All Forum Posts by: Jay Koch

Raymond,

I have a colleague who in Denver, but is not a Bigger Pockets member. He said he would help you with those documents.

Contact me via e-mail (you should be able to find it in my profile), or accept my colleague request and I will give you his contact information.

Have fun...

jay

Mike,

I took a couple of days to get back to you because I have been preparing my web site for my first free teleseminar this coming Wednesday evening (2/4/09) at 6:00 PM Mountain time, and now it is ready.

[SOLICITATION REMOVED]

Some time this week, I would like to contact you about recording a case study about one of your owner financed deals. May I do that?

Have fun...

jay

When a seller carries a note on a property, and there is an existing mortgage the parties have entered into a transaction referred to as "wrapping" the existing mortgage. The buyer agrees to pay the seller in monthly installments, and the seller pays the underlying mortgage out of the proceeds of the buyer's payments. However, should the buyer miss or is delinquent in a payment to the seller, the seller is still obligated for the payment to the underlying mortgage since the seller holds the buyer harmless from the mortgage obligations. The seller’s failure to insure the underlying payment is made in a timely manner will affect his credit score, not that of the buyer.

There are a several legal instruments used for wrapping an existing mortgage. They are similar, but not congruent, and their flavor varies from state to state. These instruments are called "Land Contracts", "Contracts for Deed", "Note and Deed of Trust", or "Real Estate Contract." Check with your attorney (you are using an attorney, aren't you?) about the instrument that is customary in your state.

Here in New Mexico, we often use a Real Estate Contract. An REC or a Memorandum of REC is recorded giving equitable title to the buyer, but no deed is recorded until the contract is paid in full. The seller remains as the title holder.

Usually RECs are serviced by an escrow agent. In New Mexico servicing the contract is called "escrow," but in other states it is "account servicing" or even "contract collections." When the title company closes the transaction, (you are using a title company, aren't you?), two deeds are created to be held by the escrow agent for the benefit of the buyer and seller. A Warranty Deed is given to the buyer when the contract is paid off. A Special Warranty Deed is released to the seller if the buyer defaults. This is how the seller gets the property back.

Let's suppose that Sam Seller is selling his house for $100,000. Billy Buyer has $20,000 to put down, but since his credit is bruised, it's hard for him to get a regular mortgage. Sam's existing mortgage is just under $60,000. He doesn't need all of the $40,000 in cash, so he agrees to carry a contract in the amount of $80,000. (We'll ignore closing costs and broker fees for this example) (You are using a broker, aren't you?)

For those of you keeping score at home with a calculator, we'll get precise on these numbers. Sam's existing mortgage of $59,426.02 at 7% at $498.98 per month has 17 years left on it. Here are three different ways to structure this deal.

1. Create one contract in the amount of $80,000.

The early negotiations had suggested a payment of $750 per month at 7.5% on the $80,000. The problem is that this note would pay out in less than 12 years, leaving a balance on the underlying mortgage. That would cause problems for every one involved.

Sam and Billy, with the broker's help, settle on a payment of $694.97 at 7.5% for 17 years, which matches the length of the mortgage. After the mortgage payment is made, Sam would pocket about 694.97 – 498.98 = 195.99.

2. Create two separate contracts

Another way to structure the deal is to create two separate contracts. The one in first position would exactly match the terms of the mortgage. This is called a "dollar for dollar" wrap. It would match the mortgage's balance, interest rate, and payment amount. The second contract would be the difference between the $80,000 and the mortgage balance.

This second contract, if it amortized at the same rate as the mortgage, would have a balance of $20,573.98. At 7.5% for 17 years, the payment would be $178.73 per month. Billy's total payment would be 498.98 + 178.73 = 677.71.

This situation is advantageous for Billy because he get's the same interest rate as on the mortgage for most of his payment.

3. Different terms on second contract

Sam only wants to collect payments for the next 5 years. So, on that second contract, he asks Billy for shorter terms.

For that $20,573.98 at 7.5% for 60 payments, the payment amount would be $412.26. If Billy can afford this payment, it would be great for him because in five years, his payment would go down to $498.98.

However, Billy doesn't think he can afford the higher payment right now. As a matter of fact, he would like as low a payment as possible. Sam says, OK, we'll do a 30 year amortization, but you will have to pay off the whole balance in five years. Billy thinks his credit will be better in five years and he'll be able to refinance, so he says OK. The payment would be 143.86, but the balance would still be $19,466.57 in five years. Billy gets a lower payment, but has the risk of having to come up with a large payoff in five years.

