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How Dodd Frank Law Changes Seller Financing for Investors

by Ken Corsini on January 17, 2014 · 28 comments

  
Frank Dodd

I was actually in the process of negotiating a seller finance with one of my tenants and was halted in my tracks. I was reminded that the new Dodd Frank legislation went into full effect on January 10th of this year and will have a huge impact on investors who use seller financing as an exit strategy. While much of the Dodd Frank discussion has been centered around more stringent debt to income requirements for conventional borrowers, I thought it would be helpful to discuss new guidelines surrounding seller financing.

While the seller financing portion of the 900 page Dodd Frank bill is a relatively small fraction of the legislation, it has huge implications for many investors around the country. For many investors, using short-term seller financing plays a major role in their investment business. Going forward, most of these investors will have to re-think how to structure these types of deals (if at all).

At a high level, the new rules break down sellers into 3 distinct buckets:

1.) Individuals and Trusts that seller finance one property or less per year (to an owner occupant)
2.) Individuals and Trusts that seller finance one to three properties per year (to owner occupants) AND and LLC, partnership or Corporation that seller finances less than three properties per year (to owner occupants)
3.) Basically any person or entity that seller finances more than three properties per year (to owner occupants)

As a point of clarification, these rules apply when seller financing to an owner occupant. This is not the same as lending on a commercial property or to another investor who does not intend to occupy the property.

1.) INDIVIDUALS/TRUSTS – ONE PER YEAR

Under this bucket, the following rules are worth noting:
*The Note can contain a balloon (A balloon payment mortgage is a mortgage which does not fully amortize over the term of the note, thus leaving a balance due at maturity.)
*Seller does not have to prove borrowers “ability to pay” (for more information on what this actually means – http://www.dodd-frank-act.us/Dodd_Frank_Act_Text_Section_1411.html)
* Interest rate must be based on index (ex. prime, T-bill, etc) and must be fixed for first 5 years. After 5 years, the rate can only adjust 2 points per year to a max of 6 points above original interest rate.

2.) INDIVIDUALS/TRUSTS – ONE TO THREE and BUSINESS ENTITIES LESS THAN THREE

Under this bucket, the following rules are worth noting:
* The Note cannot contain a balloon payment (this is big deal for investors who typically don’t want to hold a note over the entire amortization schedule)
* Seller does have to prove borrowers “ability to pay”
* Interest rate must be based on index (ex. prime, T-bill, etc) and must be fixed for first 5 years. After 5 years, the rate can only adjust 2 points per year to a max of 6 points above original interest rate.

3.) ALL ENTITIES MORE THAN THREE PER YEAR

For any individuals or entities that make more than 3 loans per year, the new law requires that a Mortgage Loan Originator be involved to complete the transaction. Loan requiremenst are the same as bucket 2 (ie. no balloon payments, prove ability to pay, interest rate restriction)

There you have it – probably clear as mud. This is by no means a comprehensive look at the new law, but probably the most pertinent guidelines for investors who use seller financing.

My advice would be to find a good attorney to help write the note on your first deal under this new law …. and for those investors who do more than three a year, I’d find a good MLO (mortgage loan originator) to help oversee your deals.

Related: How the Dodd Frank Act Will Impact Your Real Estate Business

Photo: Jenni C

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{ 28 comments… read them below or add one }

John Thedford January 17, 2014 at 6:33 am

Thanks for some clarification. Dodd-Frank more than likely will hurt the mortgage market.

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Martin January 17, 2014 at 6:42 am
Martin Cortez January 17, 2014 at 8:09 am

I think the biggest deal killer in this bill is the interest rate restrictions. Even if you jump through all the hoops, you would probably wind up with a very small cash flow if any.

I suppose this strategy might work for investors who intend to keep the note long term and begin to see some modest returns after year 5.

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Andrew January 17, 2014 at 8:55 am

Is there any issue with conflict of interest if the seller is a licensed mortgage originator for bucket 3?

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Dennis January 17, 2014 at 9:18 am

Just another example of government legislating in order to prevent the future from happening.
Next will be a bill to correct the issues Dodd Frank creates. Now who wants to lend money at a low interest rates to buyers with no or bad credit?

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Susan Zwarych January 21, 2014 at 11:05 am

Because that’s what the world needs, more government intervention in EVERYTHING. They run everything they already do so well, so why not get involved in everything else they don’t already have their hands in…?

