Can Ike Buy Now With No Credit?

Yesterday, I saw an interesting question.  A seller, who we will call Sally, was talking to an investor, who we will call Ike, about selling her house.  Sally is very motivated to sell now, but she has no equity.  The house is in good shape and was built a couple of years ago.

Although Ike would like to buy it, his financial picture makes it difficult to borrow from the bank (there could be lots of reasons!).  Ike contends that he will be able to borrow the funds needed within 2 years.  He wants to buy the property, but is not sure how he can.

There are a couple of solutions that Ike can try.

Subject-To

Ike can purchase the property now, subject to the underlying mortgage.  This means that the ownership passes to Ike now, but Sally’s mortgage stays on the property in a superior position.  If that mortgage defaults, then its foreclosure can take the property away from Ike.  This is often described as ‘taking over Sally’s payments’. 

The advantage for Ike is that he does not have to qualify for a loan – he just starts making the payments.  Additionally, this mortgage will not show up on Ike’s credit report (it is Sally’s mortgage and stays on her credit report).  The advantage for Sally is that she can move on with her life – her house is sold now.

The disadvantages are some risk for each party.  They should both be concerned with insurance and with default.  Let’s talk about default first.

Sally’s mortgage is likely to have a ‘due on sale’ clause.  This means that the lender has the right to ask for a payoff of the balance when the property changes ownership.  Lenders started adding this clause back in the 1970’s when interest rates went sky high – the banks wanted to force the new buyer to originate a new loan at the higher rates.  However, in the current market, interest rates have been fairly stable and the banks have more foreclosed properties than they should.  As long as payments are being made, and there are no other issues that draw too much of the bank’s attention, most banks are not exercising their right to a payoff.  Sally and Ike both need to recognize this risk, even if small, since it will destroy this transaction.

The mortgage is likely to have an insurance requirement to protect against the loss of the collateral (the house).  Prior to the sale, the insurance shows Sally and the lender as payees in the event of a loss.  Changing the insurance to show Ike as a payee will alert the bank of a change of ownership.  However, if a loss occurs, then Ike will not get any money if he is not on the insurance.  A possible solution is for Sally’s insurance to stay in place and Ike buy additional insurance for his investment.

Wrap-Around Mortgage

This is a type of subject-to transaction.  In this case, Sally takes back a mortgage from Ike for the purchase of the house.  This new mortgage wraps around Sally’s existing mortgage.  In general, the new mortgage balance, interest rate and term are set to be at least equal to the existing mortgage – this way the payment of the new mortgage covers the payment on the existing mortgage.  Ike pays his mortgage payment to Sally and she makes her own payment to the existing lender(s).  Or Ike sends a check to Sally and to Sally’s lender.  Or they may decide to use an escrow service – this gives Ike assurance that the underlying mortgage is being paid.

Insurance is usually kept separate – Sally keeps hers and Ike buys insurance for his part of the investment as it grows.

This method has an extra advantage to Sally – if she tries to borrow money for another house, the new mortgage shows as an asset that balances out the mortgage that continues to show on her credit report.  The lender may discount Ike’s payment some, but the bank will still consider that it is reducing the outgoing drain on her finances.

Lease Option

Ike can rent the property with an option to purchase it at a later date.  In this case, the deed stays in Sally’s name until the option is exercised.  Ike and Sally can set the rent at the market value or any value they choose.  Some of the rent can be counted towards the purchase price (usually as part of the down payment). 

In the previous methods, if a default happens, Sally would need to foreclose to get back the deed to the property.  In this method, she can just evict Ike.  Evictions are often quicker and cheaper than foreclosures.  If the option is recorded, then some additional action will be required to clear the cloud from the title.

In all three methods, Ike benefits from any appreciation of the property.  However, in this method, some of that appreciation can be shifted to Sally by setting a higher purchase price on the option.  Basically, let’s say that the current purchase price is $200K, and the option price is set at $220K in 2 years.  Now, Sally will get the first 20K of appreciation in those 2 years and Ike will receive the rest of the appreciation as equity.

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