One of the things that bothers me about today’s real estate market is the relative scarcity of sellers willing to carry back mortgages.
To understand why I think it’s weird, we first need to understand what seller carry back financing is.
Simply put, seller carry back financing is when the seller of a property provides the mortgage for the buyer to buy it. The way it works is that the buyer comes in with a downpayment, just like in a regular sale. But, instead of getting a loan from a bank for the rest of the purchase price, the buyer executes a note in favor of the seller. Then, over time, the buyer pays off the note.
Here’s an example:
- Buyer agrees to buy a property from Seller for $1MM
- Downpayment is $250k
- Seller agrees to carry back a note for the balance of the price, $750k, at 7% interest only, with a balloon repayment after five years
- At closing, Seller gets the $250k (less transfer taxes, escrow fees, and whatever he has to pay his broker)
- Buyer makes monthly mortgage payments of $750k x 7% = $52,500 / 12 = $4375 / month for five years
- At the end of five years, Buyer either re-finances the $750k loan with a bank loan or else sells property and pays off Seller’s note
- If, at any time Buyer fails to pay, Seller simply forecloses, takes back the property, and keeps Buyer’s $250k downpayment
It’s pretty easy to see why a buyer might like to get seller carry back financing. First, if it a seller might agree to a higher loan-to-value or a lower debt service coverage ratio than would a bank. Second, a seller probably doesn’t need to get the ridiculous amount of paperwork that a bank requires to do a loan. Third, a seller might be willing to loan to someone with bad credit or insufficient income, which a bank wouldn’t do.
All of the above makes seller carry back financing sound pretty risky. So, why do I think more sellers should do it?
Well, one important reason is that, because the seller can offer as much leverage as he wants, he can probably get a buyer to pay a higher price than the buyer would otherwise be willing to deliver.
But, perhaps even more important is the interest rate the seller can earn on the note. In our present, low interest rate environment, it’s pretty hard to get a safe 6-9% / year return. So, the question is, if you sell your property, what are you going to do with the money?
Why not get a chunk of money now (the buyer’s downpayment) and invest the balance in what is effectively a bond paying 6-9% for, say, five years? That’s better than you’ll do anywhere else. And, in the unlikely event the buyer defaults on the loan, you take the property back, keep his downpayment, and sell it again!