What problems arise for the seller and the buyer in owner financed homes?
UPDATED: June 19, 2018
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An alternative form of financing much hyped during a languish seller’s real estate market is owner or seller financing or owner carryback. This means the owner participates in financing the buyer’s purchase of the property, either in whole or in part. However, if the deal if not properly structured, owner financing can cause significant problems for both the buyer and the seller under various circumstances. (Owner or seller financing typically becomes more prevalent when home sales slow down in a given geographical area and sellers of real property who are highly motivated to sell their property are more willing to take risks in its sale than they normally would if the real estate market was not slow.)
Example: A seller owns his or her home free and clear with no mortgage. The home is worth $200,000. A buyer agrees to purchase the home for $180,000 with $15,000 down and the seller agrees to carry the balance of the purchase price ($165,000) by way of a promissory note in his or her name secured by a first mortgage on the property being sold at a stated rate of interest payable in so many years.
Unless the seller and buyer have an experienced real estate attorney assisting him or her in an owner (seller) finance, the chances for serious problems arising from the transaction can be significant to both the seller and the buyer.
A typical problem for the buyer is if the seller does not own the property being sold free and clear of any mortgage or trust deed and the buyer cannot get a loan to pay off the existing loan, the buyer runs the risk of obtaining a loan from the seller and taking title subject to the existing loan in place. Should that happen, the buyer will have to pay on this loan just like the seller was doing. The problem that could arise for the buyer is that the loan in place may not be assumable. If the loan is not assumable, the transfer of title to a new owner of the property may very well trigger a due on sales clause in the existing mortgage where the lender refuses to accept payments from the new owner. This will force the new buyer to scramble to get a new loan, assuming one is available. If not, the new buyer could lose the home in a foreclosure.
If a foreclosure proceeding happens in such a scenario, the seller will be forced to service the loan that was in place or risk losing the equity in his or her seller finance. As you can imagine, the above situation invariably leads to litigation by the seller against the buyer.
When there is an owner financing situation and an existing first mortgage, it is imperative that the seller disclose this fact to the buyer advising him or her to ascertain whether or not the loan secured by the mortgage is assumable or not.
A typical problem in an owner financing situation is when the buyer can only qualify for a loan up to a certain dollar amount and the loan needs to be in a first secured position to be sold. In such a situation, the seller may agree to “loan” the buyer the balance of the home’s sales price evidenced by a promissory note secured by a second mortgage on the home.
The problem with the seller being in a second secured position for his or her “loan” to the buyer is that if the buyer defaults on the first secured loan, the seller in order to protect his or her loan must keep current the first loan that has a mortgage on the property. If not, the seller faces the possibility that the first loan will foreclose upon the property, wiping out the his loan on the home.
The most common problem arising out of an owner finance of a sale to the buyer is when the seller’s loan comes due for payment. Many times the buyer makes a claim that there are problems with the home that were not disclosed by the seller before close of escrow in an attempt to reduce the balance owed on the loan.
Most promissory notes have attorneys fee provisions within them. When a dispute arises concerning a promissory note containing an attorneys fee clause, the result is usually a very long and expensive litigation because the attorneys fee clause seems to be the force that drives the lawsuit between the attorneys representing the buyer and seller.
On its face, an owner (seller) financing situation seems like a good idea. However, if the transaction is not properly supervised by an experienced real estate attorney for both the seller and the buyer, many hidden traps may emerge.