Chapter 44
Alternative Financing Agreements
INTRODUCTION
When market conditions dictate that lending institutions making traditional long‑term, fixed rate loans can make such loans only at exceptionally high rates, if at all, the need to buy and sell property often forces individuals to use alternative financing agreements. This chapter will present information on several alternative financing techniques such as the loan assumption, purchase money mortgages, wraparound loans and land contracts.
When a real estate licensee recommends a financing alternative which does not supply all of the safeguards built into the traditional loan types and traditional lending system, the licensee must avoid misrepresentations which can result in harm to either buyers or sellers. For example, a buyer who cannot afford the payments on a second mortgage can cost a seller needless expense in collection costs or foreclosure proceedings. Thus, a licensee recommending that a seller accept a second mortgage will also recommend that the seller have the buyer’s credit rating checked. Likewise, a buyer proposing to give a seller a first or second mortgage will want to have an independent appraisal of the property done to assure that the value of the property exceeds the amount of the loan or loans.
Some licensees think of alternative financing as a way to help buyers assume loans without triggering due on sale provisions in security deeds. A licensee participating in such financing arrangements may violate the License Law’s prohibition against substantial misrepresentations or falsification of a sales contract or other real estate document. It is a sound practice for licensees to encourage clients and customers who use alternative financing and who intend to avoid activating due on sale clauses to seek competent legal advice before signing sales contracts.
THE LOAN ASSUMPTION: INTRODUCTION
A loan assumption occurs when a buyer assumes the financial responsibility for the seller’s loan as part of the purchase agreement in the sales contract. Many buyers finance their homes by assuming an existing loan. Interest rates on older loans may be low compared with current market rates, and loan assumptions have low closing costs. Buyers may assume FHA and VA loans. Most conventional loans currently contain a “due‑on‑sale” clause which prohibits an assumption, or if it is permissible, requires the buyer to qualify for assumption and may increase the interest rate.
The main problem with loan assumptions is that the loan balance may be low creating a large equity gap between the selling price and the loan balance. Therefore, the buyer must produce a large downpayment, or use some other form of financing.The buyer might obtain a junior or second loan from a lending institution or the seller to bridge the equity gap.
“ASSUMING” AN EXISTING LOAN VS. BUYING THE PROPERTY “SUBJECT TO” AN EXISTING LOAN
Buying a property and “assuming a loan” and buying the property “subject to the loan” are two different legal situations. The difference may not be readily apparent to an observer of a real property transaction, but it is a very important distinction. When the buyer assumes the seller’s existing loan, he or she accepts the seller’s liability for payment of the debt. If the buyer fails to repay the loan as agreed, the lender forecloses on the real property and forces the sale of the property to obtain the funds to cover the unpaid loan balance. If the sale results in a deficiency, the lender may sue the original borrower (the seller) for the deficiency, and the seller may in turn obtain a judgment against the buyer who assumed the loan. Where the buyer wishes to avoid personal liability for the outstanding loan but agrees to make the monthly payments, the buyer is buying the property subject to the loan and merely making the payments. The buyer has no personal liability on the promissory note and will not be liable for any deficiency if the lender forecloses. A licensee representing the seller must make the seller aware of the potential risk involved in this type of financing and counsel the seller to seek legal advice.
THE LOAN ASSUMPTION: THE BUYER’S PERSPECTIVE
The loan assumption can be a financial advantage to the buyer because of four factors.
| (a) | LOW INTEREST RATE – If the interest rate on the loan is below the current market interest rate, a loan assumption by the buyer can result in a substantial savings. However, the buyer needs to inquire whether a loan assumption will lead to an increase in the interest rate. | |
| (b) | LOWER CLOSING COSTS – Closing costs on a loan assumption usually include attorney’s fees, loan transfer fee, recording fees, and title insurance if desired by the buyer. The total cost is substantially less than the cost of obtaining a new loan which includes points and origination fees. | |
| (c) | LESS TIME TO CLOSE THE LOAN – As a general rule it takes less time after signing a sales contract to close a loan assumption than it does to close a new loan. | |
| (d) | NO PERSONAL LIABILITY IF TAKEN “SUBJECT TO” – A buyer who purchases “subject to the existing loan” assumes no personal liability if he or she fails to make the payments. The buyer could, however, lose all of his or her equity. |
A loan assumption also has financial disadvantages for the prospective buyer.
