Finance_13 Instructor Materials.docx

13. Seller Financing Learning Objectives After completing this lesson, students should be able to… Discuss when and why seller financing might be used and how it works Define “seller second” and describe how it can be used to supplement either a new loan or an assumption Understand how seller financ...

13. Seller Financing Learning Objectives After completing this lesson, students should be able to… Discuss when and why seller financing might be used and how it works Define “seller second” and describe how it can be used to supplement either a new loan or an assumption Understand how seller financing might be used as primary financing Describe how a land contract differs from a mortgage or deed of trust Explain how wraparound financing works List alternatives to seller financing, such as buydowns or lease arrangements Summarize an agent’s responsibilities in a seller-financed transaction Suggested Lesson Plan 1. Give students Exercise 13.1 to review the previous chapter, “VA-Guaranteed Loans.” 2. Provide a brief overview of Chapter 13, “Seller Financing,” and review the learning objectives for the chapter. 3. Present lesson content: How Seller Financing Works When and Why Seller Financing is Used EXERCISE 13.2 When and why seller financing is used Seller Seconds – Supplementing a new loan – Supplementing an assumption EXERCISE 13.3 Seller seconds Seller Financing as Primary Financing – Unencumbered property – Land contracts – Encumbered property: wraparound financing Alternatives to Seller Financing – Buydowns – Contributions to closing costs – Equity exchanges – Lease arrangements Legal Responsibilities in Seller-Financed Transactions – Disclosure statements – Buyer’s ability to repay – Agent’s liability EXERCISE 13.4 Land contracts and seller financing alternatives 4. End lesson with Chapter 13 Quiz. Chapter 13 Outline: Seller Financing I. How Seller Financing Works A. A seller can use a promissory note and security instrument to finance the buyer’s purchase; such a loan is known as a purchase money loan or seller carryback loan B. A seller may also use a land contract, where the buyer takes possession of the property but the seller retains title until the price has been paid in full C. Seller financing is usually secondary financing, where a “seller second” supplements an institutional first mortgage II. When and Why Seller Financing is Used A. If interest rates are high and buyers have difficulty qualifying for loans, the only way a seller may be able to sell the property is by financing part of the purchase price B. Sellers may use seller financing as a marketing tool; buyers may pay more for a house if they can get favorable seller financing terms C. Seller financing may have tax advantages: if payments are made over a period of years, the seller doesn’t have to report the full profit from the sale in the first year EXERCISE 13.2 When and why seller financing is used III. Seller Seconds A. Often, seller financing is secondary financing: the seller accepts a second mortgage (a “seller second”) for the difference between the primary loan amount and the purchase price B. Supplementing a new loan 1. The seller second must meet the primary lender’s requirements; for instance, for a conventional loan, the primary lender might state that the total financing can’t exceed 95% of the sales price, and the second loan may not require a balloon payment less than five years after closing 2. A buyer considering a seller second needs to consider how much he has for a downpayment, the total monthly payment he can qualify for, and how large the balloon payment for the seller second will be 3. A seller considering a seller second needs to think about whether cash flow and yield will be adequate, possible negative tax consequences (such as the imputed interest rule), and lien priority C. Supplementing an assumption 1. A seller second can supplement a buyer’s assumption of an existing loan; the buyer will make a monthly payment to the seller, as well as making the monthly payment the seller has been making to the lender 2. If the loan has a due-on-sale clause, an assumption isn’t possible unless the lender agrees to it 3. Regardless of whether there is a due-on-sale clause, the lender’s consent is necessary for the seller to be released from liability EXERCISE 13.3 Seller seconds IV. Seller Financing as Primary Financing A. Unencumbered property 1. Seller financing is straightforward if the seller owns the property free and clear 2. While lien priority is not as much of a concern with primary seller financing, the seller must make sure that taxes and special assessment liens are paid so that the government doesn’t foreclose 3. Escrow account can be set up to handle the buyer’s tax and hazard insurance payments 4. If a seller is willing to provide substantial financing but needs cash at closing, a possibility is seller financing with an institutional second mortgage B. Land contracts 1. A seller providing primary financing might choose to use a land contract (also known as a conditional sales contract or installment sales contract) instead of a mortgage 2. Under a land contract, the seller (or vendor) retains legal title to the property until the buyer (or vendee) pays off the entire purchase price in installments 3. A land contract is not accompanied by a promissory note; the contract