RELE 1319 Chapter 13


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Chapter 13 PowerPoint presentation for Spring 2014 RELE class.

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RELE 1319 Chapter 13

  1. 1. Financing Residential Real Estate Lesson 13: Seller Financing
  2. 2. Introduction This lesson will cover:  how seller financing works  why seller financing is used  forms of seller financing  alternatives to seller financing  agent’s responsibilities in seller-financed transactions
  3. 3. How Seller Financing Works Two ways for seller to finance buyer’s purchase:  purchase money loan  land contract
  4. 4. How Seller Financing Works Mortgage or deed of trust  Seller is extending credit to buyer, not providing loan funds.  Buyer makes installment payments to seller.  Seller is mortgagee or beneficiary, with right to foreclose in case of default.
  5. 5. How Seller Financing Works Contract for Deed Buyer (vendee) takes possession of property, but seller (vendor) retains title until contract price paid in full.  Alternative to a lien.  Seller extends credit to buyer.
  6. 6. How Seller Financing Works Seller financing may be:  primary financing  seller is buyer’s main or only source of financing for purchase  secondary financing (seller second)  supplements primary loan from institutional lender  covers part of downpayment or closing costs required for primary loan
  7. 7. How Seller Financing Works Choosing finance instrument Seller generally decides which type of finance instrument  Real estate lawyer should prepare/review.  Deed of trust: trustee must be appointed.
  8. 8. Why Seller Financing is Used Seller financing can:  attract buyers when interest rates are high  help buyer qualify for institutional loan  enable seller to charge higher price  provide tax benefits to seller
  9. 9. Why Seller Financing is Used Seller financing:  seller isn’t bound by institutional policies regarding yields, loan-to-value ratios, or qualifying standards  not an option for seller who needs to be cashed out quickly
  10. 10. Seller Seconds Seller second:  buyer paying most of purchase price with institutional loan  seller accepts second mortgage for remainder
  11. 11. Seller Seconds Supplementing a new loan Seller second supplementing new institutional loan must meet institutional lender’s standards. Combined loan to value (CLTV) Credit Income and debt ratios Assets (including reserves) Terms
  12. 12. Supplementing New Loan Buyer’s situation Factors in buyer’s financial situation may shape design of seller second:  funds available for down payment  buyer’s qualifying for total monthly payment  interest rate  balloon payment
  13. 13. Supplementing New Loan Buyer’s situation May be easy to refinance seller second with balloon payment if:  property has appreciated substantially  interest rates are low But if interest rates are high or property has lost value, refinancing could be difficult.
  14. 14. Supplementing New Loan Seller’s situation Seller’s evaluation of second:  cash at closing  monthly income  timing of payoff (balloon payment)  yield on investment  tax consequences  lien priority
  15. 15. Seller Seconds Supplementing an assumption Seller second can supplement buyer’s assumption of seller’s existing mortgage.  Buyer makes payments on seller second to seller.  Buyer takes over monthly payments on seller’s existing mortgage.
  16. 16. Seller Seconds Supplementing an assumption Assumption only possible if:  existing mortgage doesn’t have due-onsale clause, or  lender agrees to assumption.  Needed to release seller from liability.  Usual underwriting standards to evaluate buyer assuming loan.
  17. 17. Seller Financing as Primary Loan Unencumbered property Seller financing is most flexible when seller has clear title to property.  Buyer and seller negotiate price and terms  Buyer may need less cash  May not have discount points or origination fees  Lower closing costs
  18. 18. Unencumbered Property Protecting seller’s security First lien position if finance instruments are recorded. Seller should still be concerned with:  property taxes  special assessment liens  hazard insurance
  19. 19. Unencumbered Property Protecting seller’s security Failure to pay taxes or insure property should be grounds for default under the finance instrument.  Seller can require impound account.  If not, seller should require proof be sent to him.
  20. 20. Unencumbered Property Institutional second Buyer might want to supplement seller financing with secondary financing from lender.  Seller should investigate terms of proposed second loan before agreeing to transaction.  Can buyer afford monthly payments on both loans?  Does second have provisions that make default likely?