| (a) | The buyer might have to make a large downpayment to cover the difference between the sales price and the loan amount, or he or she may need to obtain a junior loan to get the funds to cover this difference. | |
| (b) | The buyer may not be able to offer a loan assumption to a future buyer. If the property increases in value and the loan balance declines as the new owner makes payments, a subsequent buyer may not be able to consider a loan assumption because of the size of the downpayment that would be required. |
THE LOAN ASSUMPTION: THE SELLER’S PERSPECTIVE
The loan assumption can also be a financial advantage to the seller because of three possible considerations.
| (a) | ADVANTAGEOUS SALES PRICE AND A HIGHER CHANCE OF SALE – If a buyer can assume an existing loan, the parties avoid the high closing costs and loan discount associated with new financing. Therefore, if the buyer does not ask the seller to pay high closing costs, the seller may agree to a lower sales price and increase the chances of selling the property. On the other hand, a buyer not having to pay high closing costs may offer the seller a higher price for the property. In either case, the parties benefit from not having to pay additional costs to a third party. | ||
| (b) | RELEASE OF LIABILITY – If the lender requires the buyer to qualify for a loan assumption just as he or she would for a new loan, the lender may release the original borrower from liability on the note. Lenders that follow this practice also require the buyer to sign a loan assumption (or loan modification) agreement obligating the buyer for all indebtedness. | ||
| (c) | RESTORE VA ENTITLEMENT – By selling a home to a qualified veteran, the seller who purchased his or her home on a VA loan may in effect trade entitlement with the new buyer. This substituting of entitlement can occur only if the buyer: | ||
| (1) | is a qualified veteran according to VA standards; | ||
| (2) | has the same amount or more of entitlement as the seller; and | ||
| (3) | agrees to the transaction. | ||
A loan assumption also has financial disadvantages for the seller.
| (a) | NO RELEASE OF LIABILITY – Unless the lender releases the seller from liability on the note, the seller continues to be liable for payment of the debt. If the buyer assumes the existing loan and fails to make the payments, the lender may sue the seller for any deficiency; and the seller may in turn sue the buyer. On the other hand, if the buyer takes subject to the existing loan and fails to make the payments, the lender may sue the seller; but the seller has no legal recourse against the buyer for any deficiency. | |
| (b) | IMPEDIMENT TO NEW FINANCING – If the seller needs a new loan to purchase another property, the lender may refuse to make a new loan to the seller unless the old loan is paid off in full and the seller has no liability for the original loan. |
THE LOAN ASSUMPTION: FINANCIAL CONSIDERATIONS
The loan assumption becomes a more desirable financing arrangement when these other conditions occur.
| (a) | THE SELLER WILL FINANCE PART OF THE PURCHASE PRICE – If the difference between the sales price and the loan amount is large, the buyer will more than likely require some form of a second loan. The seller’s willingness to provide such a loan may greatly facilitate the loan assumption process. | |
| (b) | LOANS ARE NOT AVAILABLE – During a period of credit restriction or tightness when interest rates are high and loanable funds are in short supply, a loan assumption may be the best and, possibly, the only financing alternative available to the buyer and the seller. Here the seller may have to offer a second loan (a purchase money mortgage) to the buyer. Also in tight money markets, buyers may be able to get only 80% financing and may be required to pay discount points. If the present owner obtained a low downpayment loan originally and the present loan is about 80% of the sales price, the buyer and seller may save money by arranging an assumption. | |
| (c) | THE BUYER CANNOT QUALIFY FOR A NEW LOAN – Often a buyer who could not get a new loan may be able to assume a loan which does not require him or her to qualify. For example, a young married couple may not have the necessary downpayment to obtain a new loan; but because they both have good jobs, their income is sufficient to make the monthly payments to the lender and pay the seller monthly for financing most of their downpayment. If a buyer is unable to get a loan because of poor credit, he or she may agree to make the monthly payments and not assume any personal liability for the debt. The seller should be aware that if the buyer fails to make the payments, the seller is still responsible for the outstanding debt. |
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| (d) | DECREASES IN PROPERTY VALUE – Because of physical deterioration, functional obsolescence, and external obsolescence, the current market value of the property may be only slightly higher than or equal to the unpaid loan balance. In such a case the original loan amount and any new loan are of about the same magnitude. The loan assumption could be the less expensive choice for the buyer. This condition may occur if the present owner failed to maintain the property. Depending on the severity of wear and tear or physical deterioration, the amount of depreciation could easily exceed (and offset) the seller’s downpayment and principal reduction. The property could also suffer a loss in value due to changes in the neighborhood or external obsolescence. A change in zoning regulations may allow commercial use of homes in a previously all-residential neighborhood, thus resulting in a loss of value to homes in the area. Consequently, homes in the neighborhood may have loan balances near current market value, making properties for sale in that area attractive for loan assumption financing. |
THE LOAN ASSUMPTION: LENDER REQUIREMENTS
To process a loan assumption, the lender may require several things from the buyer and/or seller.