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Yu January 17, 2014 at 11:32 am

“As a point of clarification, these rules apply when seller financing to an owner occupant.”

So if you are buying an investment property and have the seller carry back the financing, you are not affected.

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Brian Gibbons January 18, 2014 at 3:36 pm

Hi Ken:

Wow, that article gives me an article! Poor Note Creators!

IMHO, If you send all owner financed buyers through a RMLO you should be fine. Learning the ATR (ability to repay) rules would be prudent.

I think an opportunity lies with real estate investors willing to buy on sub2 and sell on seller financing if they manage the risks.

Also, agents should look at assisting home sellers that have little equity or home buyers that just miss financing to consider seller financing, with the ATR taken into consideration.

ATR pdf from cfpb

http://files.consumerfinance.gov/f/201301_cfpb_ability-to-repay-summary.pdf

Tools that real estate investors could consider:

Buy on sub2, cfd, wrap – AITD, owner financing (DOS issues to navigate)

Buy on Lease Option and Assign

Sell on a Lease and a Pure Option (no Dodd frank); no rent credits, no financing option.

Food for thought: there are 20 million houses that have little equity to no equity to upside down, these sellers need creative solutions.

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Tracy February 21, 2014 at 9:32 pm

Thanks @BrianGibbons and Yu, this answered questions that popped into my mind immediately.

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Doug Roberts January 19, 2014 at 11:04 am

I hope to see an increase in sellers wholesaling their notes as a result of the new balloon restrictions.

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Jeff Rabinowitz January 19, 2014 at 12:03 pm

Doug, if you purchase a note that was originated improperly the borrower’s remedies may be visited upon you. Also, if an originator sells a note that was originated improperly he may still be held liable for the borrower’s remedies. Tread carefully.

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Jeff Rabinowitz January 19, 2014 at 11:58 am

Ken, I am not an expert on Dodd-Frankenstein. I attended a seminar where the speaker noted the law states a 60 month minimum before a balloon could be due. It would seem 60 months and 5 years is the same but it may be safer to have the balloon due at 61 months as it could be a violation if it is due in 60 months. I expect there will be no shortage of borrowers suing note originators as the law actually creates a body that teaches borrowers how to sue if they think their lender has not complied.

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John Thedford January 19, 2014 at 4:14 pm

Ken: a question for you. Are notes generated before 1/10/14 grandfathered in?

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Ted Fall January 19, 2014 at 5:33 pm

Great article Ken, informative and concise.
Does Dodd Frank apply to an investor buying a property as an investment too? In other words If I were to buy a property financed by the seller will they have to have the 60 months terms indicated on the note? Is there any penalty that the government is imposing if the buyer finances out of the note early with conventional financing?
Does D-F apply to restructuring non performing notes too?

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Stephen Watkins January 20, 2014 at 1:45 pm

* Interest rate must be based on index (ex. prime, T-bill, etc) and must be fixed for first 5 years. After 5 years, the rate can only adjust 2 points per year to a max of 6 points above original interest rate.

So is this to be read as interest rate must BE that of the index chosen or could it be index + 2% (or whatever you choose) fixed for 5 years?

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Brian Gibbons January 20, 2014 at 4:10 pm

Here is a complete explination from the Note Industry.

http://papersourceonline.com/5040/dodd-frank-note-business-explained/

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Mike January 21, 2014 at 4:25 am

We can’t be having the free market compete against the banks now can we. That is what it boils down to.

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Curt January 21, 2014 at 10:53 am

