Discover a High Yield Seller Financing That Buyers Love, Too

17

I’ve accepted the fact that whenever I point out the history of the “subject to” approach to purchases, investors who love ’em lose their minds. At some point those with many props acquired using that method will face a market with interest rates substantially higher than the loan they took over.

Remember, most of the subject to sales in the last several years have been engineered purposefully to keep the lender in the dark. Sharon Vornholt, a pro’s pro, does it the right way, which is why I admire and respect her as much as I do. Simply put, Sharon gets the lender’s okey dokey in writing. Who knew that would work? 🙂

For those who scoff at my thinkin’, ask yourself what you would do if you were the lender with a huge portfolio of loans with 3-4% rates having been taken subject to in the dark, while the current market is 6% or higher? Would you demand payment for contract violation? Or would you just kick the dirt with your toe, and say, “Oh those clever real estate investors. What’ll those smartypants think of next?” 

The 20 Best Books for Aspiring Real Estate Investors!

Here at BiggerPockets, we believe that self-education is one of the most critical parts of long-term success, in business and in life, of course. This list, compiled by the real estate experts at BiggerPockets, contains 20 of the best books to help you jumpstart your real estate career.

Click Here For Your Free eBook!

Here’s a solution allowing all players to win. Let’s set the table.

You wanna sell a property acquired long ago. It’s worth $200,000, sporting a loan balance of around $100,000. The interest rate is 4%. The payments are $573 monthly. It has a little over 22 years to go.

Related: The Definitive Guide to Using Seller Financing to Buy Real Estate

The buyer is putting 10% down, which makes you a bit queasy, but you’re biting the bullet on that one for your own reasons. You’ve agreed to carry the entire 90% for 6% interest, amortized for 30 years, due in 10. You’ve already obtained written approval from the lender, who at this point just wants the payments made.

So, how does all this work out?

First off, the buyer gets a loan that’s comparable to what portfolio lenders offer, except for the minor point that they generally want double to triple this down payment. The buyer is only responsible for the seller’s note, as the seller will continue making payments on the original loan.

The property cash flows, showing an acceptable cash on cash return. In other words, the buyer’s all in on this.

What’s the bottom line for the seller at the end of 10 years when the note pays off in full?

Let’s first talk about what he decided to do with the leftover dollars he had after receiving the buyer’s monthly payment and paying the underlying loan payment. He looked at the pathetic 1% or less his CDs were making and decided that applying all or most of the carry back payment to the original loan made sense. His logic was that OldSchool arithmetic says 4% is roughly 4 X better than 1%.

Again, who knew? Brilliant, right? 🙂

May the gods be praised — what happened when he did that?! The underlying loan was paid in full over a half year before his carry back note was due. He then changed the formula and added only that amount that would pay off his original loan more or less simultaneously with his carry back loan. This didn’t take all of the carry back payment amount.

The result of that strategy?

He pockets just over $150,600 when the buyer pays off the loan.

If he’d not applied the extra payments to the original loan each month, his net payoff woulda been around $64,700. But wait, there’s a possible glitch in that thinkin’. If over the 10 years he’d kept the difference between the two loan payments — roughly $506 — what would he have had over the 10 years?

The short answer begins with, “Is your crystal ball back from the shop?”

Why? Cuz it’s silly to assume he’s gonna average a 1% return from CDs for all 10 years, right? Isn’t it just as foolish to assume he’d average over 4% too? An easier way to put this is that 4% is his opportunity cost. When the first 1-3 years your return is just 1%, imagine how high the CD interest must increase in order to average MORE than 4% for the 10 year period.

All our seller knows for sure is that putting most or all of his carry back payment into the other loan will definitely earn him 4% compounded interest. Remember, every dollar the loan is paid down is a dollar he won’t be payin’ at 4%. See how this can sometimes make ya crazy? It’s always simple as pie ’til we do the analysis. 😉

Which approach is better?

That depends on multiple factors — not the least of which is the tax impact.

The interest he receives, which is the difference between interest paid AND received, is taxable each year at “ordinary” rates. Interest is taxed as if it’s pay from another job. Cap gains rates are much lower, generally speaking, which would have some conclude that sooner’s better than later, right?

