WHY DO PEOPLE USE SELLER-FINANCING?
This section is an exerpt from input Cascade Funding, Inc. provided to The Washington State Department of Financial Institututions in August 2013 regarding regulations related to the Dodd-Frank Act.
(Important Note: In the aftermath of the the financial collapse of 2007 - 2009, Washington State actually made it illegal for most people to sell their own real estate using seller-financing and of course to then sell their note. Although few industry professionals knew about this, it was indeed the law. Recognizing that this may have gone too far, as part of new rule making the state of Washington requested input from the public. What follows was a portion of our input. Amazingly, we had to first make a strong argument to allow seller-financing to even be legal! We then had to explain clearly why investment companies such as ours were vital to the overall economy. We were very honored that rule makers in Washington State asked for our input and pleased that they listened and incorporated many of our suggestions into final law passed in 2014.)
Seller-financing (also called owner-financing, seller-carryback financing, or owner-contract financing) is a method of buying and selling property. The process is simple: a buyer offers to purchase a property by providing the property seller with a cash down payment along with a Promissory Note secured by a Deed of Trust for the balance. The Deed of Trust is secured by and recorded against the property. (These transactions are also accomplished via a Real Estate Contract instead of a Note & Trust Deed.) The amount of the down payment as well as all of the terms of the note are freely negotiated between buyer and seller.
Promissory notes are frequently sold to investors on the secondary market. These sales provide the note seller with a lump sum of immediate, risk free cash. Notes are sold at a discount, generally, and the price they command is commensurate with the risk. Notes are mostly purchased by individuals and small investment companies as passive investments. Often notes are purchased into retirement accounts.
Cascade Funding, Inc. is a Kirkland, WA based investment company that purchases seller-carryback real estate notes. We are note buyers. It is all we do, and we have been engaged in this activity in the same location since 1992. I am Thomas C. Brophy, its President, and I thank you very much for the opportunity to provide input into the rule making process dealing with seller-financing and the sale of seller-carryback real estate notes.
II. Seller-Financing Is Essential
Seller financing is essential to many people. The number and variety of situations where seller-financing is the only workable option makes it necessary for some individuals, companies, and trusts to utilize this technique several times per year. To make this clear, let’s look at the wide variety of situations where seller-financing is indispensable.
A. Property Not Bank Financeable (i.e., doesn’t qualify for a lender-loan).
With a third party loan, a property has to conform to lender criteria. If it doesn’t, no loan is made and no property sale takes place. If a buyer wishes to purchase a non-conforming property and the owner wishes to sell it, what are they to do? Unless the buyer has all of the purchase price in cash, the only option for the buyer is to make a down payment and pay the balance in installments to the seller.
a) Mobile Homes on land
These properties account for a very large amount of housing for lower and even middle income families. However, they are most likely not lender-financeable, especially if the mobile home is a single wide or if it is older than a certain age. These make very nice homes for many people, but almost none of them would be able to purchase the property for all cash. Not allowing a seller to carry the note for these buyers prevents them from owning their own home.
b) Unconventional Build
If a house has been built in some manner not allowed by lenders, seller-financing is the only way for a buyer to sell their property. Single bedroom houses often fall into this category.
c) Mixed Use Residential and Commercial
Many houses are used for both residential and commercial purposes and, therefore, are not lender-financeable. Also, quite often businesses are sold with a residence in one package. Seller-financing is usually the only way these deals can be completed
d) Large Amount of Land – Most Value in Land
Lender-financing is mostly available only on a house and some minimal amount of land. If a house is on 50 acres, for example, and most of the value is in the land, it is not lender-financeable.
a) Deferred Maintenance
A house is run down and needs a great deal of work to be livable. Lenders take one look at these properties and the loan is denied. An investor, or a person wishing to own their own home, may wish to make a small down payment and put their remaining cash into the house to make it livable again. Seller-financing is the only alternative for these people and everyone wins: The buyer gets their home, the seller sells their property, and the city and state have a vastly improved property which increases nearby property values and, therefore, tax revenues. It also decreases the likelihood of vandalism, squatters, crime, pest infestation, and condemnation of the property.
b) Construction Materials or Quality
Sometimes properties are built with less than acceptable materials. There may be nothing dangerous about the property, but lenders will not lend on them. The property sits unless the seller can carry a note for the buyer.
c) Add-ons and Modifications
Owners have been known to make additions to their homes that lenders don’t approve of. These can be outside decks, extra bedrooms, and so on. The add-ons and modifications may improve the value of the house both in market value and livability, but don’t try to convince a lender of that. Seller-financing once again is the difference between that property selling or not.