| (a) | A LOAN APPLICATION – The lender may require buyers who seek to assume a loan to follow the same procedures as those applying for new loans. This practice is becoming more popular, especially with lenders holding conventional loans. If the ratio of the loan balance to the original appraisal of the property for the loan being assumed exceeds 80%, the lender usually requires written verification of downpayment and employment along with a written credit report. The lender cannot refuse the transfer if the buyer is creditworthy. | ||
| (b) | A NEW APPRAISAL – The lender may require a new appraisal prior to an assumption if there is to be a second mortgage for part of the downpayment and if the current loan balance exceeds 80% of the original appraisal. The new appraisal must reflect a property value high enough so that the loan to value ratio including all loans is 80% or less. As an example, there is a loan balance of $65,000.00 on a home originally purchased for $75,000.00 several years ago with a loan for $67,500.00. The original loan-to-value ratio was 90%. Today, a buyer agrees to pay $83,000.00 for the home but wishes to assume the loan, pay $10,000.00 down, and let the seller finance the other $5,000.00 of the downpayment. The current loan-to-value ratio for the original lender is $83,000.00/$67,500.00 which is 81.3%. The lender will typically request an appraisal since both of the loan to value ratios are greater than 80% and a second loan is part of the financing. If the seller financing were not part of the transaction, the lender would still request an appraisal because the loan-to-value ratio is in excess of 80%. |
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| (c) | A LOAN TRANSFER FEE – The lender may charge a loan transfer fee under the terms of the original promissory note and security deed signed by the seller. | ||
| (d) | A WARRANTY DEED – The lender will typically require a copy of the warranty deed conveying title to the buyer at the time of closing. | ||
| (e) | HAZARD INSURANCE – The buyer must furnish evidence of fire insurance before the lender will complete a loan transfer. This insurance may be a new policy or the one assumed from the seller. The lender will need the name of the insurance carrier, the anniversary date of the policy, and the amount of coverage. The coverage must be sufficient for the new purchase price, and the buyer will need to bring an endorsement of his or her assumption to closing. As is frequently true, if the insurance company will not allow the buyer to assume the policy, he or she will need to buy a new policy and pay the first annual premium at or prior to closing. | ||
| (f) | AN ESCROW ACCOUNT – Lenders do not normally refund an escrow account to the seller in a loan assumption. Therefore, the seller must satisfy any deficiency in the escrow account before the lender will allow the loan assumption. How the buyer and seller handle the existing escrow account is a matter of negotiation, but neither party can demand the escrow funds from the lender. The buyer and seller may choose to handle the escrow account in one of two ways. | ||
| (1) | The buyer can purchase the escrow account. If the buyer assumes the seller’s insurance policy and they prorate the taxes and insurance, the buyer can assume the escrow account on a dollar for dollar basis. In other words, if the seller’s escrow balance is $500.00, the buyer will pay the seller an additional $500.00 at closing. | ||
| (2) | The parties can agree on a transfer of the account to the buyer in lieu of proration if the buyer and seller elect not to prorate taxes and insurance. The lender will usually transfer the escrow account at no additional charge. | ||
PURCHASE MONEY MORTGAGE: INTRODUCTION
While sellers want to receive cash for their equity at the closing, many transactions require some form of a purchase money mortgage (seller financing) in order to close. The purchase money mortgage (PMM) is a loan from the seller to the buyer evidenced by a written and signed loan agreement. The PMM can be a first or senior loan or it can be a junior or second loan. Most often, it is a second loan.
The PMM is usually a fixed-rate, short term loan for five or 10 years. However, based on the needs of the buyer and the willingness of the seller, the PMM can exist for any mutually agreeable period of time. It can also take forms other than the fixed rate loan such as a graduated payment loan, an interest only loan, or a fixed rate loan with a balloon payment; and it can have payments structured on a basis other than a typical monthly routine.
The PMM can be an attractive alternative to both buyers and sellers who tailor the terms to fit their needs. The buyer may need a PMM to raise the cash to close the transaction. The seller may offer a below market interest rate PMM as an inducement to sell the property, or the seller may want a PMM to receive an income stream over a period of time rather than a lump sum at the time of the sale.
