1) Get prepared for the buyer to default on the seller financing loan
There’s a reason that banks won’t lend to a buyer who needs an owner-financed mortgage. The buyer might not have enough saved for a standard down payment (i.e., let’s say 20% on a jumbo, non-conforming mortgage). Though that wouldn’t necessarily be bad if the buyer has a steady source of income. However, it’s more likely that the buyer isn’t financially qualified even if they had the money for the down payment.
More likely than not, the buyer doesn’t make enough income to sufficiently cover anticipated housing expenses with a margin of safety. For example, the maximum debt-to-income ratio allowed for a conforming loan is 43%. Banks may have some flexibility for non-conforming jumbo loans.
More likely than not, the buyer doesn’t qualify for a regular mortgage. He or she doesn’t make enough income to keep anticipated housing expenses under 40/50% of their total revenue. As a result, if you agree to finance their purchase when banks won’t, you’ll be much more likely to underwrite a non-creditworthy borrower. Let’s be honest, why do you think you’ll do a better job of vetting a potential borrower than the underwriting department at a major bank? So prepare yourself for default. We’ve heard statistics from lenders that owner-financed mortgages have a default rate of approximately 60%.
2) Foreclosure and eviction can take months
The borrower inevitably defaults on your seller-financed mortgage. You’ll have to spend an enormous amount of time, money, and energy to foreclose on the property and evict the borrower. Remember that it’s illegal in many states to try to evict a tenant without a court order and a sheriff to do it. In fact, the foreclosure and eviction process varies significantly between states. In states like New York, with an enormous amount of tenant protections, the process can take many months and even years.
3) You may have to make significant repairs
Remember that during all of this time, you’ll receive zero rental income. Also, the tenant most likely will be tearing the place apart. If you have a poorly written loan agreement, the tenant might even strip out all of your furnishings and appliances to sell for some extra pocket change. As a result, once and if you’re finally able to recover your property and vacate the premises, you’ll most likely have to do quite a bit of renovation work to repair it back to its former condition. Even if you don’t have the money to fully restore the property to prime condition, you’ll still most likely need to do some basic repairs to increase your chances of marketing the property again for sale or rent.
4) You’ll have to try to sell all over again
This brings us to the last point. After all the stress and hassle of evicting the borrower and repairing your property, you’re back to square one with less money. You’ll have to spend money to market the property once more. You must pay a new real estate broker commission if you wish to try selling again. Let’s say you give up and don’t try to sell again. Seller closing costs are very high in NYC. Therefore, you’ll be lucky to break even despite getting some cash flow from the buyer’s 10% down payment.
Benefits of a seller-financed transaction
We believe agreeing to a seller-financed deal is a poor idea. However, there are some benefits and a few exceptions on when it might make sense.
1) When the bank won’t finance a property due to liens or violations
It might make a lot of sense for sellers to consider offering owner financing. If they know that banks will be loathed to lend against their property. The most common reasons are underlying issues with the property’s title, liens or judgments against the property, or violations.
For example, perhaps the owner installed a sauna illegally without getting the city’s proper permits. Or he has already gotten caught and receive a violation noticed by the NYC Department of Buildings. Either situation might make the home unfinanceable for most traditional lenders, which means the owner stepping in might be a great idea if it’ll expand the universe of potential buyers.
Keep in mind that contracts usually stipulate that properties are to be delivered free and clear of title and any violations, liens, or judgments. Therefore, some explaining and negotiation will be necessary if you wish for a buyer to purchase it anyway.
2) Seller financing expands the range of possible buyers for their home
Besides greatly expanding the possible range of buyers from offering financing if banks won’t lend, the range of buyers expands even if banks will lend. That’s because some buyers won’t qualify for a mortgage from a traditional bank lender.
Perhaps because they don’t meet various financial requirements such as post-closing liquidity, minimum down payment, or debt-to-income ratio. For instance, banks typically require six months, while co-op boards can require up to 1 or 2 years worth),
A great example is a high-income buyer who works at Google. Let’s say he’s a talented software programmer. He makes $2,000,000 a year with Principal Engineer’s title (i.e., one of the highest ranks for an engineer at Google). However, for some reason, he doesn’t have a lot of savings, even though he makes a ton of income and has job security. Let’s say this buyer can only put down 10% and won’t have any post-closing liquidity. Would it make sense for the seller to finance his purchase if banks won’t lend to him? Of course, it would!
3) Sellers can cash out by selling their loan to an investor
Don’t forget that just because you extend home seller financing to a buyer doesn’t mean you can’t still cash out. There are plenty of investors out there who are willing to purchase mortgages and promissory notes on the secondary market. Of course, you’ll have to keep in mind that you’ll most likely be taking a haircut from the face value of the loan if you do sell to an investor. The secondary market for one-off mortgages like this isn’t precisely liquid. Investors will be looking to make an excellent return for the additional risk involved. You can expect to receive offers for anywhere between 60% to 90% of the loan’s principal value from an investor.
4) Easy underwriting process and faster closing with seller financing
An often understated benefit of seller financing is the significantly quicker contract to the closing process. This may help you seal the deal with a buyer. You won’t have to wait around for the bank’s conservative mortgage underwriting department to jump through its hoops and approval processes. You can perform your expedited version of underwriting to make sure you’re comfortable with the risks involved. And as a result, you can choose a closing date significantly sooner.
5) Shorter loan terms structured with seller financing
Sellers do not need to grant a long-term mortgage like a traditional 30 year, fixed-rate mortgage. Sellers can structure the note to be more of a bridge loan to more conventional financing. For example, sellers might structure a five or seven-year note with a balloon payment at the end of the term. This is with the understanding that the buyer intends to secure a traditional mortgage by that time.
6) Sellers can earn a higher return vs. banks
Sellers can typically expect to make a percentage point or two more than traditional mortgages’ market rate. This is due to the irregularity and additional risk involved. Of course, all of this is negotiable. Still, on average, and typically given the buyer’s lack of options, the seller can get away with charging a higher interest rate than a conventional mortgage.
Does seller financing count as an installment sale?
Yes, a deal where the seller provides owner financing to the buyer can be counted as an installment sale. This leads to favorable capital gains treatment. This can be quite useful to sellers who do not qualify or are over the limit for certain tax benefits associated with real estate sales. Those include the 1031 exchange for investors or IRC Section 121 for primary residences. For example, an investor trying to sell a rental property may have missed the window to qualify for a 1031 exchange. This investor would therefore be subject to regular capital gains taxes.
To minimize those taxes, the investor could spread out the gains over a more significant number of years via an installment sale. This way, he qualifies for a lower tax bracket each year. A homeowner trying to sell a primary residence can benefit as well if he or she doesn’t qualify for IRC Section 121.
For example, this tax exemption for primary residence sales exempts up to $500,000 of capital gains for married filers and $250,000 for single filers. However, what if the amount of capital gains will be significantly over the limit? In that case, it might make quite a bit of financial sense to defer those capital gains over more years via an installment sale. Another requirement of IRC Section 121 is that the homeowner must have lived in the home for at least 2 out of the past five years. What if the owner moved a few years ago and no longer qualifies? Once again, an installment sale might help reduce the seller’s capital tax burden by spreading gains over more years.
You can learn more about the taxes related to buying and selling property in this white paper on NYC real estate taxes on our blog.