A Seller Financing Primer

I want to discuss some of the issues involved in seller financing.

We begin our discussion with the sales contract. It is important for sellers to realize that when they sign a contract to sell a property and agree to provide seller financing, they are, in effect, signing two contracts: one to sell real estate and one to provide financing.

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 in the sales contract. If they are not, the seller has no right to insist upon their inclusion in the final loan documents.

The TREC addendum for seller financing provides for a late fee of 5% of the amount past due for more than 10 days, and has options for requiring a “due on sale” provision as well as escrows for taxes and insurance. If an owner’s title insurance policy is provided, the TREC contract also requires the buyer to provide the seller with a mortgagee’s title insurance policy insuring the validity and priority of the mortgage securing the note received by the seller.

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.

As long as 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 decease in the value of the property, the risk that the seller will suffer a major loss from the loan increase 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 will have to sue the buyer, recover a judgment, and locate property which can be taken from the buyer to satisfy the judgment. As long as 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. Consequently, 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: one, a loss of economic value due to market conditions, such as we experienced in the mid 1980s or 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 more than 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 result in substantial loss of collateral value and greatly increase a seller’s risk. It is therefore extremely 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 is required to 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 the fact that there is a primary first lender whose lien is superior to the second lien retained by the seller. Consequently, 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 completely eliminated, by keeping the loan to value ratio conservative, making sure ad valorem taxes are paid prior to 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.