How Does Seller Financing Work?

Q:  I’ve listed my home for sale. A potential buyer is interested, but can’t qualify for a loan. Is there some way to facilitate the sale without an outside lender being involved?

A:  Yes – if the seller acts as the lender. This article will describe seller financing generally, discuss the key instruments and terms used in these transactions, and explain how our firm assists parties in complying with the myriad of new federal and Colorado-specific requirements that affect owner-carry deals.

In its most basic sense, seller financing means that the owner of a property acts as the bank and loans the buyer the money necessary to purchase the property. However, instead of giving the buyer cash, the seller provides a loan that will be secured by the property being sold. The loan amount is for the difference between the purchase price and any money that the buyer contributes as a down payment.

Prime buyer candidates for this type of arrangement are typically those who are not able to qualify for institutional financing when they are ready to purchase. Whether those circumstances are expected to change in the future – allowing the buyer to pay the seller off by refinancing with a traditional loan – is a point of discussion for the parties. Prime seller candidates are those who do not need the cash proceeds from the sale of their property and instead prefer a passive income stream. If the buyer defaults on repayment of the loan, the seller has the option to foreclose on the property, just like an institutional lender.

Sounds simple enough, right? Not so fast. This area has been complicated recently by both federal and state regulations. In January 2014, the federal Dodd-Frank Act went into effect, which: (1) limits the types of sellers who can offer owner-carry financing, (2) sets parameters on acceptable loan terms, and (3) can limit a seller’s recourse against a defaulting borrower if the seller has failed to meet particular requirements. The Dodd-Frank regulations are in addition to Colorado-specific disclosures that borrowers must receive when residential loans are made. I discuss both the Dodd-Frank and Colorado statutory requirements in greater detail in this article.

The Colorado Real Estate Commission and Board of Mortgage Loan Originators recently added another wrinkle to owner-carry financing deals by removing licensed Colorado real estate brokers from the negotiations. A 2014 Bulletin stated unequivocally: “Real estate brokers are prohibited by Colorado law from taking a residential mortgage loan application or offering or negotiating the terms of a residential mortgage loan, including a seller-financed loan. A real estate broker should not even assist a seller or buyer in any way with the application process or related documentation or engage in any loan term discussions if the seller-financed loan involves residential property.“

Now, if a buyer or seller wishes to consider the possibility of owner-carry financing, any real estate brokers involved in the deal must step aside and allow the parties or their legal counsel to discuss potential loan terms directly. This runs counter to the traditional notion of buyers and sellers conducting all negotiations through their brokers, per the terms of their respective Listing Contracts.

The remainder of this article is designed to familiarize buyers and sellers with the documents and terms used in these types of deals:

1. Contract to Buy and Sell Real Estate. The Buy/Sell Contract describes the terms of the purchase and sale generally. Section 4.7 of the current Colorado Real Estate Commission-approved Contract (2014) confirms the Bulletin position above, stating that “Brokers should not prepare or advise the parties on the specifics of financing.“

The Seller Financing section of the Contract allows the parties to designate who will prepare loan documents and gives both parties potential options to terminate the Contract if acceptable loan terms or documents cannot be agreed upon. The Contract is also the appropriate place to initially specify whether a lender’s title insurance policy will be required, as would be the case with an institutional lender.

2. Promissory Note. The Promissory Note is executed by the buyer at closing and describes the loan details, including terms of repayment. Some of the key terms that must be agreed upon and incorporated into the Note are:

1. 1. Loan Amount: The principal amount initially borrowed.
   2. Interest Rate: The rate of interest that will be charged on the loan.
   3. Payment Timing and Amount: The interval and amount of each payment, based on the amortization period of the loan. The amortization period is the length of time it would take to pay the entire loan off when making regular monthly payments.
   4. Escrow Payments: Whether the borrower is required to pay the lender any additional amounts to cover property tax and insurance obligations.
   5. Payment Recipient: Description of how payments are to be made. Some seller lenders require automatically recurring electronic payments or that payments be made to a third party servicing company.
   6. Maturity Date: When the balance of the loan becomes due. A loan with a Maturity Date that falls before the end of the amortization period is referred to as having a “balloon payment.” Sellers must be mindful of complying with Dodd-Frank restrictions on balloon payments, particularly if the seller is not an individual (for instance, if the seller is an LLC or other entity).
   7. Prepayment: Whether the buyer may pay the loan off in advance, and if so, whether any additional fees will be charged for doing so.
   8. Late Charges and Default Interest: Additional amounts owed by the borrower in the event that payments are not made on time.

3. Deed of Trust. The Deed of Trust is also executed by the borrower at closing and is recorded as a lien against the property to secure repayment of the loan. The Deed of Trust incorporates many of the Promissory Note terms, describes additional obligations of the borrower relative to the property, and outlines lender remedies in the event of default.
4. Seller Financing Addendum. While the Colorado Real Estate Commission provides standardized forms for the Contract, Promissory Note, and Deed of Trust, no standardized form is available to ensure that sellers comply with the disclosure requirements contained in Colorado statutes. These requirements are similar to Truth-in-Lending disclosures, which require divulgence of the loan’s Annual Percentage Rate (APR), Finance Charge, Amount Financed, Total of Payments, and Schedule of Payments, among other items. Please refer to my more detailed article on this subject for additional information.

Our firm has created an Addendum to meet these Colorado-specific loan summary requirements and to make those disclosures required by law. Once the parties have reviewed and agreed on the terms and form of the Promissory Note and Deed of Trust, they acknowledge their acceptance of the instruments by executing this Addendum, which then becomes a part of the Contract.

Correctly papering seller-carry finance deals has become much more difficult for buyers, sellers, and their real estate brokers in 2014. As recently as 2013, the standard Contract to Buy and Sell Real Estate contained a section to summarize pertinent loan terms, which allowed brokers to facilitate discussions about the financing. But we’re in a different era now.

Both buyers and sellers should consult with an attorney who is well-versed in this area of law before entertaining the idea of an owner-financed deal. Real estate brokers should point their clients to this article and advise them to do the same.

However, sellers in particular should absolutely work with an experienced attorney to ensure that: (1) the seller qualifies to offer owner-carry financing under Dodd-Frank, (2) all Colorado-specific disclosures are made, and (3) the loan documents are prepared to protect the seller’s investment. Failure to comply with applicable laws and regulations could have dire consequences for sellers if the buyer defaults and contests enforcement of the loan terms. Sellers could potentially be required to return loan payments, pay damages, and be limited in their ability to foreclose. These aren’t risks that sellers should take with a significant financial investment on the line.

Our firm routinely assists parties in owner-carry finance deals by facilitating negotiation of loan terms, drafting loan instruments, ensuring compliance with the vast array of new federal and state requirements, and making sure the deal closes as expected. Contact me if you’re interested in learning more or documenting your seller financing deal.