These days, most of us who are considering buying a home pretty much start the process the same way – we contact our bank or other institutional lender and apply for a mortgage loan that will allow us to borrow a rather large sum of money and pay it back over a long period of time. After considerable due diligence to determine not only our own our creditworthiness, but also the value of the property we want to buy, the bank lends us the money and we have a home.
It might be hard to believe, but the home buying process we all know and love today didn’t always exist.
Imagine living in the early 1900’s when homes were paid for in full with savings or privately financed with a 50% down payment and a 5-year, variable rate loan. After five years, the loan balance was due in full (also known as a balloon payment).
Only four out of ten households could even afford to own their home – everyone else rented!
The Beginning of the 30-Year Mortgage
When the stock market crashed in 1929, many homeowners found themselves unable to pay the balloon payment on their mortgages and the homes went into foreclosure.
It wasn’t until the Federal Housing Authority was created in 1934 to insure home mortgage loans and stimulate home buying during the Great Depression, and when the Veteran’s Administration created an insurance program to back loans for military personnel during World War II, that 30-year mortgages requiring a small down payment became commonplace.
Home ownership rates rose dramatically as a result. By 1980, nearly 6 in 10 households owned their own home, a number that still holds steady today.
Even so, high inflation rates in the 1970’s and early 1980’s made home buying incredibly difficult and expensive once again. Interest rates were at 18% in 1981!
Think about it – if you took out a $200,000 mortgage at today’s rate of 4.5%, your monthly payment would be about $1000, and you would pay $164,000 in interest over the life of the loan.
The same mortgage at an 18% interest rate would mean a monthly payment of $3000 and you would pay about $885,000 in interest if you kept the loan for 30 years, a huge difference!
And This is Where Seller Financing Enters the Picture…
Seller financing refers to an agreement in which a homeowner who typically (but not always) owns their home outright and assumes the role of the bank in a traditional mortgage transaction. The owner agrees to sell their home to a buyer and allows that buyer to pay the monthly principle and interest payments on the home directly to them.
Why would a seller offer seller financing?
- The extremely high interest rates in the 1970’s and ‘80’s made it harder for people to buy homes but they also made it nearly impossible for people to sell homes because there were few buyers who could afford them.
- Sellers willing to forego the lump sum payout they would receive from a traditional mortgage transaction and accept monthly payments over time instead could offer buyers a lower interest rate than the banks.
- A lower interest rate made their property much more affordable and attractive to potential buyers.
- According to the National Association of Realtors, 40% of all home sales in 1981 utilized seller financing.
But what if a seller didn’t own their property outright? Another option in seller financing is a wraparound mortgage.
In this situation, the seller issues a new mortgage to the buyer for the purchase price less any down payment. They would charge an interest rate high enough to allow them to continue making the payments on their underlying mortgage while also making a profit on the new loan; the rate was often still less than those available from a bank.
Seller financing and other creative financing options remained popular until the early 1990’s, when interest rates finally began to fall and obtaining mortgages from conventional lenders became easier.
The only exception to this trend involved sellers who owned their homes outright and wanted to avoid taxes on the sale of their home.
Since 1997, the IRS has allowed homeowners to avoid paying taxes on the first $250,000 (or $500,000 if your tax status is married filing jointly) in profit from the sale of a principal residence where the ownership and use test is met. Any profit over that amount is subject to a 15% tax rate.
In states where home prices were soaring (for example, California), many people found that the profit they were likely to make from the sale of their homes would easily exceed the IRS limits.
Seller financing was a way to avoid a big tax liability. Instead of having to pay taxes on one big payment all at once, with seller financing they only needed to pay taxes on one year’s worth of income from the sale at a time.
Seller Financing and the 2008 Financial Crisis
Enter the financial crisis of 2008. The causes of the crisis are complicated, but most agree that subprime lending – when banks were willing to issue mortgages to people who didn’t qualify according to traditional standards – was a big contributor. As a result:
- There were now more people who could buy homes, and not enough homes for everyone who wanted them.