describes the terms of sale and the financing arrangements 4. For some land contracts, if a vendee defaults on the contract obligation, the vendee’s rights in the property are terminated and the vendor retains all payments made so far; this remedy is known as forfeiture 5. Courts won’t necessarily allow forfeiture, depending on how long the vendee has been making payments 6. The main disadvantage of a land contract is the expense and delay of court proceedings in the event of breach 7. Lenders are not likely to offer institutional secondary financing if the primary financing is through a land contract C. Encumbered property: wraparound financing 1. With a wraparound, the property remains subject to the existing mortgage (or underlying loan), and the seller continues to make payments 2. Each month, the buyer makes a payment to the seller, and the seller uses a portion of that payment to make the payment on the underlying loan 3. A wraparound can use a mortgage, a deed of trust (called an all-inclusive deed of trust), or a land contract 4. The underlying loan cannot have a due-on-sale clause; it is never a good idea to use a “silent wrap,” where the lender isn’t informed of the sale of the property 5. Wraparound financing can be attractive if rates have been rising; it allows the buyer to finance a purchase at a below-market rate on the total amount financed while the seller receives an above-market rate on the credit extended V. Alternatives to Seller Financing A. Buydowns: the seller may assist a buyer with a buydown, by paying discount points to reduce the buyer’s interest rate B. Contributions to closing costs: the seller may pay some of the buyer’s closing costs, which can be more helpful than a price reduction for the same amount C. Equity exchanges: a seller may accept other assets from a buyer in addition to cash D. Lease arrangements: a seller may lease a property to a buyer for a time before the buyer purchases it, either through a lease/option or a lease/purchase 1. A lease/option involves a lease for a specific term along with an option to purchase the property at a specified price 2. The option money and/or the rental payments may be applied toward the purchase price in a lease/option, either deducted from the sales price or treated as part of the downpayment 3. In a lease/purchase, buyer and seller sign a purchase contract along with the lease, so that deciding not to purchase at lease’s end means a breach of the contract VI. Legal Responsibilities in Seller-Financed Transactions A. An agent should recommend that both parties get legal and tax advice, and have documents reviewed by a lawyer, before proceeding with seller financing B. Disclosure statements: some states require disclosure forms when a third party (such as a real estate agent) helps arrange seller financing C. In some seller-financed transactions, an agent may be responsible for evaluating the buyer’s ability to repay the loan D. Agent’s liability: a disclosure statement does not limit an agent’s liability 1. An agent who encourages an unwise financial arrangement might be liable for breach of fiduciary duties 2. An agent who arranges seller financing might create an inadvertent dual agency EXERCISE 13.4 Land contracts and seller financing alternatives Exercises EXERCISE 13.1 Review exercise To review Chapter 12, “VA-Guaranteed Loans,” have students answer the following questions. 1. What fee does a VA borrower pay at closing instead of a mortgage insurance premium? 2. What document does the VA issue to veterans that enables them to apply for a VA loan? 3. What is the guaranty amount available to a particular veteran known as? 4. What is the document issued by a VA-approved appraiser concerning the security property’s value? 5. What’s the term for the income that’s left over after the monthly shelter expense, all other recurring obligations, and certain taxes are subtracted from a VA borrower’s gross monthly income? 6. What happens when a veteran repays a loan in full with the proceeds from the sale of the property? Answers: 1. Funding fee 4. Notice of Value or Certificate of Reasonable Value 2. Certificate of Eligibility 5. Residual income 3. Entitlement 6. Restoration of entitlement EXERCISE 13.2 When and why seller financing is used Match the correct term to the descriptions below. Purchase money loan Installment sale Land contract Loan origination fee Seller second High market interest rates Promissory note Blanket loan 1. When a home buyer gives a mortgage to the seller. 2. A tax advantage of seller financing is that the seller can report the transaction to the IRS as one of these. 3. A seller financing arrangement in which the buyer takes possession of the property, but the seller retains title until the price is paid in full. 4. Financing provided by a seller to supplement the buyer’s institutional loan. 5. One of the charges a buyer can avoid or reduce with seller financing, to make the transaction more affordable. 6. These make seller financing especially attractive to both sellers and buyers. Answers: 1. PURCHASE MONEY LOAN. When a seller extends credit to the buyer and the buyer gives the seller a mortgage or a deed of trust, it’s called a purchase money loan. 2. INSTALLMENT SALE. With an installment sale, the seller can defer payment of some of the taxes on the gain. 3. LAND CONTRACT. With a land contract, the buyer receives possession immediately, but doesn’t take title until the contract price is paid in full. 4. SELLER SECOND. A seller may provide either primary financing or secondary financing that supplements an institutional first mortgage. Secondary financing provided by the seller is called a seller second. 