Variously known as "taking back a mortgage" or "holding the paper," private financing is often heralded as the easiest and fastest way to sell a house, especially in a slow market.
Sellers who really need to cash-in their houses should consider lining up an investor to buy the note the instant it is created. Some note purchasers are willing to do simultaneous closings, in which your buyer signs the mortgage and you immediately sign it over to the investor.
One of the benefits of lining up an investor in advance is that you can structure the note exactly the way the investor wants it. That way, the note will have maximum value.
-- Lew Sichelman
If you need the proceeds from the sale of one house to purchase another, assisting with financing may not be the way to go. But even in that scenario, it may be worth considering, especially if you can line up an investor to take the note off your hands.
Private financing also could merit some consideration if, say, you're near retirement and looking for a steady cash flow at a higher rate than you can earn elsewhere. And if you already have another place but are having trouble unloading this one, becoming a lender may prove to be your ticket.
Actually, seller financing is often treated as a last resort, and for good reason. It is, at best, an adventurous tactic that could backfire if your buyer decides not to pay. And almost by definition, buyers who need the seller to carry the first mortgage are not as good a risk as those who can obtain whatever financing they need through normal means.
"That doesn't mean they're all deadbeats," says William Mencarow, who buys and sells seller-held mortgages and publishes "The Paper Source," a monthly newsletter that services professionals who buy notes from seller-lenders.
"Many are worthy borrowers who just don't fall into the net of conventional lenders," says Mencarow. "Some are new to their jobs, others are self-employed and still others are retired or semi-retired with lots of savings, but little in the way of monthly income."
Another factor coming into play is the implosion in the subprime mortgage market, which is causing lenders to tighten their standards up and down the line. Consequently, a buyer who might have qualified for funding earlier this year may not make it now.
Still, if a conventional lender takes a pass on your would-be buyer and you decide to assume that role, it is incumbent upon you to structure the deal properly -- not just as a protection against default, but also in case you decide to sell the note to an investor at a later date.
You may even be able to borrow against the note if the need arises, but only if it is considered sound collateral.
For starters, insist on a substantial down payment -- the bigger, the better. Mencarow says a substantial number of notes that people try to sell to him and other investors are "worthless" because they have little or no down payment.
Remember, loans with less than 20 percent down are far more risky, which is why conventional lenders require those borrowing more than 80 percent of the purchase price to pay for insurance that protects the lender from the greater possibility of default.
You probably won't be able to get this kind of mortgage insurance, so demand the next best thing -- a large chunk of change up front. Ten percent is minimum, 20 percent is safer, but if you can get it, more than 20 percent is better.
And we're talking cash here, not a promissory note, car or jewelry. If you always wanted a cabin cruiser and your buyer offers his 40-footer as a down payment, fine. But remember, it's tough to convert these things into cash, especially at full value.
At the same time, though, if your buyer has more equity in more valuable real estate, such as an expensive condo at the beach, he should used that property, rather than yours, as collateral, says Bill Broadbent, co-author of the self-published book "Owner
Will Carry: How to Take Back a Note or Mortgage Without Being Taken." .
Before putting your money on the line, however, you should obtain your buyer's written permission to check his credit, employment, personal references and previous landlords or lenders.
You can obtain a credit report from any local credit bureau. The real trick is deciphering it. Fortunately, your real estate agent or note broker should be more than willing to help you with that.
Obviously, the higher the interest rate, the better. And you should be able to charge above the going rate, not just because you are the buyer's only source of funding, but also because he won't be paying the application or origination fees that traditional lenders charge.
Not as obvious, but equally as important, is the length of the loan: the shorter, the better. But beware of small monthly or interest-only payments with a large balloon payment at the end. A balloon puts the buyer right back in the same situation he was in the first place -- trying to find financing.
In other words, try to structure the deal so the monthly payments are enough to pay off the entire loan in the shortest amount of time. Why? Because the market value of a seller-financed mortgage for 30 years with no balloon is roughly 50 cents on the dollar, Mencarow says. But at 20 years, a note buyer might be willing to pay 75 cents for every dollar of outstanding principal. And a 15-year note could be worth as much as 80 cents per dollar.
Another key is the loan's position compared with other liens on the property. A first mortgage takes precedence over all others and is, therefore, more valuable than a second mortgage. And a second "is much more valuable than a third, which I'd stay away from completely," says Mencarow. "A second is about as far as you want to go."
The amount of the second mortgage vis-a-vis the primary loan is also important. Unless the buyer makes a big down payment, and thus has significant equity at risk, a small second behind a large first is not a terribly safe investment and not very valuable if you want to sell your note to an investor.
That's because if the buyer defaults on the first lien, you would be responsible for making up all back payments on both mortgages, plus all future payments until the holder of the primary mortgage forecloses. Otherwise, your investment would be worthless. The other option would be to take over the first position by paying off the first lien.
Consequently, your note should contain a clause requiring your buyer to keep up the payments on all mortgages. Otherwise, you can foreclose. Similarly, there should be another clause requiring him to pay the property taxes and fire insurance on time.
You should call the holder of other loans on the property periodically to be certain the payments on those notes are being made. If not, your borrower could get so far behind that he'll never dig his way out, and neither will you.
The best way to be sure your buyer is paying the taxes and insurance is to make him pay you a portion every month so that when the bills are due, the money will be on hand to pay them. Alternatively, you can hire a note-servicing company to administer the loan on your behalf.
Another important protection is a clause allowing you to sell the loan -- without recourse. That means the new owner of the note can't hold you responsible if the borrower doesn't pay him.
You also want a "due on sale" clause so that the loan is not assumable. That way, when your buyer sells the place, he has to pay off the mortgage with you. He can't pass it along to a new buyer.
Finally, the mortgage should provide for a late fee. Exactly how much and when the charge kicks in is usually determined by local or state law. But whether you can charge 5 percent after five days or 10 percent after 10 days, you should always collect. Always.