How to Set Up A Seller Financed Mortgage

Seller Financing in real estate is when property owners provide financing rather than a buyer obtaining a third party loan. If you'd like to find more buyers and weather market downturns, knowing how to set up a seller-financed mortgage is a valuable tool.

Sellers Need Buyers, and Buyers Need Funding

Real estate is credit-driven. Unfortunately, not all buyers or properties fit within criteria institutional lenders use. For example, residential properties such as those needing substantial renovation and affixed mobile homes typically don't qualify for bank loans.

Self-employed business owners often don't qualify either. Especially in our current pandemic environment.

Another issue is loan size. Since the "Dodd-Frank Wall Street Reform and Consumer Protection Act" passed in 2009, the number of loans under $150,000 declined by more than 26%. Under 70%, the percentage decline was 38%. "Dodd-Frank" made it more expensive for banks and other large lenders to originate loans. Since small loans generate less revenue and profit, they stopped offering them.

Offering seller financing opens the door to getting deals done. For some, it can lead to smart financial planning too.

The Steps

Set The Foundation

1. People – A third party mortgage involves a SELLER, a BUYER, and a LENDER. With owner financing, you remain the SELLER, but also become the LENDER once the sale closes.
2. Property – The property you're selling.
3. Paper – At closing, you'll receive two documents from your buyer:
   1. Promissory Note – This is a contract between you and your buyer, where they promise to pay you the money they've borrowed. It also states the loan terms.
   2. Mortgage or Deed of Trust – Depending on the state you live in, you'll receive a mortgage or a deed of trust. Among other things, it contains language that pledges the property as collateral for your loan.

Involve Professionals

The concepts of seller financing are simple, but setting it up can be complicated. There are laws to comply with, legal documents to draft, and local recording requirements. Though many title or escrow companies can prepare and record your docs, hiring a real estate attorney is usually the best way to go.

Marketing

A common misconception about owner financing is that it's for the "No credit? No problem!" slice of the population. Marketing plays a role in finding the types of borrowers who are likely to break this mold.

Consider these two phrases:

A: "Owner Will Finance!"
B: "Financing available to qualified buyers." 

I recently sold an old farmhouse in Maine. I listed it myself using Craigslist and Facebook. And I offered owner-financing. Because there wasn't a realtor involved, I received all incoming inquiries.

My marketing copy included the text from option B - "Financing available to qualified buyers."

Adding "qualified buyers" let each prospective buyer know they'd have to qualify to get the house – which was true (more on that later). Option "A" would have brought in more calls, but many wouldn't have thought about needing to qualify.

Most of those who contacted me asked about the financing and about qualifying. That's how I knew my ad copy was effective.

The last thing you want is to trade a property you no longer need or want for a loan that doesn't pay. Finding a borrower who is likely to make payments as promised should be a thread throughout the process.

Set The Terms

1. You may be filling the role of a bank, but that doesn't mean you need to offer the same terms a bank would. To begin with, you're lending your personal assets, whereas banks lend other people's money. If a borrower could go to the bank for a super low-interest rate, they generally would. Chances are you're taking on risk a bank wouldn't be willing to.

• Downpayment – A large downpayment gives you more security. It shows that your borrower has "skin in the game" and had the discipline or the resources to come to the table with a large sum of cash. Ask for at least 10%.
• Interest Rate – Owner financing interest rates are generally 4 – 5 percent higher than what banks are charging. Remember, you're lending your money, and banks loan other people's money. Don't cheat yourself here.
• Term – Think in the 5 – 15-year range for the time required to receive all of your money back. It's best if payments are amortized.
• Balloon – Not all owner financed loans have balloons. However, many do because the buyer can't afford the payment if they were to make amortized payments on a shorter-term loan. A balloon loan may calculate payments based on 30 years amortized, but set the ballon due date 5 – 10 years out.

Underwriting

• Borrower – If your buyer can't make payments as promised, you'll need to foreclose or give forbearance. Both can be expensive and stressful. It's best to hire a loan underwriter or mortgage loan originator who will verify your borrower's ability to repay. 
• Property – Some people view owner financing as an opportunity to sell a property for more than it's worth. The problem with this strategy comes if you need to foreclose or if there were an expectation the buyer would refinance at some point. Get an appraisal if necessary. You can sell your property at the high end of the appraisal range, but resist the urge to go above it.
• Title – To protect themselves, your buyer should want to have a title company perform a search to verify that the title is free from any flaws, and then purchase an "owner's title insurance policy." It would be best if you also considered purchasing title insurance. Your policy will be called a "lender's policy." Purchasing your policy at the time of closing when the buyer is also purchasing title insurance makes the policy more affordable.

Closing

1. Banks require closings to be handled by an entity such as a title or escrow company. Some Attorneys also provide closing services. To protect yourself, use a licensed third party to close your transaction.

Loan Servicing

1. After you've closed and completed the sale, you take on the role of the lender. The best advice is to use a loan servicer or title company for:

• Original Document Storage – Your promissory note is similar to a check. If the original is lost, you've got a problem. It's good to hold the note and other original docs with someone who can ensure their safety. If someone else doesn't hold them for you, store them in a fireproof safe or safe deposit box.
• Payment Collection – Your loan servicer will usually allow electronic payments, which makes it easier for the buyer to pay on time. They will also issue statements and sometimes send friendly reminders when a payment doesn't arrive.
• Property Tax & Insurance Verification – Property taxes and insurance must be kept current. It's your buyer's responsibility to do so. A loan servicer can stay on top of verifying this or can collect funds from the buyer each month. They'll use these "escrowed" funds to pay insurance and taxes on the buyer's behalf.

Bottom Line

Just like real estate, a mortgage note is an asset. Focus on how to set up a seller-financed mortgage, put care into its creation, and you’ll have something that you can collect on for years to come. Another perk - the higher the quality of your note, the more it will be worth if you ever decide to sell your mortgage note for cash.

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