‘Carrying paper’ is risky

Published 9:00 pm Saturday, February 18, 2006

Question: I am planning to offer my home “For Sale by Owner” this spring. I will offer to finance the home on a deed of trust with a balloon payment. I am looking for income for my retirement. My house is in a very desirable location and will sell in the $600,000 range. I would expect to receive a 25 percent down payment and have a lawyer draw up an agreement for the payments. I would appreciate any advice you can offer if you were in my situation in regard to the negative aspects of carrying a contract on the house, such as foreclosure of the buyer. Also, are buyers attracted to this type of financing? Could I receive a higher interest rate than the mortgage lenders? What type of buyer would be interested in this kind of financing? How many years should the contract run?

L.B., Edmonds

Answer: Although mortgage interest rates have increased from the historically low rates of summer 2004, they remain very low and affordable for most homebuyers. Seller financing is very unusual is this kind of housing market, but under the right circumstances a seller contract may make sense for both the buyer and the seller.

First, here are some of the pros:

* Seller financing can make your home more marketable to a wider range of buyers. Even though interest rates are low, some homebuyers still have trouble qualifying for a loan from conventional mortgage lenders because they don’t meet the standard underwriting guidelines for income and/or credit. You would not want to offer seller financing to a buyer with bad credit, but some people who do not earn a steady paycheck (such as commissioned salespeople and self-employed business owners) can be a good loan risk even though they do not technically meet the lenders’ underwriting guidelines because of their fluctuating income. By opening your home to these potential buyers, you increase the chances of selling for a top price. Of course, if you are looking for a 25 percent down payment, it is unlikely that people with credit problems will have that much money available.

* You will not be able to get an interest rate higher than the current rates offered by mortgage lenders unless you sell your house to a buyer who cannot qualify for a conventional mortgage. But even if you offer an interest rate on your private note that is significantly lower than the rates being charged by conventional mortgage lenders, you will still earn a much higher rate of return on your money than you could receive in a bank savings account.

* You are in complete control of the financing process. Your home sale cannot be killed by a mortgage underwriter nitpicking the buyer’s loan application.

Now, some of the cons:

* The buyers may not make their payments. As you pointed out in your letter, you will then have to foreclose on the note and take back your home. This can be a time-consuming and expensive process, and you have to worry about the buyers trashing your house in revenge for the foreclosure. If the buyers declare bankruptcy, the foreclosure process is stretched out even longer.

* The buyers may make their payments, but on an irregular basis. You will never be able to count on the check showing up in the mail and you’ll constantly be on edge as to whether you should foreclose on the loan.

* The buyers burn the house down and you discover that they never bothered to purchase homeowner’s insurance. You’re left with nothing – no contract payments and no house to take back. Of course, you could prevent this problem by requiring the buyers to let you make the homeowner’s insurance and property tax payments to make sure they are paid on time. You could collect a twelfth of the annual cost of these expenses with each monthly loan payment, just as mortgage lenders do with their “impound accounts.”

The lists could go on, but the bottom line is you must weigh the benefit of extra income against the risk of nonpayment and property damage. Remember that when you carry a contract, you are essentially becoming a private bank, so you should handle the transaction the same way that a banker would. Run a complete credit check on the buyers to make sure they have a history of paying their bills on time. Also, check with their employers to verify their income. As you suggested in your letter, require a large down payment so the buyers have something to lose if they fail to make their payments and walk away from the house.

You asked what kind of buyers are attracted to seller financing. That depends on the terms you offer. If you offer a long-term, below-market rate loan, you’ll have buyers beating a path to your door. But if you want to charge more than conventional mortgage lenders, you’ll limit your market to buyers who either can’t qualify for a conventional loan or don’t want to jump through all the hoops required by mortgage lenders.

By definition, these buyers are riskier than borrowers who can qualify for a conventional mortgage. When you’re selling a home in the $600,000 price range, you’re probably going to be dealing with buyers who are financially sophisticated. If you don’t offer rates that are as least as attractive as those available through a conventional mortgage lender, you will not attract a quality buyer.

As for the length of the contract, that depends on your financial needs and goals. Don’t make the balloon period too short. As a homebuyer, I wouldn’t want a balloon period of less than five to seven years. If you are counting on the contract to provide long-term retirement income, be sure to include a very strict prepayment penalty clause in the note to prevent an early payoff.

A common trick used by unscrupulous real estate investors is to convince a seller to take a lower sales price for their home in exchange for a high interest rate on the private contract. They emphasize the amount of money the seller will earn over the years from the fat interest rate, but without a prepayment penalty, there is no guarantee the income stream will continue. Shortly after the deal closes, the investors could refinance with a lower-rate conventional mortgage and cash the seller out. The interest income is gone, and so is the house.

Carrying paper can be a good investment if you are a sophisticated real estate investor. But I don’t think it’s a good idea for the average home seller unless you have no other choice. With mortgage rates so low, and many loan programs that allow homebuyers to purchase a home with little or no down payment, there is really no reason to offer seller financing as an incentive to attract buyers.

The income potential beats bank savings accounts, but you are assuming a lot more risk. You have to decide if the added income is worth the additional risk. Frankly, I think most people are better off selling for cash at the best price they can get and letting the bank worry about collecting the monthly payments. If you want to earn a higher return on your money, consider a bond or stock mutual fund.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box 930, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com.