The real answer is ‘it depends’. It depends on the situation and the parties involved in the transaction. Let’s talk about it from the Seller’s perspective and the Buyer’s perspective. We’ll also talk about the investor’s perspective in each of these roles. Remember, I am an investor, not an accountant – please check with your own accountant to confirm how this would apply to your own situation!
For the purposes of our discussion, suppose that a house sells for $150K and the seller takes back $100K as a mortgage as part of the sale (the buyer pays the other $50K as cash to keep this simple). The Seller owned this property free and clear – or owed less than the net cash received. Say the note has an interest rate of 6%, interest only payments (or more), with a balloon payment of the outstanding balance in 15 years. This makes the payments equal $500 per month – assuming only the interest is paid.
Seller – The Good:
The Seller can reduce the amount of tax they pay on the sale. When the Seller ‘takes back paper’ at the sale, that part of the equity of the house is not counted towards their capital gain. As payments come in over time, the principal received in each tax period is considered a capital gain for that tax period. Since our note is interest only payments, the $100K capital gain will be deferred for 15 years. This means that a seller can lower the tax they would need to pay for the house sale – both immediately and possibly as a total over time.
The seller gains an income stream from the note. For the next 15 years, the Seller will have $500 each month to spend – minus ordinary income tax (which will depend on the Sellers financial situation). The Seller actually makes more money for the sale of the house. The total amount this Seller earns is $150K + 15 years * $6000/yr = $240K.
As an investor Seller, this kind of financing can help you stabilize your income stream and result in better returns on your initial investment. Also, by offering seller financing, you may be able to demand a higher sales price at the time of the sale.
Seller – The Bad:
The Seller is still ‘attached’ to the house for the length of time that the note is collateralized by the house. This can be bad if the quality of the house is suspect, or the neighborhood value is declining – as the house decays or the defects are discovered, the security for the note (the house) looses value. This can be countered by requiring a larger down payment, charging a higher interest rate or doing more qualifying of the Buyer. For example, a Buyer who lives in the property is generally more likely to maintain or improve the property while a non-occupying Buyer may not have the same incentive to maintain the property (and the renter likely has no incentive at all).
The Seller may not receive payments on time. Ultimately, the Seller can solve this by foreclosing – which is a process defined by the area where the house is located. For example, in Washington the foreclosure process takes about 4 months while in Oklahoma it averages about 7 months. During this time, the Seller will not receive payments and the house may be vacant or damaged. Again, the Seller can mitigate some of these risks by requiring larger down payments or charging higher interest rates. In our example, the $50K downpayment can mitigate some losses. For instance, if the payments stop and it takes a year to foreclose, the Seller will have lost out on $6K worth of payments. Since the foreclosure process is not free, let’s assume $10K cost (remember that the cost will depend on the location of the property). This means that the Seller still has $34K in cash and now can resell the property. If the Seller can sell the house for more than $116K, then the Seller is still ahead (remember to also add the amount of payments that were received prior to the foreclosure).
As a rehabber, I feel that investor sellers can also mitigate the quality / damage issues more easily than a homeowner. Part of a rehabber’s job is to manage the quality and costs of repairs and to focus our buying in areas of town that are more likely to appreciate.
Buyer – The Good:
It can be easier for a Buyer to qualify for the loan. Mostly because the lender has already qualified the property – the lender/seller agrees on the current value of the property and they have some history with the property’s quality. Additionally, many Sellers do not require as much documentation as an institutional lender would require to qualify the Buyer. Institutional lenders have a process that they use to qualify Buyers – this process is supposed to reduce the risk to the lender (the current economic situation was caused by a loosening of this process). Most sellers who do Seller Financing don’t have a process but instead do just enough to feel comfortable with the Buyer’s promise to pay.
