Your property’s for sale but the only interested buyer can’t get bank financing. Or maybe some aspect of the property itself doesn’t fit the bank’s mold. Then again, like many, you may just like the idea of a property you sell providing income for years to come. Seller financing can be a great tool in all these situations. But there are several common seller financing mistakes you need to watch out for.
In this article, we’ll cover the 5 most common.
Mistake #1 – Not Underwriting Your Borrower(s)
I’m not sure about you, but If I’m going to trade the hard-earned equity I own in a property for a piece of paper saying someone’s going to make payments to me for years to come, I need to feel comfortable that whoever’s signing that paper is able to keep their promise.
How do you do that? Banks call it underwriting. It’s the process of qualifying a borrower’s ability to pay and their past history of making other payments.
The “right” way to do this is to hire a Licensed Residential Mortgage Loan Originator (RMLO) who will request your borrowers complete an application, submit paystubs, and check their credit reports. Check with us, or with your Attorney, Title or Escrow company for referrals.
Beyond what the RMLO provides, your part is to judge the potential buyer’s character as best as you can. Is this someone you want to enter a long term “payor-payee” relationship with?
Mistake #2 – Low Seller Financed Interest Rate
As of writing this, banks are offering 30-year mortgage interest rates as low as 3.42%. You, however, are not a bank and should not base your interest rates on what they charge. For one thing, banks loan other people’s money. You will be loaning your own valuable asset.
Also, those super-duper low-interest rates are for borrowers with great incomes, amazing credit, and who can easily qualify for a bank loan. In fact, if your buyer feels you should compete with the banks on interest rates, your reply should be that they’d be better off working with a bank to obtain their loan. As an individual, it’s not advisable to take on the risk of loaning your own money to someone without adequate compensation. Again, banks risk other people’s money.
Seller financed interest rates should start at around 7% and go up from there. 8% – 10% is common and appropriate. Check local “usury” laws regarding the higher limits, or better yet consult an Attorney (see below).
Your Borrower always has the opportunity to re-finance down the road as circumstances change.
Mistake #3 – Low Down Payment
Equity in a home means how much of the home a borrower “owns” above the loan amount. For example. If a house is worth $100,000 and the loan balance is $80,000, the borrower has $20,000 of equity in their home.
In desperation, many seller financers allow a $0 down payment. Even when renting, landlords require at least the first month and usually last month plus a security deposit paid in advance.
The more equity your borrower has in their house, the safer this makes you as the lender.
Requiring a good down payment makes it less likely your borrower will default, and protects you in case the value of the house drops. Remembering back to 2008, may borrowers found themselves underwater with their mortgages because the house was worth less than what they owed. Give yourself as much cushion as possible from the risk of an underwater borrower. 10% is okay. 20% is better.
Mistake #4 – Not Working With Professionals
Avoiding this seller financing mistake is easy. Use a lawyer to help you draft your documents. Use a title or escrow company to close your transaction. When reviewing your paperwork, remember that a bad contract is like a bad fence. Every agreement should include the following:
- Purchase Price – Identify the agreed-upon amount and the real estate location, contents, and improvements included in the purchase.
- Down Payment
- Balloon Payment (if any) – some restrictions may apply depending on current regulations.
- Amortization Schedule – The breakdown between how much of each monthly payment credited to interest on the debt and how much is credited to the purchase amount.
- Interest Rate
- Monthly Payment – Scheduled amounts and dates that payments must be made upon before penalties are imposed with remedies including NSF check fee charges, short payments, and other associated issues.
- Late Charges – Charges for payments made after due dates and grace periods for payment resolution before default is declared.
- Default Conditions – Specific circumstances that will determine debtor is in default of the financing agreement with remedies included as well as time frames for resolving default before the property is returned to the seller.
Mistake #5 – Collecting Payments Yourself
Yes, if you wish you can collect payments yourself. But it’s not recommended, and here’s why:
The alternative to collecting seller-financed loan payments yourself is to work with a licensed loan servicer, escrow company or title company. As a disinterested third party, they’ll give confidence to both the buyer and seller that the balance remains correct. They will issue regular statements and can “escrow” tax and insurance amounts and make those payments so they remain current.
Also, most can set-up regular automatic checking withdraws from your borrower’s account, and electronic deposits to your account. This helps to keep payments arriving on time and makes your life easier. A servicing company will also report interest paid and received accurately to the IRS.
For $15 – $20 per month, why wouldn’t you want everything listed here?
What If I Need To Cut A Corner?
We’ll let you in on a dirty secret, there’s no such thing as a perfect “note.” Seller Financing mistakes sometimes aren’t really mistakes. Your buyer may not have the downpayment you want. Okay, negotiate a higher interest rate. Or they may have something undesirable in their credit history – but can make a higher down payment, or can pay a higher monthly payment to reduce their balance more quickly. That can work too.
The beauty of seller financing is that its people working with other people, and together you can find solutions as creative and varied as the day is long.
What’s important though is that you never lose sight of protecting your own interests.
Questions? Contact us! We love to talk about seller financing!