I will explain who would want to do a seller finance deal, second, why they would want to do the deal, and third how to put the deal together. Finally I will sum up the some of the misconceptions of the deal, and some landmines to avoid so that the deal can become  win-win for everyone.

 

It takes 2 people to do a Seller finance deal, a willing seller and a willing buyer.  In markets where the financing is difficult the buyer may want to and be able to afford to buy, and the seller wants to sell, but for whatever reason the buyer can’t or does not want to obtain traditional lender financing.

For a buyer seller financing has 2 benefits. The first is the fact that the Seller is the bank. Sellers can be more flexible than banks and the deal can be put together rather quickly. The second benefits are the loan terms.  If a Seller has a great rate or a lot of equity this savings can be passed on to the buyer. This can help the buyer afford a property that normally wouldn’t be able to be financed. This is not to be confused with the Seller giving equity to the buyer, but when I explain how it works it will make more sense.

For the Seller the major benefit is that they can create an income stream as well as a way to relieve themselves of having to make the payments to their bank. If a seller is having difficult times making their payments to the bank, and their home is not selling, a Seller Finance option often is the easiest and quickest way to relieve the pressure.

How the deal can be structured:

We have all ready established that the deal has to have a willing buyer and a willing seller. Let’s look at an example:

Joe wants to sell his home. He owes $100,000 and his monthly payment is $600/mo. for a 30 year fixed loan.  Joe has lived in his home for 10 years and now it is worth $200,000. The real estate market in Joe’s area isn’t moving very well and homes are taking a long time to sell… if they sell at all. Joe has all ready purchased a new home in a nearby town but is stuck making both payments until he sells his old property. When Joe sells his home he is planning on putting the $100,000 profit into the stock market and saving for his retirement.

Steve finds Joe’s home and wants to buy it. Steve doesn’t have very much for a down payment, but he makes good money and could afford Joe’s house. His credit isn’t perfect because of a divorce but he wants to buy a home for his family and Joe’s home is perfect.  Steve read my eBook and knows how to put together the deal.

Steve meets with Joe and they talk about why Joe is selling and what Joe is going to do with the money. Steve comes up with this offer:

Purchase Price: $200,000

Down payment: $0

Monthly payments:  $1,200

Steve tells Joe about a 3rd party escrow company that will take his payments, cut a check to Joe’s bank, and a check to Joe every month.

Initially Joe disagrees and wants his $100,000 cash to invest. Steve then shows him how his investment is better with the seller finance.

Monthly Joe would receive $600/mo from Steve every month. If you were to calculate this as an annual rate of return it would be 7.2% ($600/mo times 12 = $7,200, $7,200 divided by $100,000 = 7.2%). Joe can then take his $600/month and invest it monthly or just put it in the bank. With stock you have to sell it to get your return. This way Joe can use the money when he needs it and sock it away when he doesn’t. The stock market goes up, and it goes down. True Joe could have some good years where his money might be in the double digits returns, but that doesn’t mean that it will. For our example let’s assume a 5% annual appreciation.

A 5 year comparison chart would look like this.

 

 As you can see in the example the return is exactly the same if he invested it or did the Seller Finance. However the value of the home has increased by $56,671. This of course helps Steve, but in the event that Steve was unable to make the payments and Joe had to take it back, he would have all the money Steve gave him + the added benefit of appreciation.  Joe was still not convinced to sell the property to Steve in this way. His concerns were as follows:

1.       He worried about how Steve would make the payment

2.       What happens if he didn’t make the payment

3.        When he would receive the payment from Steve  

Fortunately Steve knew the answers. The answer to most of the questions comes down to a third party escrow company. Here in Utah I use a company called Escrow Specialists. The way it works is that every month Steve makes his payment to Escrow Specialists of $1,200. Escrow specialist then cuts 2 checks, one to Joe for $600 and one to Joes bank for $600. This protects both parties Steve by being sure that the payment is made to Joes bank every month, and it protects Joe to create a paper trail of the entire transaction on a monthly basis.  Every month both Joe and Steve receive a statement just as though Steve was making payment to a bank.  Steve has made one extra payment in advance and by doing so in the event Steve were ever late on his payment Escrow Specialists would have money in reserves to make the payment.

 

Joe is almost convinced but he has one last concern. He remembers something about a “due-on-sale” clause in the note he signed with the bank. One of his friends says that it is against the law to sale his home without paying the bank off.  Steve has come across this before and all it takes is understading logic, and being able to separate fact from fiction. Some people think that the “due-on-sale” is a law regulated by state or fedreal governements. The fact is that it is not a “law” it is a condition of a contract that the bank and the borrower agreed to. Steve recommended to Joe to read the note again and understand the consequences of what happens if the Due-On-Sale clause is enforced. Lets look at why the bank may have that clause in the first place. If you sell the property and don’t pay off the bank the new buyer is responsible for making the payment. The bank doen’t know anything about the ability to pay of the new buyer and therfore they don’t like the idea of indirectly financing this new buyer. Also, it is a way to protect themselves for people who use “straw buyers” to buy properties. A straw buyer is a person who buys the property using their credit, but once closed they turn the home over to an investor for a fee. This is possible the worst thing that can be done and it hurts the market, lender, and everybody else in the transaction.  Some people feel that the reason the bank has the Due-on-Sale clause is to have a reason to call the loan due if rates get higher. I find this interesting, but not very logical. From a lending standpoint the best loan is one that is paying. With the seller finance there is not only 1 person making payments, but effectivly there are 2. As of this writing Countrywide Home Loans has over 14,000 loans in default. If they are receiving the payments from Joe or the escrow company on Joes behalf, foreclosing on the property seems to be a bad idea. It needs to be discussed as well as written in contract what will happen in the event the lender calls the note due or Steve is unable to make the payment.  Usually this is solved by simply doing one extra step. At closing Steve signs a Warrantee deed back to Joe. The escrow company being a nutural 3rd party holds the deed in their file and has instructions to record it in the event Steve is unable to make the payments, or the lender calls the note due.

This has been an example of the perfect conditions when it comes to putting a Seller Finance deal together. A lot of times the Seller wants money down, or they want the buyer to cash them out sooner. It takes the ability to understand the way the loan pays off and how to negotiate the right terms for the buyer and the seller. In today’s market a lot of sellers owe more than the property is worth.