5. LOAN ORIGINATION FEE. Institutional lenders usually charge a loan origination fee; sellers providing financing typically do not. With seller financing as primary financing, the origination fee is avoided altogether. With a seller second, the origination fee for the primary loan is reduced, because the loan amount is smaller and the fee is a percentage of the loan amount. 6. HIGH MARKET INTEREST RATES. When interest rates are high, it’s harder for sellers to find a buyer, and harder for buyers to afford a home. Seller financing can help both a seller and a buyer achieve their goals. EXERCISE 13.3 Seller seconds Discussion Prompts: Why does the primary lender care about the terms of a seller second? What are some of the key considerations for a buyer who’s considering a financing arrangement involving a seller second? What are some of the key considerations for a seller who’s considering offering a buyer a seller second? When would an assumption plus a seller second be allowed? Analysis: A seller second (like any secondary financing) might have terms that could make default or a loss on the primary loan more likely. For example, if the seller second required a large balloon payment after only two years, it might be very difficult for the buyer to make that payment. The buyer could end up defaulting on the seller second, the primary loan, or both. Even though the primary loan has higher lien priority, foreclosure on secondary financing can significantly impair the primary lender’s security interest and/or result in a loss on the primary loan. A buyer should consider: 1) how much cash he has available for the downpayment; 2) whether he’ll be able to qualify for (and comfortably pay) the combined payment on the two loans; and 3) how he will make the balloon payment (if one is required for the seller second) when the time comes. A seller should consider: 1) whether the cash flow from the seller second will be adequate; 2) how the return on the seller second will compare to the return on alternative investment possibilities; 3) the tax consequences of the transaction; and 4) how she may be affected by lien priority. An assumption plus a seller second will work only if there’s no due-on-sale clause in the loan the buyer would assume, or if the lender agrees to the assumption. The lender’s consent will always be needed if the seller wants to be released from liability. EXERCISE 13.4 Land contracts and seller financing alternatives Discussion Prompt: Briefly explain how each of the following arrangements works. 1. Land contract 2. Buydown 3. Lease/option 4. Lease/purchase 5. Equity exchange Answers: 1. In a land contract, the buyer takes possession of the property immediately but pays the contract price to the seller in installments, instead of in a lump sum. While the buyer (the vendee) is paying off the contract, the seller (the vendor) retains legal title to the property. The vendee has only equitable title. When the contract has been paid off, the vendor gives the vendee a deed transferring legal title. 2. In a buydown, the seller agrees to pay points to the buyer’s lender. In return, the lender lowers the interest rate on the buyer’s loan, either for a certain number of years (a temporary buydown) or for the life of the loan (a permanent buydown). This makes it easier for the buyer to qualify for the loan, and also makes the payment more affordable. 3. In a lease/option, the tenant/optionee leases the property for a certain term and also gives the landlord/optionor nonrefundable option money. During the lease term, the buyer/tenant has the option of purchasing the property at a specified price. The option money and/or the rental payments may be applied toward the purchase price. 4. In a lease/purchase, the tenant/buyer and the landlord/seller execute both a lease and a purchase agreement at the same time, and the tenant/buyer also provides an earnest money deposit. If the tenant/buyer decides not to purchase the property by the end of the term, it’s a breach of contract, so she forfeits the deposit. 5. In an equity exchange, the seller agrees to accept certain personal property instead of cash as part of the downpayment from the buyer. Chapter 13 Quiz 1. Rather than using an institutional loan, a seller extends credit to a buyer and the buyer gives the seller a deed of trust. This would be known as a/an: A. assumption B. land contract C. purchase money loan D. wraparound loan 2. Which of the following would NOT be a reason for a seller to use seller financing? A. It can help attract a buyer at times when interest rates are very high B. It may allow the seller to charge a higher price for the house in exchange for other benefits C. It provides a seller who needs to be cashed out with a large lump sum D. It provides tax benefits 3. Seller financing can provide significant tax benefits for a seller because it involves: A. an installment sale B. casualty loss C. depreciation D. recapture 4. A seller second is used to supplement a/an: A. land contract B. new institutional loan C. assumption D. Either B or C 5. A