- House prices rose rapidly because of this limited supply and increase in demand.
- As interest rates rose, subprime borrowers with adjustable rate mortgages found they couldn’t afford their rising payments and they began to default on their loans.
During the resulting ‘Great Recession” that lasted until 2012 for the housing industry, mortgage lenders severely tightened their lending standards and mortgage loans became incredibly difficult to secure.
Many credit-worthy buyers couldn’t obtain traditional bank financing for home mortgages and homes were taking much longer to sell. Instead of high interest rates stifling home sales (like in the 1970’s), now it was banks who weren’t lending much money, even to highly qualified homebuyers.
Sellers once again turned to seller financing as a way to increase the chances of selling their homes. In 2008, 32% of sellers owned their homes outright and seller financing accounted for 1 in every 50 real estate transactions.
Unlike the early 1980’s, when sellers offered lower interest rates than the banks, now sellers could charge an interest rate as much as 4% higher than the banks. This higher rate was in exchange for the buyer not paying private mortgage insurance, the money the buyer was saving in loan fees, and the fact that the buyer couldn’t likely get a loan anywhere else.
Repercussions of the SAFE Act and Dodd Frank on Seller Financing
Several pieces of legislation were passed in response to the 2007 financial crisis that affected seller financing indirectly – the SAFE Act, and Dodd-Frank.
- The SAFE Act – the Secure and Fair Enforcement of Mortgage Licensing – was signed in 2008 by President George Bush. It required licensing and registration of loan originators, including seller financers.
- Dodd-Frank – Signed into law in 2010 by President Barack Obama. Part of Dodd-Frank requires that seller financers must make a reasonable effort to qualify their borrower for the loan that’s being offered to them (due diligence).
Both pieces of legislation were really intended to regulate the larger mortgage industry. Individuals who wanted to provide seller financing on a one-time basis really weren’t affected much. A seller would have to sell (and offer seller financing), on more than three properties a year before they would be subject to regulations outlined in the legislation.
Seller Financing in 2018
Though the reasons for seller financing have changed over the years, today the practice still has its place.
Although interest rates are still quite low, mortgage lending is still restrictive. A conventional mortgage will require a down payment of at least 3%, and private mortgage insurance is required for any down payment less than 20% of the value of the property. This private mortgage insurance adds extra cost to the monthly payment. Most borrowers will also benefit from a credit score of 600 or higher. Seller financing in the current environment is an attractive option for a buyer whose credit may keep them from qualifying for a conventional mortgage, or who perhaps owns their own business and can’t easily meet proof of income requirements. It’s also popular for sellers whose property may not meet the requirements of a traditional lender. Their property may be non-traditional housing such as a mobile home, or it may be in “as is” condition. The seller may be in the midst of repairs they don’t have the means to complete, with a buyer willing to take over the task.
Sellers and buyers alike should enter into seller financing agreements carefully, doing full due diligence for the transaction.
For sellers, this means:
- Fully investigating the buyer’s creditworthiness.
- Determining a reasonable interest rate.
- Determining a down payment that will create an advantageous equity position.
- Knowing their options later on.
For buyers, this means:
- A title search to rule out any additional owners or lienholders.
- An inspection of the property to identify any potentially major problems.
- Hiring an attorney to review the documents so there are no surprises down the road.
- If the seller still owes money to their own lender, the buyer may be required to come up with a hefty down payment that the seller will be using to pay off the remaining balance of their own loan.
Although it’s not possible to predict the future, as economic conditions rise and fall and legislation comes and goes it’s expected that seller financing will likely continue to have its place in the mortgage lending arena as an appropriate response to these factors and as an alternative option to buyers and sellers alike.
For more information on seller financing and your options if you’ve provided or are thinking of providing seller financing, contact Alvernia Capital Management