Archives For Seller Financing

Brokerage Reminder: Carryback financing – the creditworthy buyer and mandated disclosures

Brokerage Reminder: Carryback financing – the creditworthy buyer and mandated disclosures

This article series analyzes the seller’s use of carryback financing as a flexible financing arrangement to encourage prospective buyers to purchase the seller’s property in a recessionary market.

Part II of this series comments on the seller’s agent’s and carryback seller’s need to investigate and analyze a buyer’s creditworthiness and capacity to pay, and the proper structure for a carryback transaction purchase agreement.

For an introduction to the concept of seller carryback financing and a discussion of the tax benefits of carrying paper for the seller, and the flexible sale terms available to the buyer, see Part I of this article series. For comments on the yield limitations which contrast loans from credit sales, and the requirements a carryback seller is to meet to be eligible for exemption from mortgage loan originator licensing, see Part III of this article series.

The need for credit checks

Carryback sellers face the risk a buyer will default, no matter how wealthy, conscientious and qualified they might appear to be. On any default in payments on a trust deed note, the seller’s sole source of recovery is to resort to the property secured by the trust deed (unless the note is subordinated to a construction loan or additionally secured by property other than the property sold).

The Consumer Financial Protection Bureau (CFPB)’s ability-to-repay regulations require an owner who carries back more than one note secured by a one-to-four unit residential property in a 12-month period to investigate and document a buyer’s ability to repay the carryback debt according to the CFPB’s criteria. Part III of this article series digests the criteria for exemption from this requirement for sellers who carry back only one note per 12-month period. [15 United States Code §1602(cc)(2)(E)]

Related articles:

Ability-to-repay, qualified mortgage and qualified residential mortgage — oh my!

Brokerage Reminder: Carryback financing – restrictions, limitations and MLO licensing exemptions

Even if the carryback seller is exempt from CFPB requirements, it’s in the seller’s best interest to ensure the buyer is creditworthy, meaning willing and able to pay as agreed. This determination must be made for the same reason a landlord must obtain reliable credit information on prospective tenants. Prudent mortgage lenders also abide by these same fundamentals when making a loan; propensity to pay and source of funds for payments.

Further, the carryback seller performs a background check on the buyer’s management of property they owned or occupied to be certain the buyer will maintain the property unimpaired as required by the carryback trust deed provisions. If the buyer is discovered to be unqualified to own and care for property, the seller may justifiably cancel the carryback transaction before closing since the buyer presents an unreasonable risk to the security for the carryback note.

The buyer needs to have the financial ability and credit history to pay the trust deed note carried back by the seller and any underlying the first trust deed loan before the seller approves and closes the sale. A default by the buyer on the first trust deed jeopardizes the seller’s security interest in the property under their second trust deed lien.

A seller’s agent has the duty in a carryback transaction to advise the seller about the need to obtain credit information on the buyer, as well as disclose any facts known or readily available to them about the buyer’s creditworthiness which might affect the seller’s interest.

The seller’s agent documents the buyer’s creditworthiness and ability to pay their debts by:

  • analyzing an application for credit, along with credit reports and criminal background reports obtained on the buyer under authority granted in the application [See first tuesday Form 203 and 302];
  • reviewing financial statements, both an operating statement (profit and loss report) and a balance sheet (net worth statement) and confirming bank balances [See first tuesday Forms 209-2 and 209-3];
  • contacting the buyer’s creditors (vendors, landlords, lenders) for their experiences with the buyer’s payment history; and
  • inspecting properties owned by the buyer to determine the level of care and maintenance the properties have received from the buyer.

Analyzing credit information

The right to obtain credit information also applies to private parties such as carryback sellers. Thus, the seller’s agent orders the buyer’s credit report. On receipt, the agent reviews it with the seller. In turn, the seller independently decides to either proceed with the transaction or cancel it under a further-approval contingency in the purchase agreement. [See first tuesday Form 150 §8.5]

Written disclosures itemizing the buyer’s credit information are mandated on all sales involving one-to-four unit residential properties when the seller carries back a portion of the sales price. [Calif. Civil Code §§2956 et seq.]

All disclosures are to be made in good faith by the buyers, brokers and agents to meet the objective of the credit investigation. [CC §2961; see first tuesday Forms 302, 209-2 and 209-3]

Even the existing trust deed lender has the right to obtain credit information from the buyer on a change of ownership. The lender, like a carryback seller, needs to make an informed decision as to whether the risk of default in the payments or care and management of the property will increase under the new ownership, a situation called impairment of the security. [Santa Clara Savings and Loan Association v. Pereira (1985) 164 CA3d 1089]

Neither a carryback seller nor a private lender typically has the resources of institutional lenders to personally investigate and assess a buyer’s creditworthiness and management capabilities prior to making a loan. Thus, a broker or an agent who assists private lenders and carryback sellers is obligated to help them, or advise that someone else needs to help them, determine the buyer’s ability to operate the property and their propensity and resources to make payments on a carryback note. [Dawn Investment Co., Inc. v. Superior Court of Los Angeles (1982) 30 C3d 695 (Disclosure: the legal editor of this publication was an amicus for this case.)]

