What Is Seller Financing And What Should I Watch For?

When a buyer wants to purchase a property but doesn’t want to pay the whole price in cash, and the seller wants to sell the property but doesn’t need the whole amount in cash, an opportunity exists for both to get what they want through seller financing.

The buyer can acquire a property that may be worth more than he or she has in cash (or the buyer may want to reserve cash for other uses like improving the property after purchase). The seller is able to sell a property that may be hard to sell for cash because it is not attractive to institutional lenders, or the seller can get a higher price because he or she will carry the financing. The seller may also want to provide financing because he or she earn a favorable rate of return as well as favorable tax treatment.

If all the stars align and both buyer and seller agree to seller financing, here are some do’s and don’ts to consider. As the seller, you should require a reasonable down payment, usually a minimum of 20 percent. Less is risky: if the buyer (borrower) misses the first payment and you need to foreclose, you will lose money by the time the foreclosure is done. Foreclosures take time and money, and at the end you still have a property to sell. Depending on the situation, you may need to spend time and money repairing the property, as well as marketing it for sale and paying brokerage fees to do so—all this time you’re losing interest income. So, get 20 percent up front. The more specialized the property, the more important a large down payment is. While it’s relatively easy to sell an office building, selling a church, school, or hospital, for example, is significantly harder.

As a seller, you should also be cautious about a buyer who plans to do major work renovating the property. At first, it may sound great. But if the buyer doesn’t know what he’s doing, you may end up with a mess. Unfortunately, I speak from experience. I sold a property and carried the financing; six months later, after the buyer gutted the buildings (down to the concrete walls), the buyer ran out of funds. I foreclosed and had to complete the renovations at my expense.

As with most agreements, things work best when both parties get what they need. The loan’s interest rate should work for both buyer and seller, and the payment schedule should be realistic for both. The buyer needs to be able to afford the monthly payments, (mortgage payment, taxes and insurance) and the seller needs to receive enough income. Be aware that the new Dodd Frank Act, may pertain to your transaction. In most cases, seller financing is exempt, but talk to your realtor to be sure you’re following the rules.

The overall term or length of the loan may need to correspond with other expenses, like sending a child to college. If the seller carrying the loan suddenly needs cash, all is not lost. The loan (or mortgage-backed note) can be sold on the open market. The value of the note depends on the loan terms, the value of the property, and the borrower’s payment record. Having carried financing, I highly recommend title insurance on the note. It reduces your risk by protecting you against buyer fraud. If you’re carrying the financing, I also recommend that you make sure property taxes are paid, the property is covered by hazard insurance, and that you report interest income to the government so the buyer can deduct the interest paid. That keeps everyone happy including the IRS.

If you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.