B. Buyer Does Not Qualify
A great deal of seller-financing occurs because buyers themselves do not qualify for a lender-loan. While we recognize that guidelines are in place to help people buy within their means, they do not allow flexibility when warranted. Here are a few examples:
Lenders rely on FICO credit scores to immediately disqualify buyers. Credit scores are useful, but it takes careful dissection of a person’s credit report to understand a person’s ability to repay an obligation. Lenders and mortgage brokers don’t have the time to do this. Moreover, lenders have rigid criteria and therefore don’t have the power to approve a loan if a borrower’s credit score is below some threshold. A person’s credit score reflects how they have paid their obligations in the past. The degree to which they have done so faithfully depends on three things: 1. how importantly they view the obligations (a character issue); 2. how well they manage debt (a competence issue); and, 3. factors outside their control. Credit scores do not distinguish between these three and neither do lenders. Sellers accepting a note from a person can. Here are some conditions outside of a person’s control that can lower their credit score thus preventing a lender from making them a loan:
Unless a person has significant financial means, divorce often prevents payments to creditors while the divorce drags on.
Medical bills can mount quickly often ruining a person’s credit. Bankruptcy is sometimes the only alternative. Try to get a loan from a lender with a recent bankruptcy. Does this really make someone a bad credit risk? Sellers understand this and will often carry a note for such people.
c) Crime Victim
Identity theft has ruined the credit and financial lives of thousands of people. Lenders make these people victims again by denying their loan. Seller-financing can be the only way these people can start rebuilding their lives.
d) Loss of job
People have lost their jobs in the middle of the loan process. They are obligated to report changes in their situations to the lender. Think the lender will complete a loan to such a person? A property seller can defer a portion of their sale price to such people.
Unforeseen accidents can result in terrible changes to peoples’ lives. Like medical, ID theft, and loss of job, these do not speak to a person’s character or ability to manage debt. Lenders cannot recognize these situations, but sellers allowing repayment of their sale price to such people can.
2. Doesn’t Fit Other Rigid Lender Guidelines
There are many other criteria lenders use to disqualify potential borrowers. There may be good reasons for considering them; however, they often cause a loan to be denied based on just one of them. This can shut out otherwise very good risk payers. Seller-financing can allow these good people to purchase and therefore fills the gap created by inflexible loan approval criteria.
a) Self Employed
b) New On The Job
c) Debt To Income Ratios Don’t Fit
C. Facilitates Estate Closures
Some families inherit a number of properties. Sometimes these are non-conforming or difficult to sell properties. Selling on contract may be the only way to get these properties sold and close these estates.
D. People More Comfortable With Seller-Financing
There are a number of people who are not comfortable with third party lenders. This is understandable. Many of them have tried in the past to get a loan only to be informed that the property they wish to purchase “does not qualify,” which they take to mean, “is not good enough.” Then they are told that they themselves are not good enough because their credit or job or something else “does not qualify.” The friends and family members of these individuals usually have had the same experience. After a while, they don’t even try to get a loan. They conclude that the process is not for them – it’s for other people. Their only option is to purchase on contract. They aren’t demeaned or demoralized using seller-financing, they feel in control with it, and they understand it. These people buy and sell on contract their entire lives and never think twice about it.
Clearly, seller-financing is a unique and vital method for people to buy and sell real estate. It is the only alternative available to people when a property buyer does not have the full purchase price in cash and when a lender-loan is not an option. It is also the only method that allows a buyer and seller to craft terms that address their specific needs and desires. This is an important part of the beauty and power of seller-financing. No other type of property sale possesses this flexibility and freedom.