Financial statements for income and worth

Two financial aspects of a buyer’s ability to perform on the carryback note need to be investigated by the seller and their agent:

  • the ability of the property’s income to cover the expenses, and carry the debt service if it is income-producing; and
  • the ability of the buyer to personally service any negative cash flow resulting from the debt burden or lack of rental income or the buyer’s use of property.

To investigate the ability of income property to carry its debt service, the property’s income and expenses are analyzed using the Annual Property Operating Data Sheet (APOD). [See first tuesday Form 352 and the first tuesday Income Property Brokerage (IPB) suite of forms]

If the property’s income is unable to support its operating expenses and debt service, the seller needs to look for other abilities of the buyer to carry the negative cash flow brought on by payment of the carryback note.

The buyer’s personal capacity to pay is investigated by a review of the financial statements delivered by the buyer itemizing their:

  • income/expenses (profit and loss statement); and
  • net worth (balance sheet).

Related article:

The asset, liability and net worth balance sheet – interpretation of financial health

Evaluating credit information

Once a seller’s agent has obtained a buyer’s credit application and financial statements, the data must be evaluated by the agent and seller.

The buyer’s representations of employment, cash deposits and loans with existing lenders is best verified by requesting confirmation, as is done by any mortgage lender or mortgage loan broker originating a loan. [See first tuesday Form 210 through 214]

Formulas for determining a buyer’s ability to pay for any negative cash flow generated by the purchase of the real estate are structured as costs of ownership-to-income ratios, referred to as a debt-to-income (DTI) ratio. [See first tuesday Form 230]

Institutional lenders generally set the ratio of home loan payment to gross income at around 33%. Further, institutional lenders typically set the ratio of total installments on all debt to gross income at around 40%.  However, when applying ratios as guidelines to determine a buyer’s creditworthiness, each buyer needs to be treated individually. Depending on other financial factors, a buyer who does not meet the DTI ratio does  not necessarily impose an increased credit risk.

Also, the seller and their agent may apply an arbitrary ratio or formula for the buyer’s installment payment burden, such as a three-to-one income-to-note/rent payment ratio, as the only basis of determining the buyer’s creditworthiness, as long as the ratio is uniformly applied to all transactions. [Harris v. Capital Growth Investors XIV (1991) 52 C3d 1142]

In addition, requiring employment to be a qualification for prospective buyers unfairly discriminates against people who receive income from:

  • investments;
  • annuities;
  •  retirement pay;
  • family support; or
  • private subsidies.

Thus, the carryback seller reviews all credit information supplied by the buyer and looks for a reason why the buyer does or does not qualify as a good credit risk for the amount of debt and the payments to be made.

Only after all credit information has been reviewed and creditworthiness has not been established can the seller reasonably cancel the carryback transaction – or renegotiate it – due to the buyer’s lack of credit.

The creditworthiness contingency

Initially, a carryback disclosure statement is to be attached to any purchase agreement containing provisions for a carryback note. The carryback disclosure statement is mandated on the sale of one-to-four residential units. However, a prudent seller’s agent will also require a disclosure statement in carryback transactions on all types of property be part of the offer/counteroffer negotiations. [CC §§2956 et seq.; see first tuesday Form 300]

Both the carryback disclosure statement and the purchase agreement include a credit approval contingency. The further-approval contingency provision calls for the buyer to hand the seller a completed credit application. [See first tuesday Form 302]

The buyer’s agent preparing a carryback offer should consider having the buyer fill out the credit application on commencement of negotiations and attach it to the buyer’s purchase agreement as an addendum. Early disclosure helps the seller determine the buyer’s sincerity and good-faith willingness to cooperate in a fully transparent credit analysis process.

The credit contingency allows the carryback seller to terminate the purchase agreement by a written Notice of Cancellation if they have grounds to disapprove of the buyer’s creditworthiness. [See first tuesday Form 150 §10.5]

However, the credit contingency does not give the carryback seller the unrestricted right to withdraw from a binding and otherwise enforceable purchase agreement.

Thus, the seller needs good reason to disapprove the buyer’s credit in order to cancel the transaction. Without good reason, the seller who cancels by wrongfully using the credit contingency as a back door provision to escape performance breaches the purchase agreement in bad faith. [Lyon v. Giannoni (1959) 168 CA2d 336]

One-to-four unit carryback transactions

All brokered transactions for the purchase of one-to-four unit residential property involving seller carryback financing are controlled by statute. For one-to-four unit residential properties, a written carryback disclosure statement is required to be presented to both a buyer and seller for their review and signatures. [CC §§2956 et seq.]

Even the use of a masked security device, such as a land sales contract, lease-option or unexecuted purchase agreement with interim occupancy, requires written carryback disclosure statements.

The written disclosure statements inform the buyer and seller about the extent of the risks presented by failing to use grant deeds, notes and trust deeds to evidence an installment sale when the buyer takes possession. [See first tuesday Forms 300, 300-1 and 300-2]

On the sale of a one-to-four unit residential property, any credit extended by the seller to accommodate the buyer’s deferred payment of the purchase price requires a written carryback disclosure statement when the carryback arrangements include:

  • interest or other finance charges;
  • five or more installments running beyond one year;
  • an installment land sales contract;
  • a purchase lease-option or a lease-option sale;
  • credit (note) to adjust equities in an exchange of properties; or
  • an all-inclusive note and trust deed (AITD). [CC §2957]

Carryback disclosure statements are not mandated in carryback transactions creating straight notes which do not bear interest or include finance charges. However, carryback disclosures are to be included as a matter of good brokerage practice since the risks and issues for the buyer and seller under a straight note are similar and the duty owed the client is the same.

