Financing for residential purchases including seller financing and unlicensed third-party lenders has been substantially affected by the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly called the “Dodd-Frank Act”. Click here for a discussion of the impact of the Dodd-Frank Act.
This article addresses some of the practical aspects of seller financing other than the Dodd-Frank Act.
We begin our discussion with the sales contract. When a seller signs a sales contract and agrees to provide financing, the contract obligates the seller in two ways: one, it establishes the terms of the sale of the property; and two, it also establishes the terms of the financing provided by the seller.
Any terms a seller wants to include in the seller financing documents must be specified in the sales contract. For instance, if the seller wants a late payment penalty, a “due on sale” provision (a due on sale provision gives a note holder the right to call the loan due if the collateral is sold without the consent of the note holder), or an escrow account for taxes and insurance, they have to be contracted for these terms in the sales contract. If the right to require these terms is not in the contract, the seller has no right to insist upon their inclusion in the loan documents.
The Texas Real Estate Commission (TREC) has promulgated sales contracts which most real estate sales professionals use. The TREC addendum for seller financing provides for a late fee of 5% of the amount over 10 days past due and has options for requiring a “due on sale” provision and escrows for taxes and insurance. Any other terms required by the seller must be inserted into the sales contract or financing addendum.
The most common question asked by sellers is whether a loan to a buyer of their property is “safe”. That is difficult to answer. What seems safe to me might not seem so safe to you. Perhaps the best way to address the issue is to say that hundreds of very conservative banks and other commercial lenders make thousands of real estate loans every day. If the loan is properly documented, the risks to any lender, including a seller, are very manageable. To make the loan as safe as possible, Sellers need to understand the risks and how to minimize those risks.
To properly document a loan, a seller will need to have a promissory note and a deed of trust (a mortgage) prepared to create a lien against the property being sold. The property sold will be the collateral for the loan and, upon default by the buyer, the property is subject to foreclosure by the seller.
If a seller retains a lien against the property sold as collateral and the value of the collateral is equal to or greater than the unpaid balance of the seller’s note, the risk to the seller is minimal. If the seller loses his lien against the property or if there is a decrease in the value of the property, the risk that the seller will suffer a major loss from the loan increases dramatically. Loss of a lien or a decrease in collateral value does not mean that a seller will suffer loss; only that the chance of loss is substantially higher. Even without a lien, the debt of the buyer to the seller is still there. But with no collateral, to collect the debt, a seller must sue the buyer, recover a judgment, and locate property which can be taken from the buyer to satisfy the judgment. If the seller’s lien is in place and the value of the collateral is greater than the note balance, the seller can foreclose his liens, regain title to the collateral, and resell the property.
If the seller’s note is secured by a valid first lien against the property, the primary way the seller can lose his lien is to allow ad valorem taxes to go unpaid resulting in a tax sale of the property. A tax sale, even if taxes accrued after the date of a seller’s loan, can terminate the lien securing the seller’s note. It is very important for a seller who provides financing to monitor ad valorem taxes to make certain they are paid. The TREC Seller Financing Addendum has two options concerning ad valorem taxes. The seller can require the buyer to provide annual evidence that taxes have been paid or the seller can require that the buyer make monthly deposits with the seller to allow the seller to accumulate funds to pay the taxes when they are due.
Loss of value of the collateral can also increase the risk to the seller providing financing. There are two primary ways to lose collateral value: (i) a loss of economic value due to market conditions, such as we experienced in the mid-1980s; or (ii) an uninsured casualty.
A seller’s primary defense against falling property values is to keep the loan to value ratio conservative. If a seller loans only 80% of the value of the property, the seller will not suffer increased risk of loss unless the value of the collateral deceases by over 20%. With a loan of 100% of the purchase price, any drop in value increases the risk of loss to the seller.
A major casualty with no insurance coverage can cause substantial loss of collateral value and greatly increase a seller’s risk. It is therefore important for a seller to monitor insurance on the collateral property to make certain that the seller is listed as a mortgagee and that insurance coverage is not allowed to lapse.
If a seller is listed as a mortgagee on an insurance policy, the insurance company must give the seller notice before terminating a policy. The loan documents will give the seller the right to secure insurance on the property and charge the cost back to the buyer.
If a seller agrees to provide secondary financing and accept a note from the seller secured by a second lien, the risk to the seller is greater. The increased risk results from there being a primary first lender whose lien is superior to the second lien retained by the seller. In addition to risks associated with a first lien, the seller assumes the risk that the note secured by a superior lien will be paid. If it is not and the first lender forecloses, the seller will lose the collateral and be left with an unsecured note.
To summarize, the risks of providing financing secured by a first lien are very manageable. The risks can be greatly reduced, but never eliminated, by keeping the loan to value ratio conservative, making sure ad valorem taxes are paid before delinquency, and monitoring insurance to make sure there is no lapse of coverage. If second lien financing is provided, the risks are greater to a seller because of the potential loss of collateral if the note secured by a superior lien is not paid when due.