As discussed in earlier Blogs, two of the most important techniques in the Five Pillars of Creative Financing are Assumptions and Seller Financing. And when used together they can provide some great results!
First, Let’s Dispel the Myths: Too many folks are allowing transactions to DFT when the Buyer doesn’t qualify for a loan, rather than using these time proven techniques, because they accept several myths as truths. So let’s look at two common myths on these topics:
Myth #1—Seller Financing can only work when the property is owned free & clear: Our firm has purchased 100’s of Seller Financed Notes when there was an existing loan on the property. Below, I will discuss the two ways of handling such transactions.
Myth #2—Assumption of loans with “Due on Sale” clauses is illegal: When something is illegal, it means that there is a law against it and upon breaking the law you can be fined or imprisoned. There is no law against Assumptions and no one will be fined or go to jail for participating in an Assumption! The sole remedy for assuming a loan without the Lender’s consent is that the Lender may call the loan due and payable in full! I will address this issue in greater detail below.
Using Seller Financing to sell a property with an existing loan: The three ways to do this are:
1. Use CA$H NOW SELLER FINANCING to pay off the existing loan: I include a full discussion of CA$H NOW SELLER FINANCING in my FREE eBOOKLET. This technique involves the Seller selling all or a partial interest in the Seller Financed Note to a Note Investor in a simultaneous closing for enough cash to satisfy the existing loan. When the amount of the existing loan is 50% or less of the sales price or when the Seller just wants to be debt free, this technique works very well. However, in other instances the other two techniques may be better.
2. An Assumption with a Seller Financed 2nd Note for the balance of the equity: For purposes of illustrating this technique let’s assume a home selling for $200,000 with a $20,000 down payment and an existing loan of $140,000 payable at $838.95 per month including 5.25% interest. In this example the Buyer would assume the existing loan (see section below on Assumptions) and give back to the Seller a Note and 2nd Deed of Trust for the balance of the equity of $40,000 ($200,000-$20,000-$140,000 = $40,000).
To account for the fact that this is a 2nd Note, it would probably be at a higher interest rate, say 8%. Using a 30 year amortization schedule, monthly payments would be $293.50. In such situations, the balance would be due in a final balloon payment in 10 years. While I have seen many transactions structured this way, I have a strong preference for the third method.
3. Create a Wrap-Around or All Inclusive Note and Deed of Trust for the unpaid balance: Using the same selling price and down payment as the previous example, this would result in a Wrap-Around Note of $180,000, from which the Seller would continue to make payments on the existing $140,000 loan. Assume that the payments on the Wrap-Around Note were calculated based upon a 30 year amortization schedule and a 6.5% interest rate. This would provide for payments of $1,137.72 per month and would give the Seller residual payments of $298.77 a month ($1,137.72-$838.95 = $298.77) and a little more than an 8% yield on the $40,000 equity in the Wrap-Around Note.
Payments on Wrap-Around Notes should always be made through an escrow with a reputable bank or escrow company with clear escrow instructions providing that payments on the existing debt are made from the payments made by the Buyer. I prefer this method because the Seller knows if payments are being made on the existing loan and it allows the Seller to step in and continue to make payments on the existing loan in the event of default. Another myth is that a Wrap-Around Note is a way of avoiding the “Due on Sale” clause. If you will read the language of the typical “Due on Sale” clause you will see that this is NOT TRUE!
Coping with “Due on Sale” clauses in Assumptions: The lowest risk way of doing an assumption is to get the Lender’s consent to the sale. Unfortunately, in this day of “brain dead” Lenders and the securitization of loans, it is often impossible to find someone with the authority to issue the consent.
Assuming that it is not possible to get the Lender’s consent, it is then important to do a realistic risk analysis. With millions of home loans in default or foreclosure—“How likely is it that a Lender will risk another foreclosure by invoking the ‘Due on Sale’ clause if payments are being made, taxes are being paid and insurance maintained?” While I can’t say that the risk is zero, I can say “The risk is extremely low!”
There are certain risks, particularly to Real Estate Licensees, that can be greatly reduced or eliminated by proper structuring. To learn these valuable structuring techniques, be sure to read the Blog posted on May 7, 2011! In that Blog there is a link to a very useful Disclosure Form.
Because of the importance of Seller Financing in Creative Real Estate, my next several Blogs will be on this topic. If you haven’t already done so, be sure to download the FREE eBooklet which provides additional detail on this important technique.