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HOUSING SCENE

Safeguards are key when seller assumes the role of lender

July 22, 2007|Lew Sichelman | United Feature Syndicate

WASHINGTON -- Variously known as "taking back a mortgage" or "holding the paper," private financing is often heralded as the fastest way to sell a house, especially in a slow market.

Of course, if you need the proceeds from the sale of one house to purchase another, assisting with financing may not be the way to go. But it may be worth considering, especially if you can line up an investor to take the note off your hands.

Seller financing is often treated as a last resort, and for good reason. It is at best an adventurous tactic that could backfire if your buyer decides not to pay. And almost by definition, buyers who need the seller to carry the first mortgage are not as good a risk.

"That doesn't mean they're all deadbeats," said William Mencarow, who publishes the Paper Source, a newsletter for professionals who buy notes from seller-lenders. "Many are worthy borrowers who just don't fall into the net of conventional lenders."

If you decide to become a lender to your buyer, it is incumbent that you structure the deal properly -- not just as a protection against default but also in case you decide to sell the note to an investor at a later date. For starters, insist on a substantial down payment. Loans with less than 20% down are far riskier, which is why conventional lenders require those borrowing more than 80% of the purchase price to pay for insurance that protects the lender from the greater possibility of default.

You probably won't be able to get this kind of mortgage insurance, so demand the next best thing: a large chunk of change up front. Ten percent is minimum, 20% is safer, but if you can get it, more than 20% is better.

Obtain your buyer's written permission to check his credit, employment, personal references and previous landlords or lenders. You can get a credit report from any credit bureau.

Obviously, the higher the interest rate, the better. And you should be able to charge above the going rate, not just because you are the buyer's only source of funding, but also because he or she won't be paying the application or origination fees that traditional lenders charge.

Not as obvious but equally important is the length of the loan: the shorter, the better.

Another key is the loan's position compared with other liens on the property. A first mortgage takes precedence over all others and is, therefore, more valuable than a second mortgage. And a second "is much more valuable than a third, which I'd stay away from completely," Mencarow said. The amount of the second mortgage compared with the primary loan is also important. Unless the buyer makes a big down payment, and thus has significant equity at risk, a small second behind a large first is not a terribly safe investment.

That's because if the buyer defaults on the first lien, you would be responsible for making up all back payments on both mortgages, plus all future payments until the holder of the primary mortgage forecloses.

Your note should contain a clause requiring your buyer to keep up the payments on all mortgages and requiring him or her to pay the property taxes and fire insurance on time.

The best way to be sure your buyer is paying the taxes and insurance is to make him pay you a portion every month so that when the bills are due, the money will be on hand to pay them. Alternatively, you can hire a note-servicing company to administer the loan on your behalf.

Another important protection is a clause allowing you to sell the loan -- not just sell it but sell it without recourse. That means the new owner of the note can't hold you responsible if the borrower doesn't pay him or her.

You also want a "due on sale" clause so that the loan is not assumable.

Finally, the mortgage should provide for a late fee. Exactly how much and when the charge kicks in is determined by law.

Lew Sichelman can be reached at lsichelman@aol.com.

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