What Is Seller Financing?
Seller financing is a type of transaction in which the seller provides financing to the buyer of real property. The seller either partially or fully covers the sale price, and the buyer makes monthly payments to the seller over time until the loan is repaid. This form of financing can be an appealing option for buyers who may not qualify for a traditional mortgage. In addition, it can be beneficial to sellers . For example, if a seller holds the financing, he or she might net a price that is substantially higher than the list price, as property taxes are often based on the sale price. In addition, the seller will likely receive more favorable financing terms, such as a higher sale price, a higher rate of return and the ability to package the loan with other assets, thereby reducing capital gains tax.
Documents Used in Seller Financing
The promissory note is at the very heart of any seller financing transaction. In it, the buyer (or borrower) makes a promise to pay the seller (the lender) back for the purchase price of the house, in periodic installments, over the term of the loan. Typically, the promissory note will set out the amount of the loan, the interest rate, the maturity date of the loan, and whether the loan is full amortizing or ballooning (meaning the buyer will be paying off the principal and interest throughout the loan’s term, or just the interest, with the remaining principal due at maturity).
To secure the promissory note, the buyer will also sign a deed of trust (or mortgage). This document gives the lender a lien on the property for the benefit of the buyer, providing the lender with a judicial oversite procedure in the event of a payment default. What that means is that, in the event the buyer does not pay the monthly installments on the promissory note, the lender can ask the court to order a sale of the property to pay off the promissory note.
Finally, there will need to be an agreement between the buyer and seller for the transaction—the purchase agreement—which will, in addition to addressing all of the other issues one might find in an agreement for home sale, set forth the terms of the financing, including how much the buyer will pay on a down payment, the cost of PMT, and any other pertinent information the parties feel is necessary.
The Promissory Note Explained
The promissory note is the document that actually evidences your seller financing of the purchase price. It is a legal document signed by the purchaser in favor of the seller that creates a legally binding obligation on the part of the buyer to pay the money loaned to him by the seller. This obligation usually runs for a period of 5 or 10, but may be for more or less depending on the parties. It is a document that obligates (legally bonds) the buyer to do what you have agreed he will do, i.e., pay in full the money owed for the purchase of your business on the terms and conditions you have agreed. It is the document that gives the seller the lever it needs to be able to make sure the buyer pays.
It is also the document that allows the seller to enforce the buyer’s obligation to pay in the event of default, and also allows the seller to sell the note to a lender or other buyer of notes if the seller wishes to cash out of the mortgage prior to receiving all the proceeds from it. Any payment history he has, either in the form of cancelled checks or a computer printout from his bank showing that the payments were made, would also accompany the note when selling it to a third party. The seller would discount the note to its present value based on the rate of interest actually earned on the note in comparison to a reasonable current market rate for a similar note.
What kind of terms should the promissory note contain? Well, the note should contain a statement of the principal owing, the date or dates when the principal or any balance thereof is due to be paid, a description of the interest-paying provisions of the note, i.e., the amount of interest to be paid by the purchaser for the loan, whether the interest is calculable on the basis of a 360 or 365-day yearly period, and the payment schedule, i.e., monthly, quarterly, annually, along with the payment due dates, the amount of each payment, and the total number of payments needed to pay the amount due under the loan.
There are some times when you might want to give the buyer the right to pay off the remaining balance of the note before it is due, subject to certain conditions. You might want to specify that the entire balance of the note is payable upon default in the payment of any installment or if any representation or warranty contained in the contract or who signed the note was not true and correct as of the date the buyer signed the note. Or you might want to allow the buyer to pay off the note prior to the maturity of the entire note, if the purchase price has been paid in full. You might want to give the buyer the right to prepay all of the note. Of course, you could also state that the note was non-callable by the buyer unless he was in default.
You would also want to provide for the imposition of late charges in the event the buyer was late making a payment. You would also likely want to provide for conversion to principal of any accrued and unpaid interest. Having the ability to capitalize interest is very important in the event the buyer defaults on the terms of the promissory note. But there are other risks faced by the seller. The seller should also receive a personal guarantee from the individual buyer or any other party who is financially responsible or a party whose credit standing is of significant importance to the seller.
And finally, what else might you want to add to the promissory note? As a general statement, the buyer needs to agree that the note will be due and payable to the seller on his demand in the event the seller determines that an event of default has occurred. You could provide for an acceleration clause, meaning that when the payments have been accelerated, the entire unpaid principal balance of the note is immediately due. You might also want to include standard provisions regarding the seller’s right to receive attorney’s fees and court costs in the event of the commencement of any legal action arising out of the promissory note. You will want the right to assign the deferred purchase price receivable obligations. And finally, the promissory note would not be complete without a specific acknowledgement that it is secured by a deed of trust and that you may enforce your rights thereunder.
Security Instruments: The Deed of Trust Versus The Mortgage
When the seller finances the sale of a property, the promise to pay is documented with a promissory note. The note is secured by either a deed of trust or a mortgage which serve as collateral for the payment of the promise to pay contained in the note. Each state has its own law regarding the method used to secure a promissory note; this of course weakens the holding of a promissory note if the seller is not familiar with the rules of that particular state. A deed of trust has the same effect as a mortgage. A deed of trust performs the function of a mortgage. The difference, aside from the law of the particular state, is that at the time the promissory note is signed the seller holds the original note. The property is not transferred until the note is paid off. At that time, the seller records a release of the deed of trust, thereby terminating the security interest given to the sellers. A deed of trust is sometimes referred to as a "Three Party" agreement because there are three parties to the agreement, the borrower (also known as the grantor or trustor), the lender (also known as the…), and the trustee. In either case, the loan is secured by the real estate, as the owner (grantor) grants a lien against the property to the lender via the trustee. The principal difference is in how the security interest is taken and how the foreclosure actions or other remedies are pursued. Whereas a deed of trust gives the lender a faster and more streamlined procedure for foreclosing than a mortgage, a mortgage gives the borrower a better chance of receiving judicial protection. Thus, while the deed of trust gives the lender stronger protection in most cases, the mortgage will give the borrower greater protections in many others.