Jon,

Thanks for the correction. I knew that. I was just sloppy in that post.

jay

Jon,

Excellent questions. I was going to answer those questions in the above post, but it got too long.

Since I worked for a company that services contracts for 25 years here in New Mexico, I am most familiar with an instrument called a Real Estate Contract we use here. A Deed of Trust or Land Contract are both similar.

Using these instruments, title is transferred when the note is paid off. The servicing agent, or escrow agent, holds two deeds. The first is a Warranty Deed to be given to the buyer when the note is paid off. The second is a Special Warranty Deed given to the seller so that the seller gets clear title back in case the buyer defaults.

I do not have first hand experience with "subject to" transactions that I have been learning about recently. It seems with those transactions, the title is transferred to the buyer, but subject to the existing mortgage.

This process seems odd to me. What I don't understand is what happens if the buyer stops making the payments to mortgage company? The seller is on the hook for the mortgage, but what recourse does he have to get the property back ?

I hope that someone on this forum can enlighten me.

jay

I am starting a school in which I teach owner financing to real estate brokers.

I know that in each state everyone does it a little differently. Here in New Mexico, the most common instrument for a seller financed note is a Real Estate Contract. Sometimes there is a Deed of Trust. But, I'd like to know how it is done in your state.

What are the instruments and methods for owner financing you use where you live? I am looking for someone in each state whose contact information I can post on my web site.

Can you recommend a real estate attorney in your state who knows owner financing?

Can you provide me with a set of forms typically used in your state?

Reply here or contact me directly. There is contact informaion in my profile.

Have fun...

jay

I have been spending a lot of time reading blogs about owner financing of real estate transactions, and there seems to be myth out there that you can not do owner financing if the property is not free and clear. I’m here to bust that myth.

One common way to sell a property with an existing mortgage is the process of “wrapping†the mortgage. That is, the seller carries a note that is at least as large as the mortgage, and then uses the proceeds of the incoming payments to make his mortgage payment.

For example, let’s suppose the price of the house is $100,000, and the existing mortgage is $60,000. The payments on this mortgage are $500 per month. Billy Buyer tells Sam Seller that he only has $20,000 to put down. In addition, Billy has some bruised credit and my have a hard time qualifying for a regular mortgage. Sam is retiring and moving to a smaller place. If he received $20,000 from the transaction he would be OK.

Sam says to Billy, “Pay me the $20,000 down payment, and give me a note for $80,000 payable at $700 per month.†Sam will take the $700 payment, use it to make his mortgage payment and pocket $200 per month. Billy does not have to qualify for a mortgage, closing costs are lower, and he can move in a couple of weeks instead of a couple of months.

The $80,000 note wraps the $60,000 mortgage. The proceeds of the bigger note are used to pay the smaller debt.

That’s the big, simple concept. Of course, there are a lot more details to it than that, and that is a topic for another article. But there is one big thing to watch out for.

The mortgage company usually has the right to call the mortgage all due and payable on sale of the property.

This means that several months or years after the sale, if the mortgage company finds out that Billy has moved into the property it will ask Sam to pony up the entire $60,000 he owes. The mortgage company can’t ask Billy to pay up, since it lent the money to Sam. But if it forecloses on the house, Billy is out of a home and out all money he paid Sam.

Sounds scary, doesn’t it? It can be, but here’s the truth: it rarely happens. In today’s market, the mortgage company would rather have a performing mortgage, even if Sam is not living in the property, than an empty foreclosed house. I worked for a company that services thousands of wrapped contracts, and there was only one mortgage called due in the last fifteen years because of a wrap.

Now, if interest rates go back up, and the mortgage companies are in a stronger market, this may change. If interest rates go to 8%, 9%, 10%, or higher, Sam’s mortgage company is going to become more active in finding wrapped mortgages. They will not want to hang onto Sam’s lower interest rate loan, and will ask that it be re-financed.

So, wrapping a mortgage is relatively safe for now, but it may not always be so. The due on sale clause is the source of the myth that it is not possible to sell a property using seller financing with an existing mortgage. It is possible. It is not uncommon. It is not illegal. But there is some risk to it. You need to assess that risk.

As usual, check with your attorney and real estate broker before making any commitments. I strongly recommend that you do not do any real estate transactions with the counsel of professionals. I am neither an attorney nor a broker, so I can’t advise you.

