In such times, seller financing can be used to obtain a premium purchase price. Not only are the underwriting process and financing fees and costs avoided, but the seller often will finance a much higher percentage of the purchase price than would a typical mortgage lender. If and when interest rates increase, sellers can benefit by providing seller financing at a lower rate.
Seller financing has become something of a lost art. Following is a brief review of major issues that should be resolved carefully and that typically require the assistance of a real estate attorney.
As published in The Daily Journal of Commerce
Real estate prices today are historically low because there are far fewer buyers than sellers. Foreclosures continue to flood the market with bargains. But people seeking to buy real estate during a severe recession often are unable to qualify for financing even though interest rates are enticingly low.
Before even offering seller financing, the first question is whether state and federal consumer-protection laws are applicable.
If in any one year a seller will engage in multiple sales of dwelling units to owner-occupants, then multiple consumer protection laws are likely to apply. The Truth in Lending Act, the Real Estate Settlement Procedures Act and the recently signed Consumer Protection Act are a few.
The CPA is much broader in its application and its restrictions as compared to older consumer-protection laws like TILA and RESPA. To be exempt from the CPA:
- Seller financing for owner-occupied dwellings cannot exceed three transactions in any 12-month period;
- The seller cannot have participated in the construction of the dwelling;
- The financing must be fixed rate for at least five years and be fully amortizing;
- The seller must determine in good faith that the buyer can repay the loan;
- The financing must be subject to reasonable annual and lifetime limitations on interest-rate increases; and
- The financing must meet any other criteria the new federal consumer-protection agency may prescribe.
These consumer-protection laws are complicated. The CPA in particular requires significant legal work to determine exemption. Accordingly, qualified legal counsel should be consulted by any seller interested in financing the purchase of a dwelling unit intended to be a buyer’s residence.
Seller financing is simpler for commercial real estate, but many issues exist nevertheless.
First, the seller must decide what percentage of the purchase price to finance. The higher the percentage financed, the higher the purchase price obtainable and the higher risk of buyer default. The seller must find a comfortable balance between these competing factors. Requiring the buyer to have enough skin in the game is an important consideration.
The type of seller financing instrument should depend on the percentage of financing. If little or no down payment is required, then an installment purchase contract probably will be most appropriate.
A lease-with-purchase option should be avoided because under Oregon law it will almost certainly be treated by the courts as a disguised mortgage far less favorable to the seller than virtually any other seller financing instrument.
A buyer who pays a large down payment should insist on a trust deed as the financing instrument. This provides better protection for the buyer in the event of a default. Mortgages are rarely used as a financing instrument in Oregon because they are so favorable to the buyer.
If most of the price is paid via third-party financing and the seller is being asked to carry a second trust deed, then the seller must consider the risks of junior financing. These risks may include violation of a prohibition on junior financing in the senior financing instrument that could trigger a foreclosure.
Ideally the seller would obtain not only written consent from the senior lender but also notice and cure rights. Otherwise the seller can protect only its junior interest by coming up with the money to fully pay the senior lender if the latter is foreclosing.
At a minimum, the seller needs evidence from the buyer of the monthly payments to the senior lender to minimize the risk of a senior loan foreclosure.
Seller financing often is very difficult if the seller has existing financing on the property. This is because the existing financing almost certainly will have a clause stating the financing is due and payable upon any sale of the property.
The lease-with-purchase option is often used as a means to avoid such a due-on-sale clause, but successfully doing so is tricky and should not be attempted without the assistance of qualified legal counsel.
When there is underlying financing, the buyer must be careful to assure application of buyer payments to the underlying seller loan, to avoid paying twice for the property. Sellers have been known to disappear with all of a buyer’s payments in such circumstances.
Even if there is no underlying financing, the buyer needs assurance that the documents will be available once the purchase price is paid to clear the title to the property. Sellers often can be difficult to find when the time comes to clear the title – particularly if an individual seller has died without a probate proceeding. The best protection is to place all title-clearing documents in escrow at the outset to be recorded automatically upon full payment.
Finally, the seller must consider the tax consequences of any seller financing. A qualified tax adviser should be consulted to determine and avoid any adverse consequences of seller financing.