However, the seller, as would any lender, faces the risk of default under a PMM. Since the PMM is typically a second or junior loan, it carries more risk of default than a first or senior loan. If the property brings less at a foreclosure sale than the debt owed, the senior lender must be paid first from the proceeds from the sale. If the sale does not produce enough to pay the second lender, the PMM provider, the seller would have to petition the court for a deficiency judgment and then undertake the collection process. Because of this added risk, the seller might try to negotiate an interest rate on the PMM that is equivalent to the current interest rate on second loans. However, the specific situation between the buyer and the seller could create a trade-off between the need for a below market interest rate on the PMM and the need for a higher return, given the level of risk.
If the seller must give a PMM or chooses to give a PMM, he or she can minimize the risk of default by taking prudent action. The seller can check the borrower’s credit and analyze current property values to determine whether the value of the property is greater than the total amount of loans against it. In addition, the seller can investigate factors that will influence the future value of the property in order to judge whether the value will remain greater than the total loan balance. A property with a good appreciation potential meets this criterion.
PURCHASE MONEY MORTGAGE: WHEN THE NEED ARISES
The purchase money mortgage is a more likely solution to the buyer’s financial need under certain circumstances.
| (a) | A TIGHT MONEY MARKET – When interest rates are high and loans are not readily available, a purchase money mortgage may be the most promising financing alternative for selling the home. The PMM could be the buyer’s primary loan or it could be a second loan. | ||
| (b) | TO ENABLE A LOAN ASSUMPTION – As a property increases in value and as the loan balance declines with each monthly payment, the seller’s equity increases. As the seller’s equity increases, the likelihood that a buyer will have the necessary cash available to pay the seller decreases. In this situation a buyer will look to a purchase money mortgage to fill the gap between the buyer’s cash and the seller’s equity under a loan assumption. | ||
| (c) | A BUYER NEEDS A SECOND MORTGAGE TO HELP FUND THE DOWNPAYMENT ON AN 80% CONVENTIONAL LOAN – Some lenders will allow the buyer to get an 80% conventional loan and give the seller a purchase money mortgage for as much as 10% of the purchase price provided the buyer pays the other 10% in cash. | ||
| (d) | BUYER NEEDS A VERY SHORT TERM INTERIM LOAN – A buyer who wants to buy another home with the equity in his or her present home may need an interim loan until he or she sells the present home. The seller who is willing to finance part of the purchase price until a buyer can sell his or her present home makes it possible for more buyers to buy the seller’s home. When the buyer sells his or her present home, he or she can then pay off the purchase money mortgage with the equity from the sale. Interim loans are typically for a term of six to 18 months. | ||
| (e) | INCOME FOR THE SELLER – A purchase money mortgage will be attractive to some sellers because of the income they will receive each month (or each year). Sellers who might take advantage of this arrangement to finance part of the purchase price because they may have special needs. | ||
| (1) | Older people selling a large, expensive home to move into a smaller home or apartment may desire an income flow from the property for a period of time. The income from the PMM could supplement their retirement income from other sources. | ||
| (2) | People who do not need the cash for reinvesting in another property and/or are selling income property may wish to finance part of the purchase price for tax reasons. If the financial arrangement meets IRS requirements, a portion of the capital gain on the property may be deferred into the future. | ||
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(3) |
Some people may see the interest income earned on the PMM as a significant increase in their return on the sale of the property. | ||
PURCHASE MONEY MORTGAGE: ITEMS FOR NEGOTIATION
When the seller or the licensee with an agency relationship to the seller considers the possibility of offering a PMM or responding to a request for a PMM, there are several aspects of the loan agreement that the seller must consider.
