Rising Rates? Try Seller Financing!

The Federal Reserve has been raising interest rates to combat high inflation. As a result, mortgage rates are about to exceed 7%. This has dampened activity in both residential and commercial real estate. Homebuyers and investors need a way to move forward with their purchases, and “seller financing” is a good choice. To maintain business production, agents and brokers need to consider it also.

What Is Seller Financing?

In a real estate transaction, seller financing is when the seller and the buyer agree that the seller will lend some of the purchase price to the buyer to facilitate the sale. This is also labeled “owner will carry” (OWC); it is a well-trodden path in residential, commercial, and land transactions.

How It Works

As in any real estate transaction, the buyer and the seller negotiate the terms of the loan, including the principal amount, due date, interest rate, and payments. Other terms could include a late charge, “due on sale” clause, etc.

The documents consist of a promissory note and a deed-of-trust or mortgage, depending on the laws of the state for securing loans on real property. Depending on the state, an attorney, escrow company, or title company will prepare the documents for the parties, making the process straightforward, though not necessarily simple.

Negotiating the Terms

Down payments are usually between 10% and 30%, depending upon the buyer’s financial position, the buyer’s creditworthiness, and the seller’s need for cash. Pulling a credit report on the buyer is essential.

It is possible to have a loan where the payments are interest-only, but some amount of amortization is preferable so the buyer is building up equity and can refinance more readily in the future. The interest rate should be a “market rate” or less if the buyer is a friend or family member. Excessive interest rates do nobody any good, just making it harder for the buyer to succeed with the property.

The length, or term of the loan is negotiable, based on the needs of the parties. The note may be written with one or more “options to extend,” in case conditions for refinancing are not favorable when the loan matures. The idea is avoid creating a condition in which the buyer cannot pay off the loan.

Dodd-Frank Wall Street Reform and Consumer Protection Act

This 2010 act applies to any seller-carryback transaction in which the purchaser will occupy one unit as their principal residence. Additionally, sellers can do only three such transactions per year; otherwise, they will be considered a mortgage broker and subject to related requirements.

The law specifies certain loan terms that are to be included and excluded. A prudent investor who uses seller financing should become familiar with the law or hire a licensed loan broker to complete the financing aspect of the transaction. (Note: Loan brokers should be paid an hourly consulting fee since they are not providing brokered funds.)

Collecting Payments and Property Taxes

Sometimes with seller financing, the buyer will neglect to pay the property taxes or keep the premises insured. The best way to prevent this is to hire a loan servicing company to handle these items. They will even foreclose if the need arises. The cost is reasonable, and the peace of mind is priceless.

If the Buyer Defaults

There are three alternatives. The obvious one is to hire an attorney or foreclosure company to legally recover the property. Then it will be necessary to make repairs and resell the property or rent it. Consider this option if the buyer’s default appears to be permanent and cannot be remedied.

If the buyer’s default appears to be temporary (e.g., the result of a job loss), then it is best to reduce or suspend payments. Once the situation is resolved, modify the note to include the missed payments and proceed as before.

The third alternative is to sell the note at a discount and let someone else deal with the default. You can do this via the internet. Discounts on defaulted notes are heavy, typically 40%-80%. Frankly, it is a terrible option, so try to avoid doing it.

If the Seller Needs Money Later

There are several alternatives available if you need money later. The first is to sell the entire note at a discount. Because the note will be performing (i.e., not in default), the discount could be in the 20%-30% range, which isn’t so bad if you need the cash.

But maybe you don’t need to sell the entire note. You can sell just part of the note, or just a certain number of the payments. There are markets across the country and via the internet. Notes can be very “liquid” nowadays.

Finally, you could borrow against the note. The legal term for this is “hypothecation.” Private parties, local banks, credit unions, and “factoring companies” all do note hypothecations. Check the internet first.

Benefits to the Buyer

Seller financing offers the buyer two primary benefits. The first is the buyer can negotiate a “customized” loan with the seller to accommodate the buyer’s needs and circumstances. Banks and mortgage brokers usually sell their loans on Wall Street, so the loans are standardized and don’t necessarily fit everyone.

In addition, commercial lenders charge “loan origination fees,” also known as “points.” Most sellers do not charge fees for lending, and in some states they cannot (e.g., California). The absence of this fee saves the buyer quite a bit of money.

Benefits to the Seller

The seller can benefit from seller financing in three ways. The first is that carrying some financing facilitates the sale.

Second, seller financing can defer federal capital gains taxes by employing an “installment sale.” Consult a tax professional or search the internet to learn more.

Third, the note that is carried back has a regular (usually monthly) income stream for the seller. This is secured by the property with which they are familiar, making it a very good long-term investment.

Between 1980 and 2021, mortgage interest rates declined from 18% to 3%-4%. This long-term trend is now reversing. Seller financing, which allows the buyer to negotiate a “customized” loan with the seller is a powerful way to continue making advantageous purchases.

Bruce Kellogg has been a real estate agent and investor in California for 44 years. He purchased about 350 investment properties for himself, mostly with high leverage and tax-deferred exchanges. In the process, he made three fortunes and experienced three real estate downturns since 1980. He has transacted approximately 550 properties for clients, creating fortunes for several. His book “Real Estate Investing Wisdom” is in publication. Kellogg can be reached at Brucekellogg10@gmail.com or (408) 489-0131.