Some Dos and Don'ts of Seller-Financed Home Sales

WHEN selling a home, owners sometimes are asked to finance the transaction.

Plenty agree to do so. Nearly $100 billion in seller-financed mortgages exist in the United States, according to Spokane, Wash.-based Metropolitan Mortgages & Securities. More than 200,000 such mortgage notes are created each year.

A strong motivation for sellers to finance their home sale is that real estate notes pay higher interest rates than bank deposits. A note instead of cash may be a good investment for retirees, for example, who are moving to a smaller dwelling and do not need all the equity from the sale of their current home, says Rachel Willis, an Austin-area realtor.

On the down side, a seller runs the risk that the buyer will not maintain the property and then stop making payments. A homeowner keen to sell may be willing to take that risk, especially at a time when rising interest rates mean that fewer buyers can qualify for a loan.

Sellers who reluctantly finance need not feel trapped. They can sell the mortgage note, too. When creating the note, sellers should try to ensure it will have a high resale value, experts say. And they should be careful in dealing with the investors and companies who compose the secondary market for such notes.

When negotiating with the homebuyer, the seller should structure the note to give the highest possible monthly payment, says Ron Rieger, acquisitions manager at Note Servicing Corporation in Houston. That means an interest rate at least as high as mortgage companies charge. The pay out should be short, perhaps through amortization at a 30-year repayment rate, but with a balloon payment of remaining principal after five years.

Keep in mind that potential buyers of self-financed mortgage notes have risk and reward criteria. Jeffrey Armstrong, president of Armstrong Capital in Canoga Park, Calif., wants to earn 10.5 percent to 11.5 percent on a note for a single-family home. Other companies seek up to 18 percent. If the note's interest rate is lower, the note buyer will offer less than its full principal amount. That way, income from the note will generate the desired yield on the note buyer's investment.

On the risk side, Mr. Armstrong will not buy a loan that is more than 75 percent of the value of a house, and only 50 percent on a note secured by raw land. So if a seller finances 100 percent of a $100,000 home, Armstrong could pay no more than $75,000 for the note. That's a serious incentive for the seller to get as big a downpayment from the homebuyer as possible.

Purchasers have costs of around $1,000 on each note they buy for a ``drive-by appraisal,'' credit check on the homebuyer, and title insurance. Rarely, then, can a note seller hope to receive full face value.

Nonetheless, ``as long as the note is structured properly, it should be a liquid investment,'' says William Mencarow, who tracks the note-buying business as publisher of The Paper Source in Winchester, Va.

A note holder need not advertise to attract interest. Note-purchasing companies pay 12 cents a name to courthouse services that compile lists of seller-financers nationwide. Dozens of companies will send postcards offering ``CASH IN AS LITTLE AS FIVE DAYS'' as an enticement to to call their toll-free numbers.

Armstrong mails 10,000 letters a month to new note holders. But he bought just 200 last year and is now averaging 40 a month.

Armstrong recommends that a note holder get a bid from every company that contacts him. Some are merely brokers who want to resell the note for a few thousand dollars profit, rather than hold it long term. Armstrong admits that he plays broker on notes that he doesn't want for his own portfolio but that would interest others.

Mr. Mencarow also cautions about the get-rich seminars that are flooding the field with aspiring buyers of self-financed mortgage notes. Some companies will promise too much, then try to change the details in the middle of the deal, he says.