Real estate is a fairly safe investment that can help diversify an investment portfolio and leverage one’s capital. To succeed in real estate investing, however, investors have to be creative. There are many financing options and each has its own risks and benefits.
Why use creative financing at all? One reason is that the buyer may not have money. Seller financing is one common option. A seller financed transaction involves the seller conveying real estate to a buyer by warranty deed with the seller taking back a mortgage note secured by a deed, deed of trust or mortgage. The mortgage or other instrument generally becomes a first lien. Therefore, seller financing allows the buyer to use as little of his own money as possible.
Seller financing is often used when the seller owns the property free and clear of all liens and encumbrances. The seller doesn’t want the property and likes the idea of receiving a monthly payment. Seller financing allows the buyer to purchase the property for very little or no money down and lower closing costs.
Eliminating the bank or mortgage lender with seller financing certainly has an appeal. Instead of a bank or mortgage company, the seller acts as the bank. Although there are risks, both sellers and buyers can benefit. Prime seller candidates are typically those who do not need the cash proceeds from the sale immediately and instead prefer having a stream of income. If the buyer defaults, the seller may foreclose just like a bank or mortgage company.
If the seller finances the entire purchase price, he will generally continue to hold title to the property for the term of the note. How long the loan is to be repaid, the interest rate, late charge and due date, among other things, are negotiated between buyer and seller or their representatives.
There are various ways seller financed loans are structured. However, a seller financed loan can be as flexible as the parties negotiate. Most of the time the seller will want to designate a time limit for when the note must be paid in full. This is generally between one and five years. A typical offer to a seller is to pay interest only monthly at the prime rate. If the seller needs cash flow, he may negotiate a higher interest rate.
The qualified seller will report his income from the sale of qualified property on the installment sale basis unless he timely elects otherwise. This means he will recognize gain from the sale proportionately over time. The buyer gets a full stepped-up basis even though he may have given only an installment note to the seller.