| (a) | THE INTEREST RATE – The contract interest rate on a PMM can reflect the prevailing interest rate charged by lending institutions for a loan with the same seniority. Therefore, if the PMM is a first loan, the interest rate might be similar to the market rate on first loans. If the PMM is a second loan, it might have an interest rate higher than that on a first loan to reflect the addition risk that a second lender faces at a foreclosure sale. However, the contract interest rate is a point of negotiation between the buyer and the seller; and even if the PMM is a second loan, the contract rate could be lower than the current interest rate on a first loan. | ||
| (b) | THE LOAN TERM – Generally, the term of a PMM which is a first loan is shorter than the typical 30 year term for a fixed rate loan. Like other second loans, a PMM which is a second loan would have a term that is shorter than or no longer than a first loan. However, the exact term of a PMM is part of the negotiations between the buyer and the seller. The number of years the seller is willing to finance part of the purchase price is a result of many considerations. People going into retirement may be hesitant to carry a PMM for a long term. The seller wanting tax advantages may be willing to carry a PMM for a longer term. And an interim PMM is by definition a short term loan. | ||
| (c) | THE AMOUNT OF THE PMM – The amount of the PMM is very often a necessity rather than a point of negotiation. If the buyer absolutely needs a $10,000.00 PM to close the transaction, the seller cannot negotiate down. However, when there is latitude for negotiation, the seller would consider at least four factors. | ||
| (1) | THE BUYER’S ABILITY TO PAY – In order to judge the buyer’s ability to pay, the seller can ask that the buyer provide a credit report, an audited income statement, tax returns, and other documentation. | ||
| (2) | THE SELLER‘S NEED FOR EQUITY IN CASH – If the seller does not need all of the equity to buy another property, he or she may be willing to finance more of the purchase price; | ||
| (3) | THE BUYER’S HISTORY OF PROPERTY MAINTENANCE – If the buyer can demonstrate an ability to maintain a home properly, the seller may be willing to risk carrying a larger purchase money mortgage. | ||
| (4) | THE SELLER’S TAX SITUATION – The seller will need to seek tax advice from an attorney or a CPA when he or she is considering financing part of the purchase price. | ||
WRAPAROUND MORTGAGES
The wraparound loan is another alternative financial arrangement to the fixed rate loan. The wraparound loan is a combination of an existing first or senior loan on the property and a new junior loan from the seller or from a third party. Very often the junior loan is a purchase money mortgage made by the owner of the property. The owner of the property agrees to sell the property at the contract price, to maintain the existing first loan and be responsible for the monthly payments, and to take back a second loan in an amount equal to the difference between the contract price and the buyer’s cash downpayment. Since both title and possession will change, this method will not work unless the existing loan allows it. If the existing loan contains a due on sale clause, the lender can call that loan due and payable upon transfer of title.
For example, a seller lists a house at $100,000.00. The existing loan is a 30-year loan for $60,000.00 at 9% and a monthly payment of $482.77. The loan has 20 years remaining on a loan balance of $53,657.85. The buyer has only $15,000.00 for a downpayment and needs a loan of $31,342.00 to close the transaction. The current rate on new first loans is 10% while the current rate on junior loans is 11.5%. An $85,000.00 wraparound loan at 10% for 20 years would allow the buyer to purchase the house. This amount would cover the existing balance on the first loan and the $31,342.00 additional financing needed by the buyer. The seller could provide the loan as a PMM, or a third party lender could grant the loan. The buyer would pay a monthly payment to the wraparound lender who in turn would pay the monthly payment on the existing first loan.
With an $85,000.00 wraparound mortgage from the seller at 10%, the buyer’s monthly payments would be $820.27. Each month the buyer would pay the wraparound lender, the seller, $820.27 on the $85,000.00 loan. The seller in turn would make the $482.77 payment on the original loan. The wraparound lender, the seller, retains the $337.50 difference each month as payment for the remaining $31,342.00 balance of the wraparound loan.
When the interest rate on the wraparound loan exceeds the interest rate on the original loan, the wraparound lender receives an additional premium for making the loan. In this situation, a new first loan of $31,342.00 at 10% for thirty years has a monthly payment of $302.46. The wraparound lender receives $337.50. The additional $35.04 per month is the return to the wraparound lender that arises because the interest rate on the existing first loan is 9% while the buyer is paying 10% for that loan to the wraparound lender. In actuality the wraparound lender is receiving a return of 11.65%, not the 10% rate on the total wraparound loan.
A wraparound loan is not advantageous to the seller if the interest rate on the existing first mortgage is higher than the interest rate on the wraparound loan. In such a case, the seller would be making the payments on a higher interest rate senior loan while receiving payments on a lower interest rate wraparound loan.
PROTECTING THE BUYER IN A WRAPAROUND LOAN AGREEMENT
The buyer needs protection against the wraparound lender’s default in making the monthly loan payments on the existing senior loan. One way to protect the buyer is to provide that the wraparound loan agreement would be considered paid in full in the event the original senior loan went into default while the wraparound loan payments are not in default. Another way to protect the buyer is to state in the wraparound loan agreement that the original lender will provide the buyer with notice of any default on the original first loan. This procedure gives the buyer time to cure the default and prevents the original lender from automatically foreclosing his or her interest in the event of default. The agreement could provide that any payments made for this purpose would reduce the balance that the buyer owes on the wraparound mortgage.
A third way the buyer can protect his or her interest in a wraparound loan is to designate an escrow agent to receive the buyer’s payments. The escrow agent then makes the payments on the first loan and forwards the balance of the payment to the wraparound lender. This procedure involves additional expenses and might be more appropriate for commercial transactions.