Hi Ken, Everyone is weighing in on Dodd Frank, DF so thanks for your piece. I’d like to add that there’s missing issues in this article. DF invents new terms: qualifying mortgage (QM), high expense mortgage and others and lender categories. You mentioned just the lender categories.
Other requirements: use of a Loan Servicer. You mentioned needing to use a Licensed Mortgage Loan Originator LMLO but a servicer.
What’s still unclear is filling in the matrix of: high expense mortgage and 1-3 per year from an entity. You state you have to “prove affordability”. My reading finds that DF has the same affordability test requirement for all classes of lender, 1 per year, 1-3 and above 3, just that required use of LMLO is for what combo: 1-3 and high cost, which is my understanding. Where in 1-2 and qualifying mortgage (QM) you still have to prove affordability but you aren’t required to use a LMLO. I think this is double talk. Why not just use a LMLO all the time is my view as an investor who does and will do owner financed loans DF compliantly. And a servicer and keep one’s life simple. A servicer just makes sense today, as does using a LMLO. But 3rd party appraisal?
My view is that few if any investor originated loans will be QM because we have to get higher interest rates than 1.5pts over floating prime or want balloons. I charge 9.5% the highest one can given 6.5% over prime. I realize that loan expense ratio, pts up front also affect the interest rate calc…
My reading also suspects, but it’s not clear, that loans CAN be over 6.5pts over floating prime BUT there’s some additional affordability requirements or a 3rd party appraisal required. IE the list of requirments at each lender volume level AND QM or non-QM or over 6.5pts is not clear in anyone’s synopsis of DF yet.
Again, my view of DF is that it’s not a single dimension (math term) set of requirements, it’s at least TWO dimensions: class of lender [1, 1-3, >3] VS [QM, high expense between 1.5pts and 6.5pts over prime, and >6.5pts over prime] varies your to do list, but not your basic affordability test requirements. DF I feel was right minded to have affordability at it’s core, but it sure is unclear what our minimum requirements are as the above 2 or more dimension matrix is not clearly spelled out in my view. This article just mentioned one dimension of the 2 or 3 that I feel exist. :)

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Greg January 21, 2014 at 10:38 pm

Hi Ken,

Great Topic!

So, does this have any effect on Lease Option Agreements? If they are still renting it until the day of closing, then it remains rental and not a sale. Unless the Agreement conveys consideration including interest rate or term length, it is not a sale. So does this still apply? If I am using this type of exit, I only do it in a Lease Option which my Lawyer and I worked out.

But I am curious, How are they going to enforce these rules? As a lot of CFD’s never get recorded, how do they discover the seller financing? and what are the consequences? (Not that I am going to undermind them, just want to know more.)

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Brian Gibbons January 22, 2014 at 8:45 am

These are good questions.

ATR is important in your business now. See http://bundlr.com/b/dodd-frank-atr

A straight lease and a pure option with out rent credits and not taking a note on option money is a good strategy for an exit. It may be a financing arrangement if other than that.

Go through an RMLO no matter what.

The note creators have the greatest challenge if they are doing a great volume, as are the mobile homes.

See http://papersourceonline.com/5040/dodd-frank-note-business-explained/

See http://www.biggerpockets.com/search?utf8=%E2%9C%93&term=Dodd+Frank

“All perceived problems are disguised as opportunities”

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Shaun January 26, 2014 at 3:23 pm

At the retail level this looks like a pure 1/1 and even 3/1 ARMs are now illegal?

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Paul Hunter Shippey February 2, 2014 at 7:19 pm

I had heard that if you sell to fellow investors (flip) that Dodd-Frank would Not apply. True or False?

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Frank March 18, 2014 at 5:25 pm

I understand the law to mean in regards to Seller carryback financing for an owner occupied property that there are NO BALLOON payments what so ever at any interest rate.

So even with Seller carryback financiing if it is a 5 year loan it has to be fully amortized for 5 years. You can’t have a 30 year amortization with a 5 year call regardless of the interest rate. That is my understanding.

Am I correct?

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Hakim tazerouti March 21, 2014 at 2:04 pm

Hi my attorney in SC said to me today that anybody in SC can owner fian 5 propertys/ year.
But a LLC can not owner fia not even 1.
Thats in sc.
Thank you.

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Brian Gibbons March 21, 2014 at 3:01 pm

Did you ask a RMLO that question? They know the fed law better than the avg attorney.

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Hakim tazerouti March 21, 2014 at 4:25 pm

Thank you so much Sir iwill ask him that on monday.

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Joe April 12, 2014 at 10:53 pm

I owner finance lots ( no home on lot) and I’m licensed as a RMLO and Mortage service co. Does dodd frank apply even though there is no home on the property ? And what is my max interest i can charge above apor ?

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AS April 30, 2014 at 12:05 pm

I have an investment property under an entity. This entity has never done owner financing. I do not do much, but this is 1st after Jan 10, 2014 and have no plan to do another owner financing anytime soon (definitely not within 12 mo). I did owner finance one Oct 2013, but under my own name, not under the entity. Looks I fall under bucket 1 above, can someone point me to CFR where I can find this? Thanks!

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