Seller Financing is BAD – Right?

Seller Financing is BAD – Right?
by: Dean Dretske


The real answer is ‘it depends’. It depends on the situation and the
parties involved in the transaction. Let’s talk about it from the
Seller’s perspective and the Buyer’s perspective. We’ll also talk about
the investor’s perspective in each of these roles. Remember, I am an
investor, not an accountant – please check with your own accountant to
confirm how this would apply to your own situation!

For the purposes of our discussion, suppose that a house sells for $150K
and the seller takes back $100K as a mortgage as part of the sale (the
buyer pays the other $50K as cash to keep this simple). The Seller owned
this property free and clear – or owed less than the net cash received.
Say the note has an interest rate of 6%, interest only payments (or
more), with a balloon payment of the outstanding balance in 15 years.
This makes the payments equal $500 per month – assuming only the interest
is paid.

Seller – The Good:

The Seller can reduce the amount of tax they pay on the sale. When the
Seller ‘takes back paper’ at the sale, that part of the equity of the
house is not counted towards their capital gain. As payments come in over
time, the principal received in each tax period is considered a capital
gain for that tax period. Since our note is interest only payments, the
$100K capital gain will be deferred for 15 years. This means that a
seller can lower the tax they would need to pay for the house sale – both
immediately and possibly as a total over time.

The seller gains an income stream from the note. For the next 15 years,
the Seller will have $500 each month to spend – minus ordinary income tax
(which will depend on the Sellers financial situation). The Seller
actually makes more money for the sale of the house. The total amount
this Seller earns is $150K + 15 years * $6000/yr = $240K.

As an investor Seller, this kind of financing can help you stabilize your
income stream and result in better returns on your initial investment.
Also, by offering seller financing, you may be able to demand a higher
sales price at the time of the sale.

Seller – The Bad:

The Seller is still ‘attached’ to the house for the length of time that
the note is collateralized by the house. This can be bad if the quality
of the house is suspect, or the neighborhood value is declining – as the
house decays or the defects are discovered, the security for the note
(the house) looses value. This can be countered by requiring a larger
down payment, charging a higher interest rate or doing more qualifying of
the Buyer. For example, a Buyer who lives in the property is generally
more likely to maintain or improve the property while a non-occupying
Buyer may not have the same incentive to maintain the property (and the
renter likely has no incentive at all).

The Seller may not receive payments on time. Ultimately, the Seller can
solve this by foreclosing – which is a process defined by the area where
the house is located. For example, in Washington the foreclosure process
takes about 4 months while in Oklahoma it averages about 7 months. During
this time, the Seller will not receive payments and the house may be
vacant or damaged. Again, the Seller can mitigate some of these risks by
requiring larger down payments or charging higher interest rates. In our
example, the $50K down payment can mitigate some losses. For instance, if
the payments stop and it takes a year to foreclose, the Seller will have
lost out on $6K worth of payments. Since the foreclosure process is not
free, let’s assume $10K cost (remember that the cost will depend on the
location of the property). This means that the Seller still has $34K in
cash and now can resell the property. If the Seller can sell the house
for more than $116K, then the Seller is still ahead (remember to also add
the amount of payments that were received prior to the foreclosure).

As a rehabber, I feel that investor sellers can also mitigate the quality
/ damage issues more easily than a homeowner. Part of a rehabber’s job is
to manage the quality and costs of repairs and to focus our buying in
areas of town that are more likely to appreciate.

Buyer – The Good:

It can be easier for a Buyer to qualify for the loan. Mostly because the
lender has already qualified the property – the lender/seller agrees on
the current value of the property and they have some history with the
property’s quality. Additionally, many Sellers do not require as much
documentation as an institutional lender would require to qualify the
Buyer. Institutional lenders have a process that they use to qualify
Buyers – this process is supposed to reduce the risk to the lender (the
current economic situation was caused by a loosening of this process).
Most sellers who do Seller Financing don’t have a process but instead do
just enough to feel comfortable with the Buyer’s promise to pay.

Seller Financing can reduce the amount of money needed to buy a property.
Some financing situations can result in zero down payment. For example,
in a ’subject to’ purchase, the seller may loan you all of their equity.
For example, the seller may owe $100K on a house that is in disrepair.
This house may require $20K of repairs and when fixed up may be worth
$200K. A deal could be crafted for a total of $120K where the Buyer takes
over payments on the $100K and owes the Seller $20K (to be paid when the
Buyer completes repairs and refinances or sells the house).

Seller Financing allows an investor to buy a wider range of properties.
An institutional lender may not qualify a property if it is in need of
some serious rehab work. As an investor Buyer, this means that I may not
be able to get a bank to lend me the money needed to buy the property
(they may be more accommodating for construction loans, but there are
limitations there as well).

Seller Financing allows an investor to hold more properties. Currently,
institutional lenders limit the number of loans that a Buyer may have in
their name. As an investor Buyer, this limits the number of properties
you can own at any one time. The current limit is actually 10, but the
qualifying process for more than 4 loans is very difficult – making a
practical limit of 4 loans. Most Sellers don’t have similar limitations
and Seller financing often does not show on a credit report, so this can
be a nice way to avoid this limitation.

Buyer – The Bad:

It can be difficult to find a Seller that is willing to accept Seller
Financing. The most common objection I hear is that they just want to
cash out. When I dig deeper, often the resistance comes from not really
understanding the good and bad aspects (Why did I write this article?!).

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About The Author
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