PROTECTING THE SELLER IN A WRAPAROUND LOAN AGREEMENT
Should the buyer default on the wraparound loan, the wraparound lender has a legal obligation to make the payments on the original first loan but may have no financial incentive to do so. If the wraparound lender stops making the payment on the existing first loan, the original lender forecloses and sells the property and the proceeds from the sale go to compensate the first lender and the wraparound lender (the junior lender) with any remainder going to the buyer who defaulted. If the buyer’s downpayment was sufficiently high, the wraparound lender will more than likely not face a deficiency.
Since the wraparound lender’s main advantage in providing a wraparound loan is to receive the interest differential between the two loans, any prepayment of the wraparound loan would not be to his or her advantage. To protect the income stream from the wraparound loan, the wraparound lender would probably want the wraparound agreement to prohibit prepayment of the junior loan or to apply a prepayment penalty for any prepayment privilege. Finally, in order to protect financial interest of the wraparound lender in the event the home is destroyed, the seller can require the buyer to maintain a hazard insurance policy naming the first mortgage holder as the first loss payee and the seller as the second loss payee. The policy should be for at least the amount of the note secured by the wraparound mortgage.
FINANCIAL CONSIDERATIONS FOR THE WRAPAROUND LOAN
A wraparound loan might be attractive to a seller from a financial perspective when one or more of the following circumstances apply:
| (a) | the existing interest rate on the first or senior loan is favorable so that the interest rate on the wraparound loan can exceed it and the borrower is financially able to pay that interest rate; | |
| (b) | the existing first mortgage does not have a prepayment privilege or has an exorbitant prepayment penalty; | |
| (c) | a higher yield is sought than a traditional purchase money mortgage could offer; and | |
| (d) | the parties can negotiate an acceptable loan term. If the wraparound lender is a third party investor, he or she will probably want the term of the loan to be at least as long as the remaining term on the underlying first loan. On the other hand, if the wraparound lender is the seller, he or she may want to recoup the equity sooner by making the wraparound loan for a shorter period of time than the term of the underlying loan. |
A wraparound loan might be attractive to a buyer from a financial perspective when one or more of the following circumstances apply:
| (a) | financing with a new first loan is not possible because the buyer cannot qualify because of the loan qualification standards relating to debt/expense ratios or because the interest rate is too high; and | |
| (b) | the interest rate in the wraparound financing is lower than the interest rate on a traditional second mortgage. |
ITEMS OF AGREEMENT IN A WRAPAROUND LOAN AGREEMENT
Before the wraparound lender agrees to accept a wraparound mortgage, he or she will want to consider the following items for possible inclusion in the loan document:
| (a) | a prepayment penalty for the wraparound loan; | |
| (b) | a late charge against monthly payments; | |
| (c) | a due on sale clause if the buyer sells the property; | |
| (d) | an escrow requirement for taxes and insurance if not required by the holder of the first mortgage; | |
| (e) | a clause prohibiting the buyer from placing additional liens against the property; and | |
| (f) | a provision for the monthly wraparound payment due date to fall several days before the due date for the payment of the first mortgage so that the lender will have the funds in hand to make the payment on the first mortgage. |
USURY AND WRAPAROUND LOANS
While the federal government has preempted state usury limits on first mortgages, it has not done so on second mortgages nor on loans made by noninstitutional lenders. Most wraparounds, at least for residential purposes, are second mortgages made by the seller. Therefore, it would seem that such loans are subject to the second mortgage usury limit . However, it is not altogether clear whether the law bases the usury limit on the effective rate received by the wraparound lender (seller) or upon the contract or stated rate in the loan documents. Therefore, in negotiating a wraparound mortgage agreement, both buyer and seller should get legal advice.
THE LAND CONTRACT
Another type of owner financing available when the buyer’s downpayment is insufficient to pay the seller all of his or her equity is a land contract. This financing arrangement is also known as an installment land contract or a contract for deed or title. Under a land contract the seller retains title until some future date. The buyer makes a downpayment, takes possession, and agrees to pay installments to the seller over a long period of time, often 15 to 25 years. The buyer receives the deed when he or she has paid the full purchase price and fulfilled all other obligations under the contract. Land contracts can be used to finance the sale of any type of real property, but may be especially useful in the sale of land or recreational property because institutional financing is often difficult to obtain.
