Sometimes in a For Sale By Owner transaction, the buyer will ask the seller to take a note back on some or all of the purchase price.
The benefits of a seller carryback are usually to speed up the transaction, and usually yields a higher rate of return to the seller. At a time when interests rates were very low, it was a way for sellers to make above market rates like 8% or 9% on a loan. Sellers sometimes consider this a method of diversifying their investment portfolio and having a regular income source.
However, when a seller takes a promissory note back and records a deed of trust against the property, there are other pitfalls to be aware of. First, in a declining market, the seller should know that purchase money loans are subject to California’s anti-deficiency laws.
This means that should the property fall in value, and if the borrower ceases payments, the seller cannot pursue a judicial foreclosure. The judicial foreclosure would allow for the possibility of a deficiency (the shortfall from the sale proceeds) judgment against the borrower.
How about a private foreclosure? I’ll get to that. First, California is a trust deed state (not a mortgage jurisdiction). That means that when a loan is made and secured by real estate, it creates a three-party relationship. The lender is the beneficiary, the borrower is the trustor and in between the two is the trustee. The trustee is someone can exercise the power of sale provision in the Deed of Trust. This means that when a trustor stops paying, the beneficiary notifies the trustee, and the trustee begins the foreclosure proceedings.
This is a private foreclosure. The sole remedy is taking the property to sale. If the fair market value of the property is $500k, and your loan is for $300k, then there is a good chance that there will be many bids at the foreclosure sale and you will be paid off.
However, in a declining market, the beneficiary (seller) will not be so lucky. For example, if the property falls to $375k in value and your loan is at $300k, factoring in the costs of sale, there is not much profit in it for a foreclosure investor to bid on the property. That means that you may end up taking back the property is no one bids. It’s not the end of the world if you can fix it up, rent it out and wait until the next cycle for the price to increase.
So far, it’s not sounding too horrible or risky, right? Well, the above scenario is if the seller takes back a note in first position. What if the buyer says he or she can get a loan for $300k, and asks you to finance $100k in 2nd position behind the bank.
You would then become a junior lienholder. Again, higher risk equals higher reward and the interest rate would be much higher. However, what many sellers are unaware of is the full extent of the risk they are taking on. First of all, the junior lienholder should realize that the borrower/buyer now has 2 loans to service. Additionally, as interest rates rise, the risk of a usury situation increases.
What if the buyer becomes disabled or loses his or her job? Well, say they stop making payments to you. The same scenario above applies. You conduct a foreclosure sale and take back the property. However, it is subject to the bank’s loan so you will now have to undertake the debt service.
What if the borrower stops paying the bank? Well, now the fun begins. First, the bank has seniority over your loan, that means that their foreclosure sale will wipe out your lien. Gone. Secondly, in a market with falling house values, you may not have enough equity to protect you. If at the bank’s foreclosure sale, the bank’s loan of $300k is paid off and no one one bids more. You now have no security left.
If there is some equity, there may be some surplus proceeds from a high bid. Again, you are subject to the whim of the market at that stage. Maybe you will end up with $5k of the surplus funds.
What remedy would you have left? Well, you could sue the borrower on the loan agreement (now unsecured) and seek money damages. Of course, if they have no money in the first place, they are essentially judgment proof. Of course, if they are young and it is a temporary setback, you can go through the civil litigation process to ultimately obtain a judgment and perhaps garnish the borrower’s wages.
Before it gets that far though, you can advance to the senior to halt their foreclosure sale and conduct your own. That assumes that you have the funds to do that. It can be very expensive. Suppose the loan payments to the bank were $2000/month and the borrower did not pay for four months, and the additional four months of the foreclosure itself after the Notice of Default and Notice of Trustee’s Sale was recorded. That’s $16k right there, in addition to late charges and foreclosure fees that you would have to advance.
What are ways to minimize these risks? Evaluate the creditworthiness of the borrower. Find a reputable appraiser who understands that you are a lender looking at the worse-case scenario. That’s the start. Have a rule about what loan-to-value ratio that you will not go beyond. Most importantly, educate yourself on the perils of the transaction and seek professional expertise.