Well, yeah, sometimes. What if the seller’s income is high, but will go down precipitously just before or in the 10th year? That could very easily result in fewer taxes paid in terms of dollars. This is especially true when incomes, counting ALL sources, exceed around $450,000 in the year the capital gain is realized. So it’s not as easy to plan as some may think.

Related: Seller Financing: What it Is and How to Use it To Invest in Real Estate

The instrument to make all this happen can be one of many things, though I prefer the land contract of sale. It only grants “equitable” title to the buyer until a specifically defined event becomes reality. At that point full title is granted. In this scenario I wouldn’t grant full title ’til the note was paid off completely.

This is just one way for the investor selling a loan-encumbered property who wants or feels they must carry back financing to potentially increase the yield or improve their tax situation — or both.

Will you use this financing strategy to optimize your yield? What’s your experience with seller financing?

Leave me a comment below!

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

17 Comments

  1. I’m very confused about the following piece…
    “The underlying loan was paid in full over a half year before his carry back note was due. He then changed the formula and added only that amount that would pay off his original loan more or less simultaneously with his carry back loan. This didn’t take all of the carry back payment amount.”
    What is the difference between the “underlying loan” and the “original loan”? I thought these would be one and the same? Obviously I’m missing some key piece of the puzzle here.

      • OK. Then this is the part that I don’t understand…

        “The underlying loan was paid in full over a half year before his carry back note was due. He then changed the formula and added only that amount that would pay off his original loan more or less simultaneously with his carry back loan. This didn’t take all of the carry back payment amount.”

        If the underlying loan is paid off, what is the reference to paying off his original loan at the some time as the carry back loan is complete?

        • Jeff Brown

          The original loan remained on the property when the sale closed. Instead of carrying back a more traditional $80k 2nd position loan, and having the new owner pay the payments on both loans, here’s what happened.

          The owner carried back a land contract (my preferred instrument) for $180k. The terms of that loan say the buyer pays the seller monthly payments based on the 180k figure. The seller is then totally responsible for paying the previously existing note’s payment.

          What he’s doing is a few things, Scott.

          1. He’s protecting his position/equity by not granting fee title to the property.

          2. He’s getting ALL of the $100k when the note is paid off in 10 years. This compared to just the balance left of the $80k 2nd he woulda carried back.

          3. Instead of making 1% on his payments each month, he’s getting 4% by paying off the debt each month with the overall payment he receives.

          You asked, “If the underlying loan is paid off, what is the reference to paying off his original loan at the some time as the carry back loan is complete?”

          Again, underlying and original in this scenario 100% synonymous. Just different ways of saying the same thing. It’s no different than saying ‘2 unit property, attached’ or ‘duplex’.

          When I spoke of paying off the underlying/original loan, I was referring to his ability to use all or most of his carry back payment to speed up the complete payoff of the 100k loan on or before the due date of his $180k carry back note. If you’d like to talk, gimme a call, and we can get into the weeds for better understanding.

          Make sense?

  2. Any idea how “Sharon gets the lender’s okey dokey in writing.”? The due on sale clause would be triggered in this instance and I would love to hear how to get a lender to approve this in writing.

    Thanks

    • Chad Carson

      Even if you don’t get their approval in writing, you can send the lender certified mail stating your intentions of selling the house subject-to their mortgage. Most big portfolio lenders will sign the mail receipt and just put the letter in their file without a reply. And most will not call the loan due (at least not right now:). But the key is you’re not hiding anything or keeping them in the dark.

      Permission, as you say Sharon does, would be even better. I’d love to hear how she does that.

  3. Chad Carson

    Jeff,
    I like this approach. I have done several wrap financing deals like you’ve described here, some with conventional mortgages underneath and others with seller financing (with no do on sale clause) underneath.

    But the novel but not fancy approach, which I love, is reinvesting all positive cash flow into debt reduction. It is consistent with your other methods of not eating the cash flow today so you can build more wealth tomorrow.

