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Never a lender be -- without safeguards
Variously known as "taking back a mortgage" or "holding the paper," private financing is often heralded as the easiest and fastest way to sell a house, especially in a slow market.
Of course, if you need the proceeds from the sale of one house to buy another, assisting with financing may not be the way to go. But even in that scenario, it may be worth considering, especially if you can line up an investor to take the note off your hands.
Private financing also could merit some consideration if, say, you're near retirement and looking for a steady cash flow at a higher rate than you can earn elsewhere. And if you have another place but are having trouble unloading this one, becoming a lender may be your ticket.
Despite these situations, seller financing is often treated as a last resort. It is at best an adventurous tactic that could backfire if your buyer does not pay.
And buyers who need the seller to carry the first mortgage are not as good a risk as those who can obtain financing through usual means.
"That doesn't mean they're all deadbeats," says William Mencarow, who buys and sells seller-held mortgages and publishes "The Paper Source," a monthly newsletter that serves professionals who buy notes from seller-lenders.
"Many are worthy borrowers who just don't fall into the net of conventional lenders," says Mencarow.
"Some are new to their jobs, others are self-employed and still others are retired or semi-retired with lots of savings but little in the way of monthly income."
Still, if a conventional lender takes a pass on your would-be buyer and you decide to assume that role, it is incumbent upon you to structure the deal properly -- as a protection against default and in case you decide to sell the note to an investor later.
For starters, insist on a substantial down payment -- the bigger, the better. Mencarow says many notes people try to sell to him and other investors are "worthless" because they have little or no down payment.
Even conventional lenders require those borrowing more than 80 percent of the purchase price to pay for insurance that protects the lender from the increased possibility of default.
You probably won't be able to get this kind of mortgage insurance, so demand a large chunk of change upfront. Ten percent is minimum, 20 percent is safer and more than 20 percent is best if you can get it.
And we're talking cash here. If you always wanted a cabin cruiser and your buyer offers his 40-footer as a down payment, fine.
But remember, it's tough to convert these things into cash, especially at full value.
At the same time, though, if your buyer has more equity in more valuable real estate -- an expensive condo at the beach, for example -- that property should be used as collateral, suggests Bill Broadbent, co-author of the self-published book "Owner Will Carry: How to Take Back a Note or Mortgage Without Being Taken" ($38.40 including shipping, 800-542-2270).
Before putting your money on the line, however, obtain your buyer's written permission to check his credit, employment, personal references and previous landlords or lenders.
You can obtain a credit report from any local credit bureau. The trick is deciphering it. And your real estate agent or note broker should be willing to help you decipher it.
Obviously, the higher the interest rate, the better. And you should be able to charge more than the going rate because you are the buyer's only source of funding and he won't be paying the application or origination fees traditional lenders charge.
Not as obvious but equally as important is the length of the loan: the shorter, the better.
In other words, try to structure the deal so the monthly payments are large enough to pay the loan off in the shortest amount of time. Why? Because the market value of a seller-financed mortgage for 30 years with no balloon is roughly 50 cents on the dollar, Mencarow says. But at 20 years, a note buyer might be willing to pay 75 cents for every dollar of outstanding principal. And a 15-year note could be worth as much as 80 cents per dollar.
Another key is the loan's position compared with other liens on the property. A first mortgage takes precedence over all others, making it more valuable than a second mortgage. And a second "is much more valuable than a third, which I'd stay away from completely," says Mencarow. "A second is about as far as you want to go."
The amount of the second mortgage as compared to the primary loan is also important. Unless the buyer makes a big down payment, and thus has significant equity at risk, a small second behind a large first is not a terribly safe investment and not very valuable if you want to sell your note to an investor.
That's because if the buyer defaults on the first lien, you would be responsible for making up all back payments on both mortgages, plus all future payments until the primary mortgage holder forecloses. Otherwise, your investment would be worthless. The other option would be to take over the first position by paying off the first lien.
So, your note should contain a clause requiring your buyer to keep up the payments on all mortgages.
Otherwise, you can foreclose. There should be another clause requiring him to pay the property taxes and fire insurance on time.
Call the holder of other loans on the property periodically to be certain those payments are being made. If not, your borrower could get so far behind he'll never dig his way out, and neither will you.
The best way to be sure your buyer is paying the taxes and insurance is to make him pay you a portion every month so that when the bills are due, the money will be on hand. Alternatively, you can hire a note-servicing company to administer the loan on your behalf.
Another important protection is a clause allowing you to sell the loan without recourse. That means the new owner of the note can't hold you responsible if the borrower doesn't pay him.
You also want a "due on sale" clause so the loan is not assumable.
That way, when your buyer sells the place, he has to pay off the mortgage with you. He can't pass it along to a new buyer.
Finally, the mortgage should provide for a late fee. How much and when the charge kicks in is usually determined by local or state law. But whether you can charge 5 percent after five days or 10 percent after 10 days, always collect. Always.
If the payment is not received within the specified time, send your buyer-borrower a letter informing him that he is in default and that you will commence foreclosure proceedings if the payment is not received within, say, five more days.
"Don't pull any punches," Mencarow advises. "You've got to be tough. ... If you don't act decisively, you stand to lose a lot more money."
Of note, have an investor in hand
Sellers who plan the "hold the paper" for their buyer but need to cash in their houses should consider lining up an investor to buy the note the instant it is created. Some note purchasers will do simultaneous closes in which your buyer signs the mortgage and you sign it over to the investor.
One benefit of lining up an investor in advance is that you can structure the note the way the investor wants it. That way, it will have maximum value.
-- Lew Sichelman
Write to Lew Sichelman c/o Chicago Tribune, Real Estate, 435 N. Michigan Ave., 4th floor, Chicago IL 60611. Or e-mail him firstname.lastname@example.org. Sorry, he cannot make personal replies. Answers will be supplied only through the newspaper.