01/26/09: Taking Back Title: A Good Idea If Done Right
By Benny L. Kass
Q: I have a rental house. After 25 years I am tired of being a landlord and am thinking of selling and carrying back the loan. Where can I get more information on what's involved?
A: Taking back financing carries some risk, but in today's economic market, it can be a very valuable selling tool.
It is said that we are now in a buyer's market. Prices have been reduced in many areas, and mortgage interest rates are at an all-time low. But mortgage lenders have significantly tightened up their requirements, and many potential home buyers are just not able to get a favorable loan - or any loan at all. Nowadays, you need excellent credit in order to get a good loan.
If you sell your property and agree to take back a mortgage, you are the bank. You want to make absolutely sure that your buyer - who will also be your borrower - has the ability to repay the mortgage both on a monthly basis and finally when the balance comes due.
In order to take back financing, your house should be free and clear of any debt - whether it is an existing mortgage or some kind of tax lien. While it is possible to do the sale with an existing mortgage, (using what is known as a "wrap-around mortgage") this is more complicated and not the subject of today's column.
Let's take this example and walk you through the process. You have found a buyer for your house, who is prepared to pay you $500,000. However, he tells you that he recently came out of bankruptcy and is unable to get a mortgage loan from a commercial lender.
- contract : the very first thing you need to do is enter into a real estate contract, which will spell out all of the terms and conditions - including information about the seller take-back loan. If you are using a real estate agent to assist you, the agent can prepare the contract. If not, you should have your attorney draft the contract.
- down payment : do not, under any circumstances, agree to lend your buyer the full amount of the sales price. That is an open invitation for buyers to just walk away should they get into financial difficulties, since they will consider themselves tenants, instead of owners. "No money down" loans were one of the major factors that caused our current housing problems.
There is no magic formula on how much money should be given as a down payment. Clearly, the larger the payment, you risk diminishes. Ideally, your buyer should put down at least 20-25 percent of the purchase price (in our example at least $100,000).
But this does not always work, since buyers often do not have this kind of money. So if you are satisfied that your buyer has a good job, and presents himself as a person who will maintain your property, you can take a lower down payment - but in my opinion, never less than at least 10 percent ($50,000 in our example).
- interest rate : this is something that should be negotiated between the parties. However, the rate should be comparable to what is commercially available. You can get information on rates by searching the internet, or calling a couple of mortgage lenders.
- amortization: the dictionary defines this as: "to pay off (as a mortgage) gradually usually by periodic payments of principal and interest". Amortization tables are available from your local bookseller, or on the internet. This will show the monthly payment that is required in order to completely pay off the loan in the number of years that is agreed upon. Typical amortization ranges between 15 and 30 years, but recently I have even seen 40 year payoffs. The longer the term of the loan, the lower the monthly payment. But if the borrower keeps the loan for the entire term, he will be paying you a lot more interest.
- term: this is also negotiable. Your buyer wants as long a term as possible, while you want all of your money now. There is a compromise, called a "balloon payment". Let's say that you agree on a 40-year amortization. If you will be lending $450,000, at 5.5 percent interest, the monthly payment will be $2320.99 (compare this to a 30 year note, where the payment is $2555.06).
Under a balloon payment approach, notwithstanding the 40-year amortization schedule, the entire loan will become due (i.e. balloon) in a shorter period of time. This is also negotiable; there is no legal requirement as to how many years you can agree upon. Typically, balloon notes come due in 3, 5 or 7 years from the initial date of the loan.
- taxes and insurance: ideally, you can require that your borrower pay you, on a monthly basis, one twelfth of the yearly real estate taxes and insurance, and then you make arrangements to make these payments. However, this involves bookkeeping and check writing issues for you.
You should insist that your borrower obtain adequate hazard insurance, naming you as the beneficiary on the policy. Additionally, once a year (or twice in the District of Columbia or in other jurisdictions where taxes are paid semi-annually) your borrower must give you proof in writing that he has paid the appropriate real estate tax as well as the annual insurance premium.
- credit check: you want to satisfy yourself that your potential borrower is credit worthy. Accordingly, you should call his employer to verify employment, get copies of his last three bank statements, and obtain a credit check. If may be difficult for you to do a credit search on a third party, but your borrower can obtain a credit report free. He should be required to provide that information to you. Your real estate contract must be contingent on your satisfactory approval, in your sole discretion, of his financial ability to pay.
Once all of the details have been work out, you will need a deed of trust (the mortgage document) and a promissory note. If you haven't already hired a lawyer to assist you, now is the time to do it. Let the attorney handle all of the remaining details - drafting the legal documents, settlement and recording.
It is not complicated, but it is your house and your money. You have to do this right to preserve the equity in the property you have built up over the years.