The parties may use land contracts when the seller owns the property free and clear or when there is an existing loan on the property. If there is an existing loan, the land contract is similar to a wraparound mortgage in that the amount financed by the owner may include any existing first mortgage. The buyer makes a single payment each month to the seller, who in turn remits payment to the holder of the first mortgage. It is usually advisable to make the term of the land contract the same as the number of years remaining on the first mortgage. In that way the buyer has more assurance that he or she will receive clear title to the property upon payment of the final installment. However, it is not uncommon for a land contract to provide for a balloon payment and require transfer of title at that time.
This financing can be advantageous to both the buyer and the seller if it does not trigger the “due‑on‑sale” clause of an existing first mortgage having a low interest rate. Of course the seller must weigh any possible benefit against the risk of giving up possession for a relatively low downpayment. If the buyer defaults, he or she can simply move away, often leaving the home in a state of disrepair and owing back taxes. On the other hand, the buyer must consider the risk that the seller may not be able to deliver good title when the buyer pays the contract. In effect the buyer is betting on the good will, faith, credibility, and financial solvency of the seller. The buyer can experience legal complications if the seller dies, files bankruptcy, or gets divorced. In most cases, a purchase money mortgage is preferable for a buyer, since the buyer receives the title immediately at closing.
PROVISIONS OF A TYPICAL LAND CONTRACT
A land contract is first of all a real estate sales contract. Therefore it contains all the typical clauses found in a sales contract plus some unique to the land contract.
| (a) | DESCRIPTION OF PREMISES – The parties agree to buy and sell the property identified by its legal description. | |
| (b) | PRICE AND TERMS – This provision sets forth the total purchase price. It states the required downpayment plus the amount of principal and interest to be paid in installments and the time and place for the installment payments. | |
| (c) | POSSESSION OF PREMISES – The seller agrees to grant the buyer exclusive possession of the property on or before a specified date. The buyer’s right of possession is to continue for the life of the contract subject only to his or her default of any obligation under the contract. | |
| (d) | ESCROW AGENT – The contract should designate a mutually acceptable escrow agent. The escrow agent maintains the original signed copy of the land contract. Also, the seller must turn over to the escrow agent an executed general warranty deed naming the buyer as grantee, along with an abstract of title or a title insurance policy. The escrow agent is authorized to deliver the seller’s deed to the buyer when the buyer makes all installment payments as provided under the contract. | |
| (e) | PREPAYMENT RIGHT – This provision grants the buyer the right to prepay installments of principal and apply the prepayments against future installments. | |
| (f) | GRACE PERIOD – This provision gives the buyer a specified time after his or her default to make overdue payments. After such time, if the buyer has not corrected the default, the seller has the right to declare the entire purchase price due and payable. | |
| (g) | TAXES – The buyer and seller usually prorate taxes as of the date of possession. The payment of all subsequent taxes is the buyer’s responsibility. | |
| (h) | INSURANCE – The buyer and seller also usually prorate insurance as of the date of possession. After such time the buyer agrees to maintain a sufficient amount of insurance to cover the insurable value of the improvements, insuring the respective interests of the buyer and seller. |
OTHER ISSUES REGARDING A LAND CONTRACT
Both parties to a land contract will want to proceed cautiously when considering a land contract as a method of finance. There are several things to keep in mind.
| (a) | A DUE ON SALE CLAUSE IN AN EXISTING LOAN – Under a land contract the “seller” owns the property even when the buyer is in possession of the property. Any existing loan against the property remains the seller’s obligation. Because of this feature there may be a tendency to think of a land contract as a technique to escape the “due on sale” clause since the property did not sell. However, many lenders use a security deed in which change of possession will also give the lender the option to exercise the due on sale provision. | |
| (b) | TITLE – Land contracts often involve first‑time buyers who may not fully understand that the “seller” remains the owner of the property. Unless he or she is a sophisticated buyer, the buyer should consider seeking competent legal advice before agreeing to this type of financing arrangement. | |
| (c) | TAX CONSEQUENCES – There are significant tax consequences in the use of a land contract. The parties must properly structure the agreement in order for the IRS to deem the transaction a sale for tax purposes. Buyer and seller should always seek tax counsel in any instance where they contemplate using a land contract. |
THE LICENSEE’S ROLE IN ALTERNATIVE FINANCING ARRANGEMENTS
Serving clients and customers effectively requires a clear understanding of the buyer’s and, at times, the seller’s financial situations. Whether the buyer can afford to purchase a particular property will depend primarily upon how much cash the buyer has for a downpayment and how much he or she can afford to pay each month. Before seeking a solution to the buyer’s affordability problems, the licensee must consider the personal needs, desires, financial status, and motivation of both the buyer and seller. Only in this way can the licensee identify the resources that are available to help overcome these financial obstacles.
