By Caleb Hanson and Paul Vachon – 10/10/2022

Buyers and sellers in the real estate market are looking for new options since interest rates on traditional, institutional loans have more than doubled in the past few months, causing the average buyer’s monthly principal and interest payment to rise by 50% in some cases. Many have begun exploring creative financing, which can create wins on both sides by helping sellers maximize their sale prices and helping buyers obtain a lower interest rate, lower cash to close, or other favorable terms not available with traditional financing options.

Before diving into creative financing strategies that don’t involve traditional lenders, here are a few ways to think more creatively about traditional loans. Most lenders offer an option to pay a fee up front to get a lower interest rate, and paying a larger fee can lower the interest rate even more. Lenders typically call this option “buying down the rate” or “paying discount points” because the fee is usually described as a percentage of the buyer’s loan amount. Sometimes, buying down the rate will lower the monthly payment more than if the buyer applied that same money toward the down payment. Also, in the current market, more sellers are willing to pay some of a buyer’s closing costs than before, including the discount points to buy down the rate. Seller contributions to a buyer’s closing costs are often called “seller credit toward the buyer’s closing costs.“ To create a win-win, some buyers and sellers choose to increase the purchase price by the amount of the seller credit toward the buyer’s closing costs or enough to cover the credit and net the seller some extra. This works especially well right now when appraised value tends to exceed what buyers can currently afford.

Traditionally, a buyer and seller agree on price and terms, and the real-estate transaction is financed through a bank. However, since rising interest rates are raising monthly payments so much, many prospective homebuyers struggle to qualify for conventional and federally-backed loans. This shift increases negotiating power for buyers while decreasing negotiation power for sellers because there is less competition between buyers. This changing tide in the market priorities and expectations makes space for more creative ways of closing deals that don’t require the buyer to get a traditional bank loan or mortgage. Some popular forms of creative financing that solve many issues that arise in today’s market are seller financing and subject to financing.

Seller Financing

Seller financing, also known as owner financing, provides an opportunity for the seller to take the place of a bank by reducing their cash proceeds at closing and taking a promissory note instead. The promissory note defines the amount of the seller loan, the interest rate, the payment schedule, and when the loan must be repaid in full. Because there’s no bank involved, the buyer and seller can define the terms of the loan, which can create wins for both of them.

Advantages of Seller Financing

In today’s market where traditional loans come with hefty interest rates, seller financing gives a seller the opportunity to beat the bank on interest rates and achieve a higher price for the seller and a lower payment for the buyer. Seller financing can also offer flexible terms that are difficult to achieve with traditional loans. For example, a seller might agree to receive very little proceeds initially but increase the monthly payment, allowing the buyer to spread out the down payment. Seller financing also supports a fast closing; because there is no outside approval required, the buyer and seller can close and put the seller loan in place as soon as both parties are ready. Additionally, seller financing can help address concerns about capital gains tax by spreading out the gain over multiple tax years. In many cases, the gain is recognized when the money is received, so receiving the payments on the seller loan over time can reduce the tax burden compared to getting all the proceeds at once. We suggest you talk with a tax advisor about the details on this.

Disadvantages of Seller Financing

Seller financing has some challenges for buyers and sellers. For sellers, their capital can’t be used for anything else during the loan period because they have not received it from the buyer yet. Also, if the buyer/borrower doesn’t pay on the loan as agreed, the seller may have to foreclose. The foreclosure process might get the seller their money, or it could end with the seller owning the property again. Thoroughly vetting the buyer/borrower’s income, assets, credit history, and character helps reduce the risk of non-payment, but medical emergencies and other financial calamities can prevent even responsible people from making their loan payments.

For buyers, seller financing can create uncertainty about the future because sellers don’t normally keep their money on loan for more than five years, and they commonly want the loan repaid in three years or less. Because the monthly payments on seller loans don’t typically pay down the entire loan balance by the end of the loan period, the buyer will often have a large balloon payment at the end for the remaining unpaid balance. When the seller loan is due, the buyer/borrower has a few options.

1. Pay the remaining balance in cash.
2. Sell the property and pay the unpaid balance.
3. Get a new loan that is at least big enough to pay the unpaid balance on the seller loan (refinance).
4. Renegotiate terms with the seller/lender.

If the buyer cannot accomplish one of these four outcomes, the seller could initiate foreclosure. Buyers can manage the risk in a few ways.