Offer includes disclosures

The best policy for a buyer’s agent is to eliminate the need for further approval of the statutory carryback disclosures by preparing and attaching a carryback disclosure statement as an addendum to the purchase agreement. If the disclosure statement is not attached, a prudent seller’s agent will include it as an addendum to a counteroffer to eliminate the disclosure contingency. [CC §2956]

If neither the buyer’s or seller’s agent prepares and includes the disclosures as an addendum to the offers or counteroffers, then, as a minimum requirement, the buyer’s agent is responsible for preparing the disclosures and obtaining both the buyer’s and seller’s signature prior to closing the carryback sales escrow. [CC §2959]

Under the statutory contingency for failure to timely make disclosures, if the buyer discovers a reasonable basis for disapproving the financing arrangements when the buyer receives the carryback disclosures after entering into the purchase agreement, the buyer may cancel the transaction and terminate their obligation to purchase the property. [CC §2959]

However, the buyer may not arbitrarily cancel the sale when they are presented with the carryback disclosure statement for their acknowledgment and approval during escrow. Similar to the conduct of the seller, the buyer needs to act in good faith to cancel by showing the carryback disclosures are inconsistent with their reasonable expectations when they entered into the purchase agreement. [CC §2961]

After closing, the only legal remedy available to the buyer or seller for inadequate or nonexistent financial disclosures is to pursue both brokers involved for any money losses actually incurred as a result of the nondisclosure. If a broker or their agent fails to make the mandated carryback disclosures, they are liable to the buyer for the buyer’s losses resulting from the non-disclosure. [CC §2965]

For a discussion on the tax benefits of carrying paper for the seller and the flexible sale terms available to the buyer, see Part I of this article series. For comments on the yield limitations which contrast loans from credit sales, and the requirements a carryback seller is to meet to be eligible for exemption from mortgage loan originator licensing, see Part III of this article series.

Dodd Frank and Reg Z

October 28, 2016 — Leave a comment

Seller Financing After Dodd-Frank

When traditional lending avenues fail, seller financing can help seal the deal. But watch out for pitfalls.

If you’re working with sellers who have seen offers collapse because buyers can’t get a mortgage loan, you might want to suggest they consider offering some variation of seller financing. If structured carefully, seller financing not only makes deals possible but also can typically help transactions close quickly, as less due diligence is required. After all, who knows the property better than the sellers?

There are other perks, too: Sellers can often negotiate an interest rate that’s more favorable than would be available for other sorts of investments. And they might also get a higher selling price as compensation for assisting the buyers. Finally, there can be some tax benefits; if the seller structures the loan as an installment sale, for example, there can be tax advantages based on how recognition of the capital gain is timed.

But against these benefits is the big downside of seller financing: the potential for buyer default. This risk is compounded if the deal is structured as a wrap-around deed of trust, as many are. With a wrap-around deed of trust, the seller issues a promissory note and deed of trust for the dollar gap between the amount of the first mortgage and the buyer’s down payment. When structured this way, the seller’s performance on the underlying first mortgage is linked to the buyer’s performance. If the buyer defaults, the seller will likely default, too.

Here are some ways to help sellers minimize such pitfalls, no matter how the transaction is structured.

  • Request a credit report and credit references. Sellers can get a credit report from any credit reporting agency, but they’ll want to get a signed consent letter from the buyer first. For credit references, one place to go is the buyer’s landlord, if they’re renting. Sellers should also ask for in­dependently audited financial statements.
  • Consider loan assumption. In many cases, the seller’s existing mortgage loan has a due-on-sale clause that requires the principal to be paid upon sale of the property. Having to settle their own financing makes it hard for many sellers to offer financing, especially if they’re buying a house themselves and need their sale proceeds to make their own down payment. In these cases, it might be better to simply have the buyer assume the seller’s existing loan. The buyer still must submit to the lender’s underwriting analysis and get the lender to approve a modification, but the process should be less time-consuming than if they were applying for new financing.
  • Provide expanded remedies. For many sellers, the only remedy for buyer default included in their loan documents is foreclosure. But it’s best to include lower-level remedies so foreclosure doesn’t have to be the only option. Suggest that sellers set rules for imposing late charges or default interest. Or suggest that sellers hire a property manager to keep track of incoming payments and to spearhead collection efforts, because these activities can be time-consuming.
  • Understand the risks to buyers, too. Although it might seem like most risks are on the sellers’ side since they’re putting their resources on the line, there are risks to buyers as well—and if you’re working with buyers, you’ll want to be aware of them. First, buyers could pay the loan in full but still not receive title if there are encumbrances that were never divulged by the seller. Second, if the transaction is structured as a wrap-around deed of trust and the sellers are supposed to be making payments on senior debt, the buyers could be at risk if the sellers fail to make their loan payments, even if the buyers are scrupulous in holding up their end of the deal. Third, buyers might not have the protection of a home inspection, mortgage insurance, or an appraisal to ensure they’re not paying too much.

These are challenging times in credit markets, so there’s a role for seller financing. But be aware of risks so you can help protect your clients.