  21. 21. Unencumbered Property Contract for deed Seller may choose to use a contract for deed instead of mortgage or deed of trust. Also known as:  land contract  bond for deed  conditional sales contract  installment sales contract  installment land contract  real estate contract
  22. 22. Contract for deed How contract for deed works Seller (vendor) keeps title to property until buyer (vendee) pays off entire purchase price in installments.  Legal title: vendor’s title during contract term.  Equitable title: right of vendee to possess and enjoy property.
  23. 23. Contract for deed How contract for deed works Contract:  not accompanied by promissory note  states all terms of sale and financing arrangement between vendor and vendee  should always be recorded
  24. 24. Contract for deed Remedies for breach of contract Forfeiture: penalty if vendee breaches contract.  Vendee’s rights in property are terminated.  Payments may be kept by vendor as liquidated damages.  Vendor may retake possession of property immediately.
  25. 25. Contract for deed Remedies for breach of contract In Texas, repossession not allowed 40% of the amount owed OR has made 48 monthly payments Trustee must be used to sell property instead
  26. 26. Contract for deed Remedies for breach of contract Vendee refusing to leave means legal action to clear title and remove vendee from property.  Drawback for vendor: may take months.
  27. 27. Contract for deed Remedies for breach of contract Judge may:  enforce contract as written  give vendee time to pay off contract balance  allow vendee to reinstate contract by paying delinquent payments plus interest  order sheriff’s sale of property
  28. 28. Contract for deed Advantages and disadvantages Advantages for vendor:  legal owner until contract paid in full  may reacquire property in event of default
  29. 29. Contract for deed Advantages and disadvantages Disadvantages for vendor:  delay and expense of court proceedings  uncertainty of trial results
  30. 30. Contract for deed Advantages and disadvantages Advantages for vendee:  slow court proceedings
  31. 31. Contract for deed Advantages and disadvantages Disadvantages for vendee:  vendor remains legal owner  judgments against vendor might cloud interest  uncertainty of court decision
  32. 32. Contract for deed Using a contract for deed Lenders generally don’t permit financing to vendees due to the nature of the ownership Two possible solutions:  Vendor agrees to have property stand as security for institutional loan.  Vendee could mortgage his equitable interest in property.
  33. 33. Contract for deed Using a contract for deed Vendor agrees to have property stand as security for institutional loan.  Vendor doesn’t assume personal responsibility for repayment.  Lender can foreclose on property but can’t sue vendor for deficiency.
  34. 34. Seller Financing as Primary Loan Encumbered property Seller of encumbered property can’t afford to pay off existing mortgage at closing.  Seller second was one alternative.  Wraparound financing is another alternative.
  35. 35. Encumbered Property Wraparound financing Wraparound financing:  property remains subject to underlying loan  buyer does not assume underlying loan  seller remains responsible for payments  buyer makes monthly payments to seller  seller uses part of buyer’s payment to make payment on underlying loan
  36. 36. Wraparound Financing Choice of finance instrument For wraparound, seller can use:  mortgage  deed of trust  contract for deed Deed of trust used for wrap: all-inclusive trust deed.
  37. 37. Wraparound Financing Underlying loan: no due-on-sale clause Wraparound financing is only proper if underlying loan doesn’t have due-on-sale clause and lender approves of it.  Silent wrap: without lender’s consent.