seller might be affected by the IRS’s imputed interest rule if the: A. seller finances too large a portion of the total sales price B. seller second includes a balloon payment C. seller second is for too long a loan term D. seller second uses an interest rate that is too far below market rates 6. If a seller is willing to finance most of the purchase price but needs some cash at closing, a possible solution is: A. a land contract B. a wraparound loan C. an institutional loan plus a seller second D. primary seller financing plus an institutional second 7. In a land contract, the seller is also known as the: A. trustee B. trustor C. vendee D. vendor 8. Who holds legal title during the repayment period of a land contract? A. Trustee B. Trustor C. Vendee D. Vendor 9. The penalty for the vendee’s breach of a land contract may be: A. forfeiture B. garnishment C. liquidated damages D. relinquishment 10. How does wraparound financing work? A. An existing loan wraps around the seller financing B. The buyer assumes an existing loan and receives supplemental financing C. The seller retains legal title to the property while the buyer repays the purchase price D. The seller financing wraps around the underlying loan 11. A deed of trust used in a wraparound arrangement may be known as a/an: A. all-inclusive trust deed B. blanket mortgage C. package mortgage D. underlying loan 12. A “silent wrap” is: A. a commonly accepted practice B. a failure to notify the underlying lender of the wraparound arrangement C. an arrangement where the buyer assumes the underlying loan D. used when the underlying loan is larger than the planned seller financing 13. A common way for a seller to assist a buyer is to use a/an ____, in which the seller’s proceeds will be reduced by a certain amount at closing, in exchange for a lower interest rate for the buyer. A. assumption B. buydown C. equity exchange D. lease/option 14. A buyer doesn’t have adequate cash to close a proposed transaction, but the seller agrees to accept a sailboat owned by the buyer in exchange for a $20,000 reduction in the purchase price. This is a/an: A. buydown B. equity exchange C. lease/purchase D. Section 1031 exchange 15. In a lease/option: A. the buyer gives a noncash asset to the seller in exchange for a reduced sales price B. the buyer leases the property for a period of time and may choose to buy it at a specified price during the lease term C. the buyer leases the property, but is committed to buying it at the end of the lease D. the seller pays discount points to the lender on behalf of the buyer Answer Key 1. C. A purchase money loan is any loan where the seller extends credit to the buyer instead of actually supplying loan funds, and the buyer repays the price in installments over time. 2. C. Seller financing isn’t an option for a seller who needs to be cashed out right away, such as a seller who needs all of her net equity to buy another house. 3. A. Because the buyer pays the seller in installments over a number of years, the seller can defer payment of part of the taxes and the profit from the sale may be taxed at a lower rate. 4. D. A seller second may be used to supplement either a new loan from an institutional lender, or an assumption of an existing loan. 5. D. If a seller offers financing using an interest rate that is too far below market rates, the Internal Revenue Service will treat a portion of the principal received each year as interest (which is taxable). 6. D. A seller who needs some cash at closing, such as the cash for a small downpayment on a new property, may choose to offer primary financing in conjunction with a supplemental institutional loan. 7. D. The seller in a land contract is also known as the vendor. 8. D. The vendor, or seller, retains legal title until the vendee has paid off the entire purchase price. The vendee has the right to possess the property, which in this context is sometimes called equitable title. 9. A. The penalty for breach of a land contract may be forfeiture, in which all payments are retained by the vendor and the vendor may retake possession of the property immediately. Depending on state law and the circumstances of the case, though, a judge might not allow forfeiture. 10. D. In a wraparound arrangement, the seller financing is larger than the balance owed on the existing mortgage, which remains in place. The buyer makes monthly payments to the seller, some of which the seller will use to continue making payments on the underlying loan. 11. A. When a deed of trust is used in a wraparound, it is often referred to as an all-inclusive trust deed. 12. B. In a silent wrap, a seller tries to get around an underlying loan’s due-on-sale clause by using a wraparound land contract and not notifying the lender of the arrangement. A real estate agent should not get involved in a silent wrap. 13. B. In a buydown, the seller gives a lump sum to the lender at closing, in exchange for a lower interest rate for the buyer. 14. B. In an equity exchange, the buyer gives the seller a noncash asset (such as an item of personal property) in exchange for a reduction in the cash sales price. 15. B. A lease/option gives a tenant the option of buying the property for a specified price during the lease term. The tenant will usually pay nonrefundable option money at the beginning of the lease term, which may be applied to the purchase price.