If your buyers are being ignored by the bank, consider a loan from the seller.

In today’s stymied real estate market, lenders are more cautious about making loans and sellers are more inclined to agree to carry financing to sell their properties more quickly. Here’s a look at how installment sales could work for your clients.

Installment sales are structured so that the seller receives payments for parts of the purchase price over a period of time following the closing.

If a buyer makes a substantial down payment and is sufficiently creditworthy, and if the seller either owns a property outright or has the resources to pay off any remaining mortgage, installment sales can be beneficial to both parties.

An installment sale also enables a seller to defer income taxes when at least one installment payment is received after the tax year in which the transaction closed. The seller recognizes the gain over the taxable years in which the payments are actually received.

Deferring taxes can be a real benefit to home owners whose capital gain exceeds the $250,000 individual exemption on the sale of a principal residence or who haven’t held the home for the two-year period required. Installment sales also benefit investment sellers who don’t want to use a Section 1031 exchange to defer taxes.

Each installment payment consists of three elements:

  • A partial return of the seller’s adjusted basis in the property sold, which isn’t taxable to the seller.
  • A portion of the taxpayer’s realized gain on the sale, which is taxable as a capital gain.
  • Accrued interest, which is taxable as ordinary interest income. An installment note must include an adequate stated rate of interest to be paid by the buyer. An adequate rate of interest is equal to or greater than the rate published by the IRS.

Each year, a seller receiving payments from an installment sale must determine how much of the year’s payments are taxable as capital gains and how much are a nontaxable recovery of the seller’s cost basis.

The taxpayer’s adjusted basis starts with the original purchase price, including initial closing costs. It then increases by any capital improvements and the selling expenses incurred in the sale. It’s reduced by any depreciation taken during the time of the seller’s ownership. The taxpayer multiplies the non-interest portion of the total payments received in that year by the gross profit ratio for the sale.\

The gross profit ratio is the taxpayer’s total anticipated gross profit divided by the total contract price. The anticipated gross profit is the contract price less the taxpayer’s adjusted basis. The contract price is equal to the selling price, reduced by the amount of any qualifying indebtedness that is assumed by the buyer.

Qualifying indebtedness is limited to the seller’s adjusted basis in the property. If the seller has refinanced the property and taken cash in an amount that creates indebtedness greater than the seller’s adjusted basis, the qualified indebtedness for purposes of calculating the contract price is limited to the adjusted basis.

Consider the example of a sale of raw land (below). In Year 1, Seller sold Black Acres to Buyer for $1.2 million. Buyer paid $200,000 in cash at closing and agreed to assume the current $200,000 mortgage. Seller agreed to finance $800,000 of the purchase price over a five-year installment note, with the first installment being due in Year 2.

The gross profit of $400,000 is divided by the seller-financing contract price of $1 million to determine a gross profit ratio of 40 percent. In applying this gross profit percentage to the $200,000 received in Year 1, the seller will recognize $80,000 of gain in the year of the sale. If the principal portion of the payments received by seller in Year 2 is equal to $160,000, the seller will recognize gain equal to 40 percent of $160,000, or $64,000 in Year 2. (Note that gain on real property that depreciates, such as an office building, would be calculated differently because gain from depreciation is taxed at 25 percent.)

Installment sellers should consult an attorney to better understand the risks of default by the buyer and inquire about ways to reduce the risk.

Calculating Gain

Selling price: $1,200,000

Less assumed mortgage: ($200,000)

Contract price: $1,000,000

Adjusted basis: ($720,000)

Selling expenses: ($80,000)

Gross profit (selling price minus adjusted basis minus selling expenses): $400,000

Reference Book – A Real Estate Guide

* Please note, format and page numbers differ from the printed version. The printed version will be available for purchase after January 5, 2011. To purchase a copy, submit a Publications Request (RE 350) . The chapters of the Reference Book below are in PDF format. You will need Adobe Reader to view them.

