Seller Carryback Financing Issues

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This is something I probably should have dealt with some time ago.



A seller carryback is when the seller agrees to "carry back" some part of the purchase price themselves. In other words, instead of getting the full sales price of the property (less outstanding liens), the seller accepts a certain amount of the purchase price in the form of a promissory note from the buyer. This note is usually secured by the property, making it a "purchase money" loan for purposes of determining recourse, which means there usually isn't recourse on the buyer. Furthermore, the seller's trust deed is usually in second or third position, behind the primary loan and possibly a secondary loan.



The reason behind doing this is that some buyers cannot qualify for a sufficient loan, or have credit sufficiently bad that no lender is willing to loan them the necessary percentage of the value, considering the down payment they have (usually zero). But in the current environment, every last potential buyer is heavily sought after, and some sellers are willing to do whatever it takes to make the transaction happen. Particularly as being willing and able to do a seller carryback is one tool for being able to get full price from a buyer who needs one.



As an example, let's consider someone with a 520 credit score and less than 5% down payment in the current lending environment. They might be able to get 80% financing full documentation, or perhaps 70% stated income. But all they've got is less than 5. If the seller wants to do business with them, it takes a carryback to make the deal happen. If the buyer needs a carryback, he's got to be willing to meet the seller's terms for making it happen. This gives the seller who is willing and able to do a carryback access to potential buyers that sellers who are unwilling and unable to do so do not have. Furthermore, it gives those sellers who are willing and able to carryback part of the purchase price leverage in negotiations to get a higher price than they otherwise would have. Not every seller has the option of a carryback. Matter of fact, right now relatively few have that ability. The ratio of buyers to sellers is in the high 20s right now locally - but the ratio of buyers to sellers willing and able to do a carryback may be 1:2 or lower.



Lest there be any doubt, a carryback is not something you keep secret. You don't need to shout it from the rooftops, but at a minimum, all of the lenders involved have to be notified in writing as to what's going on, and have to accept it, also in writing. There are some lenders who will not permit them at all, even though their loan takes priority. There are other lenders who will accept them but impose conditions. They are all going to want to see a loan repayment schedule, and include that in debt to income ratio calculations. It may be possible, in theory, for a "silent second" type carryback to be approved, but the lender wants to see something that seller is getting in return for extending financing, and most such loans will not meet the underwriter's "smell test," particularly not in the current loan environment, which has gone within a couple of weeks from being far too permissive to completely paranoid, as the lenders scramble to avoid consequences of years of bad decision-making. Trying to game the system in this environment in order to get a higher debt to income ratio through the system is highly likely to be interpreted as fraud.



I've mentioned that sellers' trust deeds will be occupying second or even third position, which means that in the event of default the loans occupying higher positions are paid in full, before there is one penny paid on the seller's. It therefore behooves sellers to be extraordinarily careful about extending financing, as if the people were able to qualify for the full amount of financing they need with regular lenders, chances are that they would have done so. Furthermore, if the holders of the higher priority trust deeds foreclose, your deed will be wiped out by the action of the trustee's sale. Concrete example: A $500,000 purchase is financed 80/10/10: 80% ($400,000) on a first trust deed, 10% ($50,000) on a conventional second trust deed, and 10% ($50,000) on a seller carryback. The seller discovers that they're in over their head, and even if prices don't recede the property only nets $450,000 at auction. Less the costs of the trustee's sale, that first trust deed gets all of their money (or at least most) the second trust deed might get some of theirs, but there is no way that you're going to see a penny of yours. Even if prices go back to ballooning like they were three years ago and the property is now worth $700,000 after two years, you might not see any of your money unless you go to the trustee's sale armed with cash to defend your interests - just like any other holder of a junior trust deed.



Servicing can be a real issue as well. Do you know the proper way to service that loan in the state you are operating in without missing any i-dottings or t-crossings? If not, you could lose most or possibly even all of your rights under the loan contract. Professional servicing organizations exist, but they 1) cost money that cuts into your margin, and 2) make mistakes anyway, which you are responsible for. Not too long ago I fought and won a battle with an out of state servicing company that was violating California law. If I had wanted to, I could have sued both them and the holder of the note as well as making criminal complaint. Servicing requirements are deadly serious.



With all that said, many sellers right now are in a situation where a carryback means, "Hey, I might get the money, where if I didn't, I definitely wouldn't." If this describes your situation, a carryback might be something you should consider.



Lest you not understand, most sellers want cash, not a loan. It's very hard to use a loan, particularly a private loan of dubious quality, to assist you in buying your next property. You can't just spend a promissory note like you can cash. There are loan buying services out there, but most of the time the amount you get will be heavily discounted, particularly if you cannot document a history of on-time payments and you are in a bad credit situation. It is this fact which sellers who are able to offer carryback financing leverage in order to get better deals.



There are those out there who like carryback financing. Most often, they are real estate sharks. What they are hoping is that they will get their twelve percent for a couple of years, during which time value will go up, and when they turn around and foreclose, having not only been paid their above market interest but also having leveraged that loan into renewed ownership of the property at an appreciated price. Another one of the tricks is to use the existence of the carryback as leverage to get a price significantly above market for the property from desperate buyers who can't get anything else, and as soon as the buyer has made the payments for a few months, sell the note. However, the note buyers have caught on to that little trick, and in the current environment of decreasing or stagnant prices, they are balking at paying full price or anything like it for those notes.



And that's where I'll stop, lest I inadvertently release more scams into the wild. Suffice it to say that there is sufficient potential for abuse in the practice of carrybacks that lenders have become very sensitized to the possibilities, and have taken what they feel are appropriate steps to limit their potential for losses due to the abuses that have taken place in the past.



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This page contains a single entry by Dan Melson published on March 13, 2007 10:01 AM.

Real Loans for Real People March 12, 2007 was the previous entry in this blog.

Should I Buy A Home? Part 2: Process is the next entry in this blog.

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