In alternative financing arrangements as in more conventional financing, an effective broker or sales associate needs to know certain key information about the buyer and the seller. The following list of questions illustrates the type of information a licensee needs to obtain from the buyer in order to be of assistance.
| (a) | PERSONAL INFORMATION – What is the buyer’s marital status and number of dependents? | |
| (b) | PRESENT HOME – Does he or she own or rent? How much are his or her monthly mortgage or rent payments? | |
| (c) | EMPLOYMENT STATUS – Where does he or she work, what are his or her duties, and how long has he or she been there? | |
| (d) | TOTAL INCOME – What is his or her total income from all sources, such as salary, bonuses, fringe benefits, stocks, bonds, interest, real estate, or expected raises? | |
| (e) | OUTSTANDING DEBTS – What are the monthly payments, balance, and time remaining on all loans and charge accounts? Are there other recurring monthly expenses such as alimony, taxes, and insurance payments? | |
| (f) | CASH AVAILABLE – How much cash does the buyer have available to apply toward the purchase, and are there other assets that can be converted to cash? | |
| (g) | PERSONAL PROPERTY – What personal property does the buyer own and what is its approximate value? | |
| (h) | OTHER SOURCES OF FINANCIAL AID – Are there other sources of financing such as friends, relatives, cosigners, or employer? |
Alternative financing techniques often involve the seller. Therefore, it is equally important to pose questions to the seller to help the seller determine if he or she is in a financial position to consider alternative financing.
| (a) | HOUSING PLANS – Does the seller intend to buy another home, rent, or make other arrangements? | |
| (b) | CASH AVAILABLE – How much cash does the seller have available, including the cash to be realized from the sale of his or her home plus all liquid assets? | |
| (c) | CASH REQUIRED – How much cash will the seller require in relocating? | |
| (d) | TAX CONSIDERATION – Does the seller plan to buy a more expensive homeor do other tax considerations make it attractive to spread capital gains? | |
| (e) | PRESENT FINANCING – What are the details any existing loans? The most reliable loan information can be obtained from the lenders. | |
| (f) | OWNER FINANCING – Will the seller consider accepting a first or second purchase money mortgage, a land contract, or a wraparound mortgage? |
If the sale involves a personal residence, the agent should get an in depth understanding of the buyers and seller’s personal needs, desires, and motivation. It is always helpful to visit them in their present home under normal living conditions. The more information the licensee has, the better chance he or she has of coming up with a financing solution that will enhance the buyer’s buying power and improve the salability of the property.
BUYER ACTIONS TO QUALIFY FOR A LOAN
Alternative financing does not have to be unduly complicated to be effective. Simple solutions are still the best and often most available if the buyer and seller are sufficiently motivated. For instance, if the buyer does not have enough cash to cover the downpayment, closing costs, and prepaid items, he or she may consider one of the following solutions:
| (a) | sell items of personal property such as jewelry, silverware, stocks, bonds, motorcycles, boats, campers, cars, antique furniture, or other real estate; | |
| (b) | trade any of the same items to the seller as payment on his or her equity after establishing the values in the sales contract; | |
| (c) | use any of the items of personal property as collateral for a loan; | |
| (d) | borrow on the cash values of life insurance policies; | |
| (e) | get a temporary second job; | |
| (f) | use the equity in the buyer’s present home to obtain an interim loan (also called a swing loan or bridge loan); | |
| (g) | obtain cash from a relative either through a loan or by gift; or | |
| (h) | obtain a personal loan through a credit union, finance company, or credit card company which extends a personal line of credit, if allowed by the lender. |
Many times the buyer will have enough cash from the equity of a previous home to cover downpayments, closing costs, and prepaid items but will be unable to qualify for the monthly payments required to buy the home he or she wants. Just as with the obstacle of insufficient cash, there may be a simple solution to the buyer’s qualifying problem. For instance, the buyer may consider one of the following solutions:
| (a) | sell personal property luxury items, such as boats, campers, or motorcycles, to pay off a debt; | |
| (b) | if practical, pay off a debt, or refinance it to lower the monthly payment; | |
| (c) | get a second job to improve stable monthly income consistent with the lender’s requirements; | |
| (d) | be sure to disclose fringe benefits and routine pay increases on the loan application; | |
| (e) | seek outside help from friends, relatives, or employers to co‑sign a note, act as a partner, or take over the payment of debt; or | |
| (f) | trade in a vacant lot to the builder to reduce cash needed. |