Reference Book

  • Introduction
    Cover, Preface, Location of Department of Real Estate Offices, Past Real Estate Commissioners, A Word of Caution
  • Chapter 1 – The California Department of Real Estate
    Government Regulation of Brokerage Transactions, Original Real Estate Broker License, Corporate Real Estate License, Original Salesperson License, License Renewals – Brokers and Salespersons, Other License Information, Continuing Education, Miscellaneous Information, Prepaid Residential Listing Service License, Enforcement of Real Estate Law, Discrimination, Notice of Discriminatory Restrictions, Subdivisions, Department Publications, Recovery Account
  • Chapter 2 – The Real Estate License Examinations
    Scope of Examination, Preparing for an Exam, Exam Construction, Examination Weighting, Exam Outline, Exam Rules – Exam Subversion, Materials, Question Construction, Multiple Choice Exam, Q and A Analysis, Sample Multiple Choice Items
  • Chapter 3 – Trade and Professional Associations
    Real Estate Associations and Boards, Related Associations, Ethics
  • Chapter 4 – Property
    Historical Derivations, The Modern View, Personal Property, Fixtures, Legal Difference Between Real and Personal Property, Land Descriptions, Other Description Methods
  • Chapter 5 – Title to Real Property
    California Adopts a Recording System, Ownership of Real Property, Separate Ownership, Concurrent Ownership, Tenancy in Partnership, Encumbrances, Mechanic’s Liens, Design Professional’s Lien, Attachments and Judgments, Easements, Restrictions, Encroachments, Homestead Exemption, Assuring Marketability of Title
  • Chapter 6 – Transfer of Interests in Real Property
    Contracts in General, Essential Elements of a Contract, Statute of Frauds, Interpretation, Performance and Discharge of Contracts, Real Estate Contracts, Acquisition and Transfer of Real Estate
  • Chapter 7 – Principal Instruments of Transfer
    A Backward Look, the Pattern Today, Deeds in General, Types of Deeds
  • Chapter 8 – Escrow
    Definition, Essential Elements, Escrow Holder, Instructions, Complete Escrow, General Escrow Principles, General Escrow Procedures, Proration, Termination, Cancellation of Escrow – Cancellation of Purchase Contract, Who May Act As Escrow Agent, Audit, Prohibited Conduct, Relationship of Real Estate Broker and the Escrow Holder, Designating the Escrow Holder, Developer Controlled Escrows – Prohibition
  • Chapter 9 – Landlord and Tenant
    Types of Leasehold Estates, Dual Legal Nature of Lease, Verbal and Written Agreements, Lease Ingredients, Contract and Conveyance Issues, Rights and Obligations of Parties to a Lease, Condemnation of Leased Property, Notice Upon Tenant Default, Non-Waivable Tenant Rights, Remedies of Landlord, Disclosures by Owner or Rental Agent to Tenant
  • Chapter 10 – Agency
    Introduction, Creation of Agency Relationships, Authority of Agent, Duties Owed to Principals, Duties Owed to Third Parties, Rights of Agent, Termination of Agency, Special Brokerage Relationships, Licensee Acting for Own Account, Unlawful Employment and Compensation, Broker-Salesperson Relationship, Conclusion
  • Chapter 11 – Impact of the Penal Code and Other Statutes
    Penal Code, Unlawful Practice of Law, Business and Professions Code, Civil Code, Corporations Code
  • Chapter 12 – Real Estate Finance
    Background, The Economy, The Mortgage Market, Overview of the Loan Process, Details of the Loan Process, Federal and State Disclosure and Notice of Rights, Promissory Notes, Trust Deeds and Mortgages, Junior Trust Deeds and Mortgages, Other Types of Mortgage and Trust Deed Loans, Alternative Financing, Effects of Security, Due on Sale, Lender’s Remedy in Case of Default, Basic Interest Rate Mathematics, The Tools of Analysis
  • Chapter 13 – Non-Mortgage Alternatives To Real Estate Financing
    Syndicate Equity Financing, Commercial Loan, Bonds or Stocks, Long-Term Lease, Exchange, Sale-Leaseback, Sales Contract (Land Contract), Security Agreements (Personal Property)
  • Chapter 14 – Real Estate Syndicates and Investment Trusts
    Real Estate Syndication, Real Estate Investment Trusts
  • Chapter 15 – Appraisal and Valuation
    Theoretical Concepts of Value and Definitions, Principles of Valuation, Basic Valuation Definitions, Forces Influencing Value, Economic Trends Affecting Real Estate Value, Site Analysis and Valuation, Architectural Styles and Functional Utility, The Appraisal Process and Methods, Methods of Appraising Properties, The Sales Comparison Approach, Cost Approach, Depreciation, Income (Capitalization) Approach, Income Approach Process, Income Approach Applied, Residual Techniques, Yield Capitalization Analysis, Gross Rent Multiplier, Summary, Appraisal of Manufactured Homes (Mobilehomes), Evaluating the Single Family Residence and Small Multi-Family Dwellings, Typical Outline for Writing the Single Family Residence Narrative Appraisal Report, Conclusion, Additional Practice Problems, The Office of Real Estate Appraisers (OREA)
  • Chapter 16 – Taxation and Assessments
    Property Taxes, Taxation of Mobilehomes, Special Assessments, Certain Assessment Statutes, Federal Taxes, Documentary Transfer Tax, State Taxes, Miscellaneous Taxes, Acquisition of Real Property, Income Taxation
  • Chapter 17 – Subdivisions and Other Public Controls
    Basic Subdivision Laws, Subdivision Definitions, Functions in Land Subdivision, Compliance and Governmental Consultation, Types of Subdivisions, Compliance With Subdivided Lands Law, Handling of Purchasers’ Deposit Money, Covenants, Conditions and Restrictions, Additional Provisions, Grounds For Denial of Public Report, Subdivision Map Act, Preliminary Planning Considerations, Basic Steps in Final Map Preparation and Approval, Types of Maps, Tentative Map Preparation, Tentative Map Filing, Final Map, Parcel Map, Other Public Controls, Health and Sanitation, Eminent Domain, Water Conservation and Flood Control, Interstate Land Sales Full Disclosure Act
  • Chapter 18 – Planning, Zoning, and Redevelopment
    The Need For Planning, General Plans, Redevelopment
  • Chapter 19 – Brokerage
    Brokerage as a Part of the Real Estate Business, Other Specialists, Operations, Office Size – Management, Office Size, Career Building, The Broker and the New Salesperson, Specialization, A Broker’s Related Pursuits, Professionalism, Mobilehome Sales
  • Chapter 20 – Contract Provisions and Disclosures in a Residential Real Estate Transaction
    A Basic Transaction, A Basic Listing, Purchase Contract/Receipt of Deposit, Disclosures
  • Chapter 21 – Trust Funds
    General Information, Trust Fund Bank Accounts, Accounting Records, Other Accounting Systems and Records, Recording Process, Reconciliation of Accounting Records, Documentation Requirements, Additional Documentation Requirements, Audits and Examinations, Sample Transactions, Questions and Answers Regarding Trust Fund Requirements and Record Keeping, Summary, Exhibits
  • Chapter 22 – Property Management
    Professional Organization, Property Managers and Professional Designations, Functions of a Property Manager, Specific Duties of the Property Manager, Earnings, Accounting Records For Property Management
  • Chapter 23 – Developers of Land and Buildings
    Subdividing, Developer-Builder, Home Construction
  • Chapter 24 – Business Opportunities
    Definition, Agency, Small Businesses and the Small Business Administration, Form of Business Organization, Form of Sale, Why an Escrow?, Buyer’s Evaluation, Motives of Buyers and Sellers, Counseling the Buyer, Satisfying Government Agencies, Listings, Preparing the Listing, Establishing Value, Valuation Methods, Lease, Goodwill, Fictitious Business Name, Franchising, Bulk Sales and the Uniform Commercial Code, California Sales and Use Tax Provisions, Alcoholic Beverage Control Act
  • Chapter 25 – Mineral, Oil and Gas Brokerage
    History, Mineral, Oil and Gas Brokerage, 1994 – No Separate License Requirements
  • Chapter 26 – Tables, Formulas, and Measurements
  • Chapter 27 – Glossary