Seller Financing can reduce the amount of money needed to buy a property. Some financing situations can result in zero down payment. For example, in a ‘subject to’ purchase, the seller may loan you all of their equity. For example, the seller may owe $100K on a house that is in disrepair. This house may require $20K of repairs and when fixed up may be worth $200K. A deal could be crafted for a total of $120K where the Buyer takes over payments on the $100K and owes the Seller $20K (to be paid when the Buyer completes repairs and refinances or sells the house).
Seller Financing allows an investor to buy a wider range of properties. An instituitonal lender may not qualify a property if it is in need of some serious rehab work. As an investor Buyer, this means that I may not be able to get a bank to lend me the money needed to buy the property (they may be more accomodating for construction loans, but there are limitations there as well).
Seller Financing allows an investor to hold more properties. Currently, institutional lenders limit the number of loans that a Buyer may have in their name. As an investor Buyer, this limits the number of properties you can own at any one time. The current limit is actually 10, but the qualifying process for more than 4 loans is very difficult – making a practical limit of 4 loans. Most Sellers don’t have similar limitations and Seller financing often does not show on a credit report, so this can be a nice way to avoid this limitation.
Buyer – The Bad:
It can be difficult to find a Seller that is willing to accept Seller Financing. The most common objection I hear is that they just want to cash out. When I dig deeper, often the resistance comes from not really understanding the good and bad aspects (Why did I write this article?!).
I hope this article helped you understand more about Seller Financing. Please share your comments or experiences!
good luck 2 all.so far, i have been able 2 hang on 2 my house.lately,drawn by the falling housing market,i’ve been tempted 2 get in2 real estate investing.if any of u can share any info,pleeez do.thanks,God Bless.
Good basic article
I am now starting to invest again. I have found is rare to find property with owner financing, as a buyer. As a buyer it is often ideal though it can take more down up front.
I would like to add a couple of caveats and a great advantage to being the one to owner finance which comes from my experience when I owned several rental properties in the early 70′s.
you get interest payments over time for long term cash flow. Caveat 1: make sure your interest on the loan you pay is less than the one you recieve. Cavaet 2: make sure the term on their loan is longer than yours; you do not want to make payments on a loan after you have given over the title,or to have your seller payoff be larger than buyers if they resell in a short time. Cavaet 3: If you want long term income with large payments in the future, have some kind of prepayment clause with a significant fee.
Caveat 4, have some kind of escrow company recieve payments so that amoritization is calculated correctly and missed payments are fully noted.
Here is my story, and this is why it is good for the seller if you are in the right position. My hubby and I bought several multi-unit builtings from a tired landlord. We bought each building at different times over several months from the same person with less and less down. We had land contracts with her. She owed little or nothing on the properties.
Over 4 to 5 years we managed and improved the property and the quality of renters with increasing rents. Then began to sell them as we were now tired landlords and stressed out. ON the buyers side this is cavaet 1: Be sure to keep cash in a set aside account to pay for large items like taxes and major repairs like roofs and furnaces. Buyers Caveat 2;
Some states use different contracts for this type of financinf. So be sure you check this and probably use a lawyer. Do not rely on just the title company. States vary widely.
Timing in 1973 was bad for selling, there was a major banking crisis and interest rates went over 15%. We sold for about 12% interest to attract buyers and wrote the contracts to cover our payments as above. Trouble was, the smaller buidings were remortgaged by the new buyers before the year was over. We did not even have time to sell the paper and had to cash out our contract with our seller.
We also did not get large enough down to cover any problems with buyers who got in trouble making payments. Those who got into trouble were Real estate agents and bankers who were looking to invest…but their business was going in the tank…not a good risk. The underlying contract owner foreclosed on our buyers, because we did not have the where-with-all to do it ourselves.
She was a great winner…She had us manage and improve her properties and pay her while doing so. Then she got them back and resold them for the same or better prices than what she sold to us for. And since now they were free and clear, she retired happy; I got divorced, and now years later I want to own rentals in my retirement. So, I would love to find someone who will sell with owners terms.