1. Stay in conversation with a traditional lender about what it will take to qualify for a long-term loan to replace the seller loan.
2. Complete some do-it-yourself improvements to increase the value and thus your odds of being able to sell for more than the loan balance if needed.
3. Always pay on time so that the seller will be more open to extending the loan if needed.
4. Work hard on personal and professional development to support better employment and income options.
5. Stay cautious about taking on other debts that could decrease borrowing power on a traditional loan.

Subject to Financing

Subject to financing allows a seller with a favorable, existing mortgage to make the purchase more affordable for a buyer by keeping the existing mortgage in place but assigning financial responsibility for the remaining balance and monthly payments to the buyer. The phrase “subject to” means “conditioned upon” or “depending upon” something, and purchasing real estate with “subject to financing” means the deal depends on keeping the seller’s existing loan in place. In that sense, “subject to financing” is a shorthand way of saying the buyer’s purchase is subject to the buyer being able to take over the seller’s existing loan on its existing terms.

In practice, the seller stays legally responsible to the existing lender, and as part of the deal, the buyer and seller create an agreement that makes the buyer legally responsible to the seller for making the loan payments.

Advantages of Subject to Financing

A buyer might find this attractive because it generally avoids lender origination fees. It can also reduce the total cash a buyer needs for a purchase. Inheriting the lower interest rate on the existing loan can make the payment more affordable compared to getting a new loan. Sometimes buying subject to the seller’s loan can also allow closing faster than getting a new loan.

A seller might find this attractive if buyers using traditional loans cannot afford a price high enough for that seller to still make some money after paying off the existing loan and paying the costs of the sale (commissions, title fees, escrow fees, etc.). The phrases “upside down” or “under water” describe owners in this kind of situation. Subject to financing can make it possible for a buyer to afford a price high enough to net the seller some money at closing by passing on the lower interest rate of the seller’s existing loan. Subject to financing can also help upside down sellers who know they can’t afford to keep making the loan payments and need a way to exit while keeping their credit history untarnished.

Disadvantages to Subject to Financing

There are a couple major concerns when considering subject to financing. First, the bank may execute a “due-on-sale” clause, and second, the unpaid balance of the existing loan still shows up on the seller’s credit report after the sale closes.

A due-on-sale clause typically appears in the promissory note but can also be part of other loan documents, and it stipulates that the full balance of the loan may be called due upon the sale or transfer of ownership of the property used to secure the loan. Since ownership is transferred in this form of financing, the bank may demand full payment of the loan. This creates risk for the seller because the seller is still legally responsible for the loan. The seller should always call the company who collects the loan payments to ask about their lender’s position on subject to financing. Some lenders will stay happy as long as they continue being paid on time, and knowing the lender’s policy is the best way to manage the risk of a due-on-sale clause.

Here are a few less-common strategies to manage that risk.

1. Due-On-Sale Clause Insurance
   Due-on-sale insurance protects the buyer and seller if the bank calls for immediate payment of the loan. The insurance provider will pay off the debt and then seller finance back the home to the buyer. The cost of due-on-sale insurance is typically about 1% of the purchase price of the home.
2. Agreement for Sale or Land Contract
   In this case, ownership rights transfer to the buyer, but the seller retains title (legal ownership).
3. Lease with Purchase Option
   The buyer could deed the property back to the seller and purchase it again on a lease option with the option price being the mortgage balance at the end of the term of the existing loan. Since the buyer doesn’t become the owner until the purchase is completed, the buyer wouldn’t get the tax benefits of ownership during the leasing period.

The second most common concern for a seller when considering subject to financing is the mortgage showing as an unpaid balance on their credit history. The unpaid balance will count towards the seller’s debt-to-income ratio and could restrict their ability to acquire credit in the future. To address this, a seller who has sold using subject to financing could provide the documentation of the new owner making the monthly payments to show that the seller is no longer the one paying off the debt. This is often enough evidence for a new lender to ignore all or a portion of that debt when deciding whether or not to grant a new loan to the seller. Lenders will commonly allow the seller to take 75% of the loan payment out of their debt-to-income ratio in the first 12 months of the subject to loan and then 100% thereafter.

As always, we are here to help you understand your options so that you can move with confidence to the best home for your best life. If you’re curious what’s possible for you in today’s market, contact us today.