For many investors, the sooner they can sell a property to recognize their profit and re-invest their capital, the better. These days, both conventional and private money lenders have tightened up their underwriting so buyers can be slowed down from closing escrow. Interest rates are still historically low. This is a classic scenario where seller carry-back financing becomes more attractive to the buyer and the seller.
How does seller carry-back financing work?
The buyer is approved for a loan that does not cover the entire purchase price. The seller takes a Promissory Note secured by a Deed of Trust1 for the balance of the purchase price.
This is effectively a “purchase money” loan. For example, on a $500,000 purchase price, where the bank agrees to finance only $400,000 and the buyer is only paying 5% down for $25,000, the seller would carry back the remaining $75,000 in second position behind the bank loan. The institutional lender would be the “senior first lien” and the seller would be the “junior second lien”.
The pros to the seller are clear, they are getting at least 85% of the purchase price, and they can sell the property sooner rather than waiting for another offer to come along. Additionally, because the seller’s loan is in a higher risk position, they can charge the buyer a higher interest rate. Many sellers on a fixed income also like the thought having additional cash flow.
The risks however are many, and sellers who did not know about their state’s anti-deficiency laws and carried back some paper in the last three years are now unlikely to see a penny.
Anti-Deficiency Statutes
In California, if a buyer defaults on his or her loan, and the senior lender conducts a trustee’s sale auction (non-judicial foreclosure sale) and wipes out the seller in second position (junior lender)—the seller is barred from going after the borrower for a deficiency judgment.
Why? California has Anti-deficiency statutes. These statutes were enacted in many states to protect homeowners and stabilize the economy and prevent lenders from doing any more damage than taking back the property. These anti-deficiency laws were enacted in the Dustbowl era to give homeowners a fresh start, without a deficiency judgment hanging over their heads.
California Code of Civil Procedure Section 580(b) states in relevant part:
“No deficiency judgment shall lie in any event after a sale of real property or an estate for years therein for failure of the purchaser to complete his or her contract of sale, or under a deed of trust or mortgage given to the vendor to secure payment of the balance of the purchase price of that real property or estate for years therein, or under a deed of trust or mortgage on a dwelling for not more than four families given to a lender to secure repayment of a loan which was in fact used to pay all or part of the purchase price of that dwelling occupied, entirely or in part, by the purchaser.”
In plain English – the statute addresses 2 types of loans:
1) purchase money loans and
2) seller carry-back loans (the statute uses the word “vendor” to refer to the seller.)
That means that in the hypothetical above, the seller who carried back $75,000 has only one remedy, and that again governed by statute, it is the “one action rule” (California Code of Civil Procedure 726) which means that the seller can only get the collateral back, and that is by foreclosure on the Deed of Trust.
While there have been some cases in California where sellers who carried back the balance of the purchase price were allowed to seek a judgment against the borrowers—it is rare. In those cases, the sellers had subordinated their loans to extraordinarily large construction loans which were intended to develop the parcels.
However, the majority of sellers who carry back financing are subject to the anti-deficiency statutes and that means their only recourse on the Note is take back the property at sale. If the borrower has stopped paying the loan, then in order for the seller to take back the sale, the seller must cure any default or arrearages on the senior loan, record their own Notice of Default to begin the foreclosure process. The seller usually takes back the property at sale and looks for tenants to rent out the property too and wait out the next economic cycle to re-sell the property.
This can work out financially in the very long term. After all, the seller received $425,000 on the first sale. If the seller is able to sell it a few years later for $550,000 then the years of servicing the senior loan could have been worth it.
In the present declining market—the above approach usually does not work because often times the property does not even have enough equity to cover the senior and worse, the borrower’s own may be incredibly onerous, with an adjustable rate mortgage and a pre-payment penalty. If the senior loan requires a $3,000 monthly mortgage payment but the tenant is only paying $1,500 the seller may not have enough capital reserves to wait out the economic cycle or the pre-payment penalty period.
What can sellers who want to carry back financing do to minimize their risk?
Sellers can carry back for a very short term. That gives the parties enough breathing room to close escrow, but not so much time that the economic landscape changes drastically. Buyers would then have to find an alternative source to pay off the seller’s Note sooner.
Sellers can also ask for a Guarantor on the loan. That means if the borrower defaults, the seller can look to the guarantor for the deficiency.
One Last Area to Watch For:
When choosing the interest rate on the Promissory Note, a seller needs to avoid usury. In California, unless the seller is licensed with the Department of Real Estate, the seller is subject to this capped rate as stated by the California’s Office of the Attorney General,
“The California Constitution allows parties to contract for interest on a loan primarily for personal, family or household purposes at a rate not exceeding 10% per year. As with all other percentages we are listing, this percentage is based on the unpaid balance. For example, if a loan of $1,000 is to be paid at the end of one year and there are no payments during the year, the lender could charge $100 (10%) as interest. However, if payments are to be made during the year, the maximum charge allowed could be much less.”
[1] California is a trust deed state instead of a “mortgage” state so we generally do not use terms like “mortgagor”, “mortgagee” etc. and instead the parties are the Trustor (borrower), the Beneficiary (lender) and the Trustee.
