Let’s discuss how the basics of owner financing, which is different depending on whether the seller has existing financing on the property.
Let’s begin the discussion with a simple explanation of owner financing in Colorado (my home state) property that is owned free and clear of any mortgage liens, that is, there is no debt owed on the property. Let’s say Sally Seller owns her home “free and clear”—that is, she owes nothing to the bank and there are no mortgage liens on the property. Sally agrees to sell her property to Barney Buyer for $100,000, with the terms of 5 percent down and owner-financing for $95,000 (95 percent of the purchase price). At closing, Barney tenders $5,000 in cash and signs an I.O.U. (called a “promissory note”) for $95,000. Sally executes and delivers a deed (ownership of the property) to Barney. The promissory note is secured by a mortgage that is recorded against the property as a lien in favor of Sally. In this case, Sally is essentially acting as a lender to fund part of the purchase price of the house.
Sally can set a balloon date in the promissory note by which the loan has to be paid in full, at which time Barney must either sell the property or get a new loan from a traditional source such as a bank or mortgage lender. When the new loan is obtained, the loan to Sally is paid off and the mortgage lien is removed from the property. In some states, (like in Colorado) a different form of mortgage called a “deed of trust” is used.
The preceding example is for illustration purposes only, because if you are reading this manual you probably owe money to a lender secured by a mortgage lien on your property. Let’s consider a more realistic example—a house that has some equity because it has appreciated since it was purchased or was purchased with a sizable down payment.
Let’s say Sammy Seller owns a property worth $100,000 that is encumbered by a mortgage of $80,000. Sammy agrees to sell the property to Betty Buyer for $100,000. Because there is $20,000 in equity ($100,000 value minus $80,000 loan), Betty offers to pay $10,000 down and borrow the balance of $90,000 from a Colorado Mortgage Lender. At the last minute before closing, Manny decides that Betty Buyer’s eyes are the wrong color and refuses to fund her loan. Instead, Manny offers to lend $80,000, which is $10,000 short of the funds that Betty needs to close. One choice is for Sammy to drop the price of $90,000. Another choice is for Sammy and Betty to part ways and for Sammy to put the property back on the market and find another buyer.
A third choice is for Sammy to accept a promissory note for $10,000 as part of the purchase price. At closing, Betty will pay Sammy $10,000 down, borrow $80,000 from Manny and give Sammy a promissory note for $10,000. Sammy signs over to Betty a deed to the property, and Betty signs a mortgage lien for $80,000 to Manny, who will have a first lien on the property. Betty also signs another mortgage lien to Sammy, who will have a second mortgage on the property.
In a year or so, Betty gets a new loan for $90,000, paying off both the first (Manny) and second (Sammy) mortgage liens. In the meantime, Betty can make Sammy payments of interest on the $10,000 promissory note, which is a nice income stream for Sammy.
If the seller has little or no equity but a reasonably low payment on his note (whether a fixed-rate loan or fixed for a few more years), he can sell the property by using a wraparound transaction. A “wraparound” or “wrap,” is an arrangement wherein you sell a property encumbered with existing financing by accepting payments in monthly installments, leaving the existing loan in place. The seller uses the payments he collects from the buyer to continue making payments on the underlying mortgage note.
For example, Susie Seller owns a house worth $100,000 and she owes $90,000 to Colorado First Federal Financial on a favorable 6 percent, 30-year, fixed-rate loan. Her principal and interest payments on the loan are roughly $600 per month. She can sell the property for $100,000 for cash, but this might take a few months and $6,000 or more in broker fees and concessions, leaving very little on the table after Susie pays off her loan. Susie advertises the property FSBO (for sale by owner) with owner financing and sells the property to Barry Buyer for $100,000, taking $5,000 down and carrying the balance of $95,000 at 8 percent for 30 years. Susie does not pay off her underlying loan, but rather collects payments from Barry (roughly $700 per month) on a monthly basis and continues to make payments on the underlying loan (roughly $600/month). Susie collects $100 per month cash flow on the “spread” until Barney refinances.
A wraparound is commonly done with an installment land contract. The installment land contract is an agreement by which the buyer makes payments under an agreement of sale in installment payments. The transaction is also known by the expressions, “contract for deed” or “agreement for deed”. The seller holds the title as security until the balance is paid. In many respects, the installment land contract is similar to a mortgage, in that the buyer takes possession of the property, maintains it, and pays taxes and insurance. However, the title (the deed) remains in the seller’s name until the balance of the debt is paid to the seller.
An installment land contract usually contains a forfeiture provision, under which a defaulting buyer may be evicted the same as a defaulting tenant. Under the contract, the legal title (deed) remains in the seller’s name until the purchase price is satisfied. When the buyer satisfies the indebtedness, the legal title passes to the buyer.
The arrangement is very similar to automobile financing. Suppose that you purchase an automobile from a dealer using a bank loan. The lender holds the title until you pay off the loan. You are the equitable owner; that is, you have the right to drive the car. The bank holds legal title, but the bank’s officer cannot drive your car without your permission.