    I’m willing to bet that for all those people out there who would complain “4%! I can get better than 4%”, most will not reinvest that cash flow well … it will slip through their fingers and get spent somewhere. I speak from experience!

    The only variation that might be ok is to add this cash flow to your snowball plan and use it to payoff one of your other rentals faster.

    Thanks for sharing.

  4. Back when loans were easy to get, anyone could pretty much just ask. If you walked in there and said, “Your buyer can no longer make the payments on the house. I want to continue to make the payments on time every month until the time when I want to refinance. Is that OK with you”? They would say sure. I even asked, “Do you intend to call this loan now”, and they would say no. Just keep making the payments. Now I was talking to the loan officer in the branch. Heck he didn’t care, and they really didn’t want to refinance.

    Sharon

  5. One thing I would like to add; this was a few years back, so I don’t know whether or not they would still do that since I haven’t done it recently. I agree with what @Chad Carson said.

    If the seller sends the letter, he can also change the insurance to your preferred carrier and name you as additional insured on the policy. That gets rid of that whole red flag before the sale.

    I was dealing with a local branch. If you got involved with the corporate headquarters in another state there is just no telling what those idiots might do.

    Sharon

  6. Interesting strategy and some good arguments for getting rid of the underlying loan to profit more.
    While I understand this is an academic exercise I really had a hard time getting past the details on the example used.

    “You wanna sell a property acquired long ago. It’s worth $200,000, sporting a loan balance of around $100,000. The interest rate is 4%. The payments are $573 monthly. It has a little over 22 years to go.”

    – 22 years to go implies the loan originated in 2006. Rates averaged around 6.5% back then, nobody would have a 4% loan from that year.
    – Ignoring that point having a $573 payment at 4% and a remaining balance of around $100K would indicate an original loan of $120K. If they made a 20% down payment at the time that means they paid $150K. So that means they have had a 33% appreciation over 8 years. Pretty nice over most 8 year spans anytime in history but kind of hard to believe when they were buying near the top of the market in most areas with several years of falling prices before any recovery.

    I suppose maybe they paid like $240K and put 50% down with a small local portfolio lender to get them to loan them the money 2-2.5% under the current market. Then they would actually be taking a bath on market price.

      • As I said I realize it was academic and think there were many good points made.

        My concern is people will read the example and think this is a deal that they can just go out and find, when it isn’t.

        If we keep the basic starting point of buying a place with an 80% mortgage for $150K in 2006 but at market rates of like 6.5% and a more realistic appreciated value of maybe $160K (Which would still make this a fairly strong market nationally IMO).

        – So now the value is $160K vs. $200K in the original.
        – At that higher rate the balance is more like $106K.
        – Combine these facts and the equity position changes from 50%/$100K to like 33%/54K, which doesn’t really change the strategy but makes it look less lucrative and less equity always makes these things more risky.
        – Payment for PI on original loan goes from $573 to $758.48 which is a huge cut into the cash flow.
        – Since you are wrapping on a 6.5% loan you need to get more like 8-9% from the borrower. So instead of offering rates similar to a portfolio lender you are marking it up several points. In today’s market those rates are roughly double the normal rates so people willing to do that will have to be pretty desperate.

        Still no reason this can’t work, but the dynamics do change quite a bit.

  7. benjamin cowles

    Jeff, thank for this chunk of good looking info but I’m totally confused.

    “You wanna sell a property acquired long ago… worth $200,000, sporting a loan balance… interest rate is 4%… The payments are… “, “The buyer is putting 10% down… “, “You’ve agreed to carry the entire 90% for 6% interest, amortized…”, now here comes the confusing part…

    “The buyer is only responsible for the seller’s note, as the seller will continue making payments on the original loan.”

    I thought the the buyer was making payments to me in this example as in a ‘wrap-around’. Who’s the “seller” here?

    Either way, how is the buyer responsible for “the seller’s” note? Wouldn’t they be responsible for the the note I created between us?

    There’s a lot left in the article but as confused as I am up to here I’m afraid to continue till I get this cleared up. Hope to get some clarification. Sorry I’m still kinda new at this.

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here

css.php