After the real estate meltdown of 2008, the lending industry has become much more conservative with its underwriting (approval) guidelines. Many borrowers don’t qualify for a loan to purchase a property for a variety of reasons: they don’t have sufficient verifiable income, they don’t have enough assets to make a standard, down payment, or their credit might fall below the minimum standards.

Problems with qualifying are particularly common with self employed borrowers who must document their income with Schedule C of their federal tax return. Qualifying becomes a bit of a “catch-22,” as self- employed borrowers usually take many deductions that in some ways artificially reduce their income for tax purposes. It then appears they don’t have  enough income to qualify for a home loan. In the past the lending industry recognized this and permitted “stated income loans” which allowed self-employed borrowers to qualify based on their stated, and more accurate income without having to verify it using their tax returns. In practice, this policy wasn’t started with the intention of allowing borrowers to exaggerate their income, but instead to declare their real income rather than taxable income.

Owner/Sellers Become the New Lenders

One way to circumvent the lending industries tough guidelines for borrowers is to have the owners (sellers) of the property provide the financing. This is sometimes referred to as “carrying the paper.”

This method is often used when a seller owns the property outright without any existing mortgages, however sellers can still “carry the paper” on a purchase even if there are loans on their property.

How it Works

When an owner carries paper, it means they become the lender. A purchaser signs a “mortgage note,” sometimes referred to as a promissory note, to the seller. In addition, the purchaser signs a trust deed which the seller records at the county recorder where the property is located. The deed of trust is written for the same amount as the mortgage note and is the security for the note. If the buyer doesn’t make his payments as promised in the mortgage note, the seller can foreclose on the buyer and repossess the property.

Here are the Steps in an Owner Financed Transaction

• Buyer and Seller agree on the terms of a purchase including: price, down-payment, interest rate on the mortgage and the length of time the buyer has to pay back the mortgage.
• Buyer and Seller enter escrow which is a third-party set up to facilitate transactions that involve the exchange of money and ownership of things like real estate.
• Buyers do all of their inspections on the property, including title insurance issues, easements and a physical inspection of the property, which sometimes involves a third-party inspector such as a general contractor who is familiar with property problems and repairs.
• Buyer puts any down payment into escrow and signs the mortgage or promissory note and the deed of trust in favor of the seller.
• Once the deed of trust is recorded by escrow at the county recorder the escrow company releases the down payment to the seller.

What an Owner Financed Transaction Look Like

Usually an owner carries paper between three and five years, sometimes longer. The promissory note is written as “interest only” which means the buyer pays a monthly interest payment to the seller. This is easy to calculate. To determine an interest only monthly payment take the loan amount multiplied by the annual interest rate and divide by twelve to arrive at a monthly payment. For example:

Assume the loan amount is $150,000 at 6 percent interest, with interest only payments for 5 years.

The annual interest would be $9,000 ($150,000 times .06)

The monthly payment would be $750 ($9,000 divided by 12)

Using this example, a buyer would pay $750 each month to the seller for five years. At the end of five years the entire principle balance of the loan becomes due to the seller ($150,000.)

At this point, the buyer will need to refinance the loan with a traditional lender or see if the seller will consider extending the “interest only”  payment period.

Advantages of Seller-Financed Transactions:

1. Buyers don’t have to qualify based on traditional loan requirements with banks.
2. Escrows can close much quicker since the qualifying process that occurs with traditional lenders is avoided.
3. By paying interest only, buyers get to make lower payments than comparable loans made by banks that involve the repayment of principle and interest.
4. Sellers might be able to defer taxes by using the installment method of calculating the recognized gain on the sale. Sellers should have their tax professional review the transaction in order to determine if a tax benefit is applicable.
5. Sellers tend to get a higher price when they carry paper since an appraisal is not involved.

Disadvantages of Seller-Financed Transactions:

1. This type of finance is considered temporary, since the term of the repayment is usually five years or less. The buyers must be able to get their financial affairs in order during this time which includes increasing verifiable income, building a larger down payment and improving credit.
2. Unless the seller is very familiar with the buyer, there is a risk that the buyer might default (stop making payments) on the loan and the seller will need to foreclose on the property.
3. Foreclosing on a property can be expensive and time consuming; in some cases as long as a year.

If you’re a buyer thinking about purchasing a home, and you are considering seller finance, contact a real estate broker in your area who might be familiar with properties for sale where the owners will consider “carrying the paper.”