Val,

I used to work for a large escrow company in Albuquerque. I wrote the computer programs to run the system, including the programs to pay the taxes and insurance. But, I never paid attention to whose name is on the tax bill.

What I do know for sure is that the escrow company will contact the county and ask that the bills are sent to them.

The biggest criterion for a note purchaser is the cash flow on the note. The buyer will check the value of the property, the seasoning, and the payment history, but the most important thing is the amount of cash coming in.

You don't mention the face value of the note, but let's assume it is $200K wrapping your $175K mortgage. If that mortgage has 28 years remaining at 6.5%, then the payment is around $1,130 per month. Using the same terms for the $200K note, the payment is just around $1,295. The net monthly income to you would be $165.

A note buyer would look at the $165 per month for 28 years as the cash flow. If the buyer has to get a 12% return on that note, he would pay you about $15,900 for that note. If he needs to get a 14% yield, it would be about $13,800.

One way to get more flexibility on selling your note is to create two notes. The first is a dollar-for-dollar wrap of the existing mortgage. The second would be for your equity. The first REC must have the same interest rate, term, and payment as the mortgage it wraps. The second can have different terms. For example, you might want to make it a 10 year note with a higher interest rate. The payment amount would be higher, which would mean it would be worth more to a note buyer.

If you have more details about this transaction that you don't want to share in a public forum, contact me privately. I can even tell you the best escrow company to use. (Of course it's the one I used to work for!)

Have fun...

jay

1. Not getting a big enough down payment

When structuring a deal, you need to be thinking of not only what will go right, but what might go wrong. You may think you are helping out the buyer when you finance 100% of the purchase price, but you are putting yourself at risk. If the buyer doesn’t have anything invested in the property, he has nothing to lose by stopping payments to you. Even if you get 10% down, it may not be enough. If the buyer stops making payments, you have to foreclose, AND the buyer trashes your place before he gets out, the amount of money you made on the down payment may be gone with legal fees and repairs before you even have time to think about it.

There is a reason that mortgage companies usually ask for 20% down and only finance 80%. Follow their lead.

2. Not checking out your buyer with proper underwriting

The time to worry about a loan and the borrower is before the loan is made.

Get to know your buyer as much as possible. Someone who has given you indications of being deceitful or unreliable is probably going to continue to be that way when working with you, even if credit scores and employment histories are impeccable. On the other hand, someone with good character with bruised credit just might be worth the risk.

Get permission from the buyer to check his credit report. Learn to read a credit report. Has the buyer been late on a lot of payments recently? Have there been any recent foreclosures or charge offs? Does he have the ability to pay? Are the ratios between his income and expenses similar to what a mortgage underwriter would expect?

3. Not using professionals to help complete your transaction

Use a lawyer to help you draft your documents. Use a title company to close your transaction. Use a real estate broker to negotiate the deal.

These professionals know all of the ins and outs of their profession. The money you spend on them will keep you safe and legal.

4. Not planning an exit strategy in case of changing circumstances

Suppose you sold a $100,000 piece of property with 5% down. Right now, you may be happy with taking a note for $800 per month for 20 years at 8% for your $95,000 note. But, what if you need some cash and need to sell your note? A note buyer would not want to buy a note with 95% Loan To Value. Or at least not without a steep discount.

A better strategy would be to create two notes, a first for $80,000 and a second for $15,000. You might even write the second with a faster amortization so that the buyer’s payment goes down in a few years when the second is paid off. An investor who would buy your note would be more willing to buy your $80,000 note than a $95,000 note.

5. Not maintaining accurate records of payments or hiring a servicing agent

Make sure that you keep track of every payment the buyer makes to you. Let the buyer know how much principal and interest is calculated for each payment. You don’t want the buyer telling you after ten years that the note is paid off, and you still think he owes $3,000.

A better solution is to use a company that services these notes. A disinterested third party will give confidence to both the buyer and the seller that the balance is correct. A servicing company will also collect 1/12 of the taxes and insurance each month, and make sure that both are paid on time. A servicing company will also report interest paid and received accurately to the IRS.

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Avoiding these five mistakes will help make sure your owner financed real estate transaction is safe and profitable.

You might try asking the sellers to carry the paper. Here in New Mexico, we use Real Estate Contracts. Other states of Deeds of Trust.

If a seller has less than prime property that he has to get rid of, it may be OK for him to accept a few hundred dollars per month instead of a lump sum of cash.