The Value of Seller Refinancing
Borrowing from the Bank Is Good for the Bank
Many investors spend too much time trying to figure out ways to borrow money from banks and other “hard money” lenders. The reason, they claim, is to purchase their next bargain property, then hold it for a while, and sell it for a big markup. Naturally, their intention is to pay off the lender and pocket a hefty profit for themselves. In theory, this sounds like a marvelous plan. However, consider several problems that are working directly against that goal.
To start with, bank borrowing costs lots of money, especially for inexperienced investors, without top-notch credit. It’s even more expensive when you’re buying property for nonowner occupancy (rental units). Normally, there will be points to pay, higher interest costs, and variable rate payment adjustments tied to indexes that are very sensitive to rising costs. Many bank loans are written with short-term call dates and very low loan-to-value restrictions. This means that larger cash down payments will be required. More often than not, there is personal liability included in bank loans—plus substantial prepayment penalties if you pay the loan off early or wish to refinance it.
Also required are document fees, appraisal costs, escrow charges, and, sometimes, expensive termite work. Sometimes deferred maintenance repair funds are held back and deducted right off the top, which reduces net dollars the borrower will receive. I may have missed several other hidden expenses.
So, let me ask you this question—Does borrowing money this way seem like a good idea? It probably does if you are a lender. Frankly, it sounds like a marvelous plan if your goal is to make your banker rich.
Borrowing money from commercial banks and moneylenders is more likely to make you poorer, rather than richer. Obviously, there’s a much better way to borrow money for buying the kind of properties I recommend in this book. Seller financing should always be your first choice.
New Bank Loans Should Be an Investor’s Last Choice
If you’re someone who underlines important parts in books, then grab your pen and mark up these next couple paragraphs—they’re important.
Always try very hard to borrow the bulk of your new mortgage money (the real estate debt) from the owner who sells you the investment property. Remember, bulk means “most”—and not in every situation. Sometimes, commercial borrowing is justified if the deal has positive cash flow. However, that’s the exception, rather than the rule. It’s OK to assume the existing commercial loans (mortgages) on a property when you buy it, but your goal should be seller-provided financing for the balance owing, after you pay the agreed-upon cash down payment.
For example, a common situation might be where you purchase a property for $100,000. You agree to pay $10,000 cash down and assume an existing $40,000 mortgage—if it’s assumable. Next, you negotiate with the seller to have him carry back a note for the balance, which equals $50,000, in this case. With this type of real estate loan by the seller, you will generally end up with far superior financing than if you had borrowed new money from a bank or hard moneylender. Most sellers are much more generous with terms—especially when they’re selling rundown properties.
With seller financing, there won’t be any points to pay and it’s quite likely you’ll be able to negotiate an interest rate lower than what most banks would charge. You can also avoid a variable interest rate mortgage, unless you and the seller design your own to fit the transaction. The beauty of this kind of borrowing is that there are no set rules to follow. When there are no rules, the Golden Rule applies—the party with the gold rules. In most cases that can be you, if you’re buying the kind of properties I sug-gest—the ones that look ugly at first glance, but get more beautiful with each dollar they earn.
Buyers of Ugly Properties Get the Best Terms
Sellers of old, ugly, or problem properties are not in a position to be very picky about who they sell to. They can’t play hardball with the price and terms like owners of higher-quality, nicer-looking properties. The main reason is that the rundown and ugly conditions turn off 95% of all potential buyers. Consequently, lack of buyer competition will greatly limit the owner’s ability to sell.
What this means is you can almost always buy these properties for much less cash up front (lower down payments). Also, it’s likely the seller will be forced to accept much weaker terms. Lower equity payments and carryback notes are very common. Some of these deals can be 100% owner financing. Ugly, fixer-type properties are generally older properties. Many of them no longer have conventional mortgages (i.e., bank loans or savings and loan mortgages) to pay off. When they do, they are most likely low-balance loans with lower interest rates and nearly always assumable to new buyers. For beginning investors especially, let me say this loud and clear—owner financing is the kind you want. Owners are almost always more flexible than banks.
Property purchases where the owners will carry back low-interest financing are the kind of transactions that allow you to buy with minimum cash down payments and yet still be able to generate cash flow. Bank financing with higher interest rates and variable rate mortgages is not what you want. Bank financing will seldom be much of a problem when you buy older, rundown type properties like I recommend. The reason is that any original bank loans have long since been paid off—and most banks won’t write new loans on older properties today.
Seller Financing Is the Cadillac of All Financing
Seller financing can’t be beat when it comes to negotiating good terms like the following:
Long-term payoff (15-30 years)
Low interest rates, 6%-9% range in today’s market
No “due-on-sale” clause in note or mortgage
No prepayment penalty in note or mortgage
No late fee in note, unless the seller insists on one
No other restrictive terms or conditions, such as buyer agreeing to repave common roadway when holes or ruts appear
Seller financing—when you structure it properly—is better than FHA loans, GI loans, or any other type of institutional financing. Naturally, fix-up property sales are perfect for this, because most banks simply won’t write loans for this type of real estate. In many cases, sellers must finance the sale themselves or they can’t sell. Motivated sellers who own properties that won’t qualify for bank financing have no choice other than to carry back a mortgage or sell for cash (which is not too likely).
Financing That Fits the Needs of Both Parties
One reason I’ve had such good success with my fixer projects is that I’ve purchased older properties where sellers could and would provide the financing. Buyers and sellers can design creative terms that work to solve each other’s problems. Banks and most institutional lenders simply cannot do business this way. Their rigid lending policies and strict bylaws will not permit the kind of creativity we often need to make these deals work. Many good buys would have been lost for me if creative financing had not been an option. Always look for properties where owners can provide all, or most, of the financing. Quite often, new investors become totally baffled when they can’t find a bank loan. I cannot overemphasize the importance of seller financing, especially for do-it-yourself investors who need to keep all their options open—like buying the note back at a discount price in the future (as mentioned in Chapter 12).
Buying Back Your Own Debt Is Worth Big Bucks
One of the most profitable opportunities you miss when seller financing is not a part of your investment strategy is the chance to buy back your own mortgage debt later on from the seller. During the course of 20 years or so, many things will change. For example, a seller who is only too happy at the time of the sale to receive monthly payments for the next 20 years may suddenly find himself in a cash bind several years down the road. Money shortages are quite commonplace for all of us. Things like death, divorce, college funds, lifestyle changes, and loss of employment or income can quickly create a serious need for immediate cash.
When you design your seller carryback mortgages with good terms for yourself, like I showed you above, they have much less market appeal to professional note buyers. Note buyers like to have a late payment clause, prepay penalty, high interest rates, and much shorter terms; they won’t pay very much for mortgages without them. This means if they do make an offer to buy the note, the price they offer will generally be so low the seller will be insulted—and probably won’t accept.
What this means is that the mortgage you purposely designed with very good terms for yourself is worth much less if it’s sold before the payoff date. Now you can buy it back much cheaper, because the seller probably can’t sell it to anyone who would pay as much as you will. This strategy is worth big bucks when you do it right. I purchased my own $77,000 note for $41,500, just three years after I signed it. You’ll never get this opportunity when dealing with banks or hard moneylenders.
Tags: Fixer-Uppers, real estate, real estate book
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