  38. 38. Wraparound Financing Compared with assumption + second If seller’s existing loan has no due-on-sale clause, parties can choose between:  assumption plus seller second  buyer gets benefit of existing loan with below-market interest rate  wraparound  may give buyer below-market rate and seller above-market yield
  39. 39. Wraparound Financing Seller’s yield Seller’s yield depends on:  amount of credit extended to buyer, and  difference between interest rate on wrap and rate on underlying loan. Credit extended is:  difference between wrap amount and balance on underlying loan  not full amount of wrap
  40. 40. Wraparound Financing Seller’s yield Example: Sales price: $200,000 Downpayment: $20,000 Underlying loan: $150,000, balance at 6% interest Wraparound: $180,000 at 7.5% interest $180,000 Wrap financing for buyer – 150,000 Seller’s underlying loan balance $30,000 Credit extended to buyer
  41. 41. Wraparound Financing Seller’s yield Example, cont. In first year:  Seller collects $13,500 in interest from buyer.  Seller pays $9,000 in interest on underlying loan.  Net interest to seller: $4,500. Net Interest ÷ Credit Extended = Seller’s Yield $4,500 ÷ $30,000 = 15%
  42. 42. Wraparound Financing Protecting wraparound buyer To ensure seller makes payments on underlying loan:  provision in finance instrument requiring seller to make timely payments, and allowing buyer to pay lender directly if seller defaults  “Request for Notice of Delinquency”  escrow account managed by third party
  43. 43. Alternatives to Seller Financing Seller can help with:  buydown  contribution to closing costs  equity exchange  lease/option  lease/purchase
  44. 44. Alternatives to Seller Financing Buydowns Buydown: seller pays to reduce buyer’s interest rate on loan.  Seller proceeds are reduced by amount of buydown.  Buyer more easily affords lower payment and/or qualifies easier with lower DTI
  45. 45. Alternatives to Seller Financing Contributions to closing costs Seller sometimes willing to make up shortfall when buyer doesn’t have enough money for closing costs.  Lenders impose limits on amounts.
  46. 46. Alternatives to Seller Financing Equity exchanges Seller may be willing to accept other assets from buyer and reduce cash sales price.  Equity in vacant land or personal property.
  47. 47. Alternatives to Seller Financing Lease arrangements Sometimes buyer wants to lease home before actually buying it.  Time to get cash for closing or downpayment.  Cannot currently qualify for loan.
  48. 48. Alternatives to Seller Financing Lease arrangements Seller can lease property to prospective buyer in one of two ways:  lease/option arrangement  lease/purchase arrangement
  49. 49. Lease Arrangements Lease/options Lease/Option: lease agreement includes option to purchase.  Seller leases property to buyer for term.  Buyer granted option to purchase property at certain price during lease term.  Seller = Landlord/Optionor  Buyer = Tenant/Optionee
  50. 50. Lease Arrangements Lease/options Lease/option:  buyer has no obligation to buy  seller can’t sell property during option period  can be used even if seller’s loan has due-on-sale clause
  51. 51. Lease/Options How lease/option works Lease/option:  buyer pays seller option money to make option binding on seller  option money not refundable  option money may be applied to purchase price if buyer exercises option  rental payments may be applied to purchase (rent credit)
  52. 52. Lease/Options Rental payments Rent charged on lease/option is often higher than rent under ordinary lease.  Gives optionee incentive to exercise option quickly.  Provides compensation to optionor for uncertainty of outcome.  Permits a lender at the exercise of the option to credit excess toward down payment.
  53. 53. Lease/Options Rent credit Three ways rent credit can be applied to purchase:  applied to down payment  deducted from sales price  applied toward closing costs/prepaids
  54. 54. Lease/Options Provisions of lease/option agreement Lease/option should:  include all terms of lease  include all terms of potential purchase contract  state that option money is not security deposit  state that option rights are forfeited if tenant defaults on lease  state that option money is forfeited if purchase is not consummated by buyer
  55. 55. Lease Arrangements Lease/purchase Lease/Purchase: purchase contract allows buyer to lease property for extended period before closing.  Parties sign purchase agreement (not option) along with lease.  Tenant/buyer provides good faith deposit instead of option money.  Closing date set quite far off; buyer rents property in meantime.
  56. 56. Lease Arrangements Lease/purchase If tenant/buyer decides not to buy property, good faith deposit is forfeited.  Tenant/buyer probably more committed with lease/purchase contract than with lease/option.  Eventual sale more likely.
  57. 57. Agent Responsibilities Real estate agent should:  make sure both parties understand seller financing arrangement  encourage both to consult lawyers or CPAs  never prepare seller financing documents
  58. 58. Agent Responsibilities Disclosures Seller financing disclosure:  required in some states when agent helps arrange seller financing  discloses all financing terms  informs seller of buyer’s financial situation
  59. 59. Agent Responsibilities Disclosures Good idea to use disclosure statement even if not required by state law.  Provides information to parties.  Protects agent by documenting that certain information was provided.
  60. 60. Agent Responsibilities Liability Disclosure statement does not completely shield agent from liability.  Breach of fiduciary duties.  Inadvertent dual agency.