Writing a Purchase Agreement
A purchase agreement is designed to spell out the responsibilities of the buyer and seller. In most cases, it will also contain provisions for a seller-financed sale. The purchase agreement contains the terms and conditions of the sale and typically bases the payments on a down payment and interest on the remaining amount of the sale. The agreement also identifies those contingencies that will allow either party to cancel the sales agreement.
The purchase agreement includes the down payment, balance due, interest rate and the fees that are to be paid. It may also include foreclosure fees, attorney’s fees and other such fees that may apply. If there are late fees, which there normally are, these should be in the purchase agreement too. If there is a default, provisions for recording a lien should be part of the purchase agreement as well.
The purchase agreement should include a provision for prepayment and a provision for deferral of the payment schedule in case of hardship. If it is anticipated that the buyer will seek relief under an option to buy another piece of property , or if they may otherwise not have the money to pay an installment, either of these can be built into the purchase agreement.
In most states the transfer of property will involve the use of a deed. An absolute deed is used when the sale closes. Title is transferred to the buyer and they take possession. The deed is either signed and notarized or in some cases, it is prepared at the closing, and becomes effective once the documents are signed. In some states ownership will pass with the last signature. In others, it will be the recording of the deed that transfers ownership. In either case, the deed identifies the buyer and seller, provides a description of the property and identifies any easements or other encumbrances. It should also include the amount of the purchase and the date of transfer.
Common Challenges and How to Tackle Them
Despite the advantages of seller financing, there are still some potential legal pitfalls you should be aware of. For one, there are specific state LTV limits placed not only on conventional loans but for seller financing as well. Likewise, there are certain tax advantages to seller financing. Tax advantages vary widely according to your state. Be sure to familiarize yourself with your state and federal laws regarding seller financing.
Below are some of the common challenges faced when it comes to formulating seller financing documents:
Failure to comply with state and federal lending laws.
Purchasers who finance their own homes are not exempt from housing discrimination laws. For this reason, it’s a good idea to familiarize yourself with the federal Fair Housing Act and your state’s laws for discrimination in housing and real estate. It’s not only advisable to comply with the law but it’s also good practice to inform sellers of this.
Don’t lend more than you can afford or that you might reasonably expect to collect in the event of a default. A mortgage is considered debt, not income. Even at a high market rate, it’s unlikely that interest rates will come close to covering the amount of depreciation you will encounter. Likewise, it doesn’t cover the cost of collection.
Equity skimming. There are also state anti-redlining laws that support minority borrowers and prevent lenders from redlining. Be sure to familiarize yourself with the laws in your state and steer clear of these violations.
Wanting to put your documentation together yourself. It’s overwhelming do-it-yourselfers, but unless you have professional training in this area, you’re well advised to let the pros handle the drafting. Even if you do know all the ins and outs of seller financing, there may be other considerations you might not have thought of on your own.
It’s also a good idea to check out your state’s Department of Financial Services office. They might even have sample forms you can use or other forms that you can model your own docs after.
Buyers and Sellers: Tips & Advice
Buyers and Sellers: Tips for Your Seller Financing Documents
It is generally to a buyer’s advantage when the seller will carry back one. First, it may allow the buyer to make a purchase that it may otherwise not afford. If the buyer were to get the bank financing and put 20% down (or more) and pay 6.0% interest on a 30-year amortization schedule, the monthly payment (excluding taxes and insurance) would be $4,474.46. If the buyer could put down, say, only 10% and borrow the other 10% from the seller and pay only 4.5%, the monthly payment would be $4,260 and the buyer would need only $214,000 (instead of $335,000) in cash. This scenario puts the buyer in the position to either buy an extra house, or get a cheaper house by using the money saved to pay more up front (assuming the seller will continue to accept the price).
Also, if a buyer gets a bank loan with a payment that is more than the rental value of the property, then the buyer may have to pay more than the rental value. If the property were to be foreclosed, the lender, and not the buyer, usually gets the foreclosure proceeds. Given this, a buyer may be willing to buy property without a bank loan for relatively the same cost as buying it subject to the bank loan. The difference is that with seller financing, the buyer gets the equity if the property is foreclosed; with the bank financing, the lender gets the equity.
Sellers, however, usually want their sales contracts to be conditioned upon a bank’s approval of the buyer’s application for an institutional loan. Here, the buyer has less negotiating power than when the seller finances the buyer. The seller will want to do everything it can to make sure it gets its loan.
Conclusion: Selling with Seller Financing
Navigating the complex world of seller financing and the documents that govern these transactions doesn’t have to be a stressful or daunting experience. Whether you’re are a buyer of real estate or a seller contemplating owner financing, understanding the intricacies of these agreements helps ensure a smooth transaction that is beneficial to both parties.
The documents discussed above represent the core components of a seller financing arrangement. However , it is important to remember that seller financing is highly flexible and can be tailored to fit the specific needs of each situation and the parties involved. Because of the versatility of seller financing documents, it is critical to engage in the process with the assistance of professionals who can provide valuable advice and guidance. Whether you’re a seller looking to provide owner financing or a buyer looking to purchase a property using seller financing, working with an attorney will ensure that your key business and legal goals are appropriately addressed in the deal.