Written by Benny L. Kass
Question. I am considering selling a rental house I own and taking back the loan myself. This would give me monthly income and get me out of the landlord business. What is the procedure to follow in doing this? Is there a risk?
Answer. A seller take back loan means that you — as the seller of real estate — will deed the house to the buyer and instead of getting all cash, you will get some cash and the balance in a mortgage or deed of trust.
Many sellers, when faced with the uncertainties in the real estate market, have found that a seller take back arrangement not only makes financial sense, but can be a good marketing tool to entice prospective purchasers to buy.
From a financial point of view, a seller take back trust can — if successful — generate more long-range income than merely putting all the cash into a bank savings account. Mortgage interest rates are now around 4percent. If you take back a first deed of trust at that rate, clearly it will provide you with more income than your bank.
From the purchaser’s point of view, a seller take back arrangement will probably save a lot of lender up-front costs, such as appraisal fees, points, and underwriting fees.
However, it must be clearly stated that there is always a risk when a seller takes back financing.
There are two kinds of seller take back trusts: a first and a second (or subordinate). (NOTE: in some states, lenders use mortgages and not deeds of trust. For purposes of this column, there are no differences between a mortgage and a deed of trust.)
If you are considering taking back a first deed of trust, this means you will be in first place in the event your borrower defaults. Let’s look at this example: you sell your property for $200,000, and the buyer gives you $20,000 cash at settlement. You take back a first deed of trust (a mortgage) in the amount of $180,000, based on a 4.5 percent per annum interest rate. The mortgage or deed of trust is recorded among the land records in the jurisdiction where the property is located. The entire loan is due and payable in 7 years, but the monthly mortgage payments are amortized over a 30 year period. This means that when the loan comes due in 7 years (called a balloon note) the buyer will have to pay you a substantial amount of money. Note that i just picked 7 years; the length of the note is negotiable between lender (seller) and borrower (buyer).
What happens if the buyer defaults — either during the 7 year period or at the end of the term? You can foreclose on the property, and if all goes well, someone will pay enough money at the foreclosure sale to make you whole (including the various fees for processing the foreclosure) or you will once again own your house free and clear of any debt. You also have the option to file suit claiming breach of the terms of that note.
But, life is not always that simple. Often, if a borrower is in default and when the lender starts the foreclosure process, the borrower will file bankruptcy. While you are a secured creditor, and may ultimately end up being allowed to foreclose (or the court will have the property sold to pay the debts of the bankrupt owner), bankruptcy is a process that is expensive and potentially time consuming. There may be many months (or even years) before you will be paid.
A second deed of trust means that you are in second place position to a first trust lender. If the first trust lender forecloses, and there is not enough equity in the house to pay off your second trust, your trust will be wiped out. While you still have the right to sue the person who bought your house under the promissory note, obviously if they are in financial difficulty, this right to sue could be meaningless. There is no cash register at the back of the courthouse, so that even if you get a judgment against the note maker, the chances of collection will at best be slim.
It is extremely important, however, that the trust documents be properly prepared — and prepared by your attorney and not the lawyer for the buyer or even the title company.
To protect yourself, you must first investigate the credit-worthiness of your buyer. Find out what income your buyer makes and obtain the buyer’s permission to do a credit search with a local credit bureau. If that credit bureau reports a history of slow or delinquent payments to such places as department stores or oil companies, you may want to reject extending further credit to an already over-extended purchaser.
You also want to make sure that there will be more than adequate security in the property in the event of a foreclosure. For example, if you are selling your house for $200,000, I cannot recommend that you lend your borrower more than $180,000 (in other words a 90 percent loan). If your buyer defaults, you want to be able to sell the house at a foreclosure sale and at least break even. My preference is to lend no more than 80 percent of the sales price, but this may not often be possible.
When you take back financing, you are lending your borrower money. Your buyer will have to sign two pieces of paper. One is promissory note in which the buyer states that he or she has borrowed a certain sum of money and agrees to pay that amount, with interest, in monthly or quarterly payments. You have to figure out whether you want the payments amortized equally over a period of years, or whether the buyer will be permitted to pay interest only, until the loan becomes due.
This promissory note must contain provisions for default, so that you will be able to call the note in the event the purchaser misses a payment or two. You have to take a tough position in connection with your buyer. If one payment is missed, and you are lenient, you may end up having to foreclose because your buyer will get too far behind in payments to ever catch up.
Additionally, to secure the promissory note, the buyer will sign a deed of trust. This mortgage paper, when recorded among the Land Records in the jurisdiction where your house is located, puts a cloud on the title to the property. If your buyer is unable to make the payments on the note, you will have the opportunity to foreclose on that property. By recording the deed of trust on the Land Records, you put the world on notice that you have an interest in that real estate.
You have to select trustees whom you respect and have confidence in. You have the right to select any person of your choosing, and it can be a relative, friend, business acquaintance or your attorney. It is advisable to have at least two trustees and you also must have absolute discretion to substitute trustees. When your buyer signs the deed of trust, in effect the buyer is deeding the property in trust to your trustees. They hold title to the property and will either foreclose on it in the event of a default or will release the trust when the promissory note is paid in full.
The deed of trust is an important legal document. It must be prepared carefully, and must reflect the true legal description of the property.
The original note, signed by the borrower, must be given to you at closing. Do not rely on the title attorney to keep that note in the files. It is a valuable piece of paper, which should be kept in a safe place.
The deed of trust will be recorded in the office of the Land Records where your property is located. Make sure that your name and address is written clearly on the original deed of trust so that the Recorder’s office will be able to mail it back to you after recordation.
Here are some provisions which must be included in the papers which will be prepared:
- The promissory note and deed of trust should contain a very tightly drawn due-on-sale clause. You may be prepared to lend this buyer money to purchase your house, but you do not necessarily want that loan to be assumed by a third purchaser later on. The general rule is that in the absence of a specific non-assumption clause in your note and deed of trust, the note and deed of trust are freely assumable.
- The promissory note should require the borrower to provide you proof of payment of taxes and insurance at least once a year.
- The promissory note and deed of trust should provide that in the event you have to take legal action to enforce the note, the borrower will be required to pay your reasonable attorneys fees.
Finally, make sure that someone visits the property periodically. If the property is rundown, its value may be diminishing, thereby impairing your security. If significant repairs are needed, you may want to insist that your borrower take care of these matters promptly. Most standard deeds of trust specifically require that the borrower maintain the property in decent condition.
If a bank can lend money and take a first deed of trust, you can also. But you must understand that there are risks. To minimize these risks, make sure that you are properly advised by your tax and legal counselors.