Seller Financing

In some situations, sellers are lining Lending Standards, Seller Financing. CFPB
Finalizes Loan 2013, The Consumer Financial Protection Bureau – 2012-03-15

Seller Financing May Be Worth Exploring | Realtor Magazine

In today’s stymied real estate market, lenders are more cautious about making loans and sellers are more inclined to agree to carry financing to sell their properties more quickly. Here’s a look at how installment sales could work for your clients. – 2008-12-01

Get Seller Financing to Work for You | Realtor Magazine

Seller financing has been a hot issue in recent real estate news due to the changes in regulations, specifically in the Dodd-Frank Act. Here’s what you need to know to incorporate this method into your business strategy and be the best advocate for your clients. – 2015-04-06

Seller Financing: Background

Seller financing is subject to new rules following the passage of financial reform legislation. Know these changes in order to serve sellers better. – 2012-01-17

My Account

Seller financing plays an important role in financing the sale of real estate, especially when credit is tight. This paper summarizes the impact of two federal laws that affect seller financing. Seller financing plays an important role in financing the sale of real estate, especially when credit is tight. This paper summarizes the impact of two federal laws that affect seller financing. – 2012-01-12

Sales Clinic: Expand Your Market with Seller Financing | Realtor Magazine

Are there any creative ways to sell a home that will maximize the salesperson’s value? —Timothy Baker, RE/MAX Affiliates, Naperville, Illinois If you want to be a top salesperson, you always have to be on the lookout for new and creative ideas to set yourself apart from the pack.…/feature/article/1999/12/sales-clinic-expand-your-market-seller-financing – 1999-12-01

Ways to Protect Yourself Under Seller Financing | Realtor Magazine

TIP: Instead of taking back an installment loan, per se, have the buyer purchase an annuity or some zero-coupon bonds in your name. These can often be bought at deep discounts to eventual payout, lowering the sale price, but guaranteeing you a higher future return.…/sell-your-business/article/ways-protect-yourself-under-seller-financing

NAR Submits Comments on CFPB’s Proposed Seller Financing Rules

On Oct. 15, 2012, NAR President submitted comments to the CFPB on its loan originator proposed rule. On Oct. 15, 2012, NAR President submitted comments to the CFPB on its loan originator proposed rule. – 2012-10-19

Sellers Can Fill a Void | Realtor Magazine

If you’re working with sellers who have seen offers collapse because buyers can’t get a mortgage loan, you might want to suggest they consider offering some variation of seller financing. – 2011-07-01

Seller Financing: The SAFE Act

In 2008, President Bush signed the Secure and Fair Enforcement of Mortgage Licensing Act or SAFE Act, which requires licensing and registration of loan originators. – 2012-03-15
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Field Guide to Lease-Option Purchases

(Updated April 2016)

Lease-option agreements* are common when acquiring personal property—such as dishwashers, washing machines, automobiles, and TVs—but are not as common for the acquisition of real property. Lease-option agreements are generally utilized in residential real estate acquisition when a home buyer would like to purchase a home, but needs to repair her credit rating in order to secure a promissory note and mortgage. The lease-option agreement allows a buyer to lease a property for a set period of time—typically between 1-3 years—with the option to buy the property at a contractual future date. “The negotiated option is typically a percentage of the price for example, one to five percent, and is credited, along with the rents and a rent premium, to the purchase price if the lessee buys the property. If the option to buy is not exercised, the buyer will lose the option fee and rent premium.” (Real Estate Law (link is external), p. 227). Read the articles below to learn more about this alternative real estate financing option. (H. Hester, Information and Digitization Specialist)

*Also known as lease-to-own, rent-to-own, lease/purchase, lease with an option to purchase, or real options.

E – EBSCO articles available for NAR members only. Password can be found on the EBSCO Access Information page.

Lease to Own: The Basics

Is rent-to-own the future of housing? (link is external), (HousingWire, Jan. 14, 2016).

Investors Bank on Rent-to-Own Comeback (REALTOR® Magazine, July 29, 2015).

How do Lease Purchase Agreements Work? (link is external) (SFGate, n.d.).

How Do I Get a List of Rent to Own Homes? (link is external) (®, July 25, 2012).

How Do I Find A Rent To Own Home In Bristol, Pennsylvania? (link is external) (®, May 10, 2012).

How Do I Find A Realtor To Explain The Rent To Own Option? (link is external) (®, Apr. 6, 2012).

Lease-to-Own Contracts (link is external), (UCLA School of Law, 2012).

Lease options are back: proceed carefully (link is external), (Realty Times, Oct. 25, 2011).

Sale-Leaseback Transactions: Price Premiums and Market Efficiency (link is external), (Journal of Real Estate Research, Apr.-June 2010). E

Informal Homeownership in the United States and the Law (link is external), see page 132. (University of Texas School of Law, 2010).

How lease-options benefit sellers, buyers … and their REALTORS®? (link is external), (CRE Online, n.d.).

Thought about lease-to-own transactions?, (REALTOR® Magazine – Speaking of Real Estate blog, Aug. 6, 2009).

Renting to Own (link is external), (®, n.d.)

Case Studies & Examples

A Valuation Framework for Rent-to-Own Housing Contracts (link is external), (The Appraisal Journal, Summer 2014). E

Lease-to-own deals offer options in sluggish Tampa Bay housing market (link is external), (St. Petersburg Times, Oct. 23, 2011).

Can I get a lease option with bad credit? (link is external), (®, May 5, 2011).

A Growing Housing Imbalance (link is external), (Mortgage Banking, Oct. 2011). E

Raising Capital Through Sale-Leasebacks (link is external), (Public Management, June 2010). E

Tax Implications

Individual Taxation Developments (link is external), (The Tax Adviser, Mar. 2012). E

Comparing Accounting and Taxation for Leases: Certified Public Accountant (link is external), (The CPA Journal, Apr. 2009). E

Tax Considerations for Buying and Selling Property with a Burdensome Lease (link is external), (Journal of Accountancy, 2009). E

Government Publications & Programs

State Agency Lease/Purchase Program (link is external), (Washington State Treasurer’s Office, n.d.).

Recent State Agency Lease/Purchase Interest Rates – Real Estate Only (link is external) (Washington State Treasurer’s Office, n.d.).

Definition from Washington State:

Lease/Purchase Obligations (Real Estate) — Lease/purchase obligations are contracts entered into by the state which provide for the use and purchase of real or personal property, and provide for payment by the state over a term of more than one year. For reference, see RCW chapter 39.94 “Financing Contracts.” Lease/purchase obligations are one type of lease-development alternative.” (Financial Budget Instructions Glossary of Terms (link is external), Washington State Office of Financial Management, n.d.).

Non-Mortgage Alternatives to RE Financing (link is external) from Reference Book – A Real Estate Guide (link is external), (California Department of Real Estate, 2010).

LFC Hearing Brief (link is external), (New Mexico Legislative Finance Committee, Dec. 2007).

Instructions for the Lease/Purchase Analysis Modeling Tool (link is external), (Idaho State Leasing Dept. of Administration, n.d.).

eBooks & Other Resources

The following eBooks and digital audiobooks are available to NAR members:

Smart Guide to Real Estate: Step by Step Rent to Own, (Kindle and ePub)

Investing in Rent-to-Own Property, 2010 (ePub)

Investing in Real Estate With Lease Options and “Subject to” Deals, 2005 (ePub)

Books, Videos, Research Reports & More

The resources below are available for loan through Information Services. Up to three books, tapes, CDs and/or DVDs can be borrowed for 30 days from the Library for a nominal fee of $10. Call Information Services at 800-874-6500 for assistance.

Who Says You Can’t Buy a Home! (link is external) HG 2040.5 R25w (2006).

Field Guides & More

These field guides and other resources in the Virtual Library may also be of interest:

Sale-Leasebacks & Synthetic Leases

Seller Financing

Information Services Blog

Have an Idea for a New Field Guide?

Send us your suggestions (link sends e-mail).

The inclusion of links on this field guide does not imply endorsement by the National Association of REALTORS®. NAR makes no representations about whether the content of any external sites which may be linked in this field guide complies with state or federal laws or regulations or with applicable NAR policies. These links are provided for your convenience only and you rely on them at your own risk.

Search Results for: seller financing
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via Search Results for “seller financing” – Real Estate News and Advice –


by W.J. Mencarow, President of The Paper Source, Inc.

Copyright 1999, The Paper Source, Inc.  All Rights Reserved.

Your First Question

There are many litmus tests used to assess the risk of a note. Primary factors include the type of property securing the note, the loan-to-value ratio (or more accurately, the investment-to-value ratio), the strength of the local and/or national economy and the payor’s financial strength.

Whenever you consider a note, ask yourself, “would I want to own the property securing this note?” If the answer is “no,” don’t buy it.

I’m not saying you should want to live in the property: it’s an investment. But assume you’re buying the actual property (after all, it’s possible you may have to foreclose). Ask questions such as:

What’s the state of the local economy?

Is the property’s value dependent upon just one or two big employers (who might have lay-offs, strikes, shut-downs, etc.)?

Is the area growing? Stagnating? Regressing?

What is the unemployment rate? How does it compare to five years ago?

How have property values changed in the past few years?

Currently in this community what is the average time a property is on the market before it sells? How does that compare to a year ago? Three years ago?

Could I afford to have it on the market for sale, unoccupied, for this period?

Does the property fit in with my investment objectives?

Is it completely different from any other properties I own?

Will it cash flow?

Does it need major work?

Does it have major design flaws?

What kind of neighborhood is it in?

How much would it cost to foreclose?

What methods would I use to sell it at a profit in a bad market?

Is it a single family house, a condo, an apartment building, a factory, vacant land, a sushi restaurant?

If I had to foreclose, what would I do with a single family house, condo, apartment building, factory, vacant land or a sushi restaurant?

Beware of These Properties

Unless you’re an experienced paper investor, stick to notes secured by single family houses, preferably owner-occupied. An owner-occupant is less likely to risk foreclosure than is an investor.

The bulk of your portfolio should be in good notes secured by properties that can be sold relatively quickly. Notes secured by apartment buildings, commercial property, lots, raw land, etc are risky.

Raise your equity requirements for condos, and stay away from paper backed by co-ops. They aren’t actually real estate, and they don’t normally appreciate like it.

The notes you select for your own portfolio should be anchored by well-secured residential properties in good locations.

On Foreclosure

Don’t be cavalier about foreclosure. Some people will tell you, “So what if you have to foreclose? You just get the property.”

That’s sheer ignorance: you don’t “just get the property.” Foreclosure can be a long, drawn-out affair involving lawyers, legal notices, fees, damaged property, bills, sheriffs, court hearings, more fees, vacant property, plumbers, electricians, carpenters, more bills, more court hearings, lost investment income, more fees, more bills. . .

In most states there’s something called “the right of redemption.” If you’ve never heard of it, I’m impressed; that means you’ve never been involved, on either side, in a foreclosure, and that’s to your credit. The right of redemption means that the defaulting mortgagor (the one who won’t pay you – the bad guy) has a statutory right to buy back his house for a certain period after foreclosure. Sit down: it’s a full year in some states. That ties you in knots, legally and gastrointestinally.

If you obtain the property for less than 70 percent of market value the former owner may be able to set aside the sale as a “fraudulent conveyance” under the bankruptcy laws. Also, your ability to get title insurance may be limited.

Will a Deed in Lieu Avoid Foreclosure?

Some people advocate a “deed in lieu of foreclosure.” The mortgagor signs over the deed and a quitclaim to the property to you which supposedly avoids the mess of foreclosure and “saves his credit and good name.”

Will a deed in lieu avoid foreclosure? Maybe, maybe not. At least one court has ruled that such a deed is an “equitable mortgage” and the mortgagee still must foreclose.

Still, suppose the mortgagor simply gave you his deed to prevent foreclosure. Wouldn’t that be much better for you? Not necessarily. If you accept a deed, you must honor any liens junior to yours. That means that if you own the second lien and there’s a third, forth, etc., if you don’t foreclose and instead take a deed in lieu of foreclosure, you must make the payments on those notes. Foreclosure would have wiped them out.

If you’re ever faced with that situation, contact the mortgagees junior to you and offer to buy them out at a price that would be less than what foreclosure would cost you. Just explain that foreclosure could cancel their notes completely, and your offer will at least give them something.

There’s another potential problem with accepting a deed in lieu. If I were an attorney representing a client who had given a deed in lieu of foreclosure, I might try suing the mortgagee (that’s you) on the theory that by requiring (or even accepting) the deed you deprived him of his right of due process under the law.

Will a deed in lieu save the mortgagor’s credit? No. The FNMA/FMAC loan application, the standard of the industry, asks, “Have you had property foreclosed upon or given title or deed in lieu thereof?” Gotcha.

Foreclosure fees vary by state and locality. It’s a simple matter to ask a local attorney how much it would cost and how much time it would take (in the worst-case scenario) to foreclose on the note you’re considering. Apply these charges to the cost of the note.

Then you must factor in the costs of the legal delays involved in foreclosure. For example, you may have to hire an attorney to get the property out of the jurisdiction of a bankruptcy court. The time required to foreclose is affected by many factors: by state law, by whether a bankruptcy is involved, by the type of bankruptcy filed, and other variables. You should count on six months to, in some states, even a year of lost income on your note.

Remember, if you hold a second position note you’ll have to make up the missed payments on that as well as any late fees and attorney’s fees the first lien holder incurred. Then decide how much you will pay for the note (some people even use this figure to calculate the investment-to-value ratio: more on that later).

The Foreclosure Formula

In deciding to foreclose, you add up your costs and compare that to the equity in the property. Here’s the math: your original investment in the note + the amount of back payments owed you + foreclosure fees + your lawyer’s fees + bringing any superior liens current (including late charges and their lawyer’s fees if they start foreclosure independently of you) + back taxes + tax penalties and interest + repairs to the property + painting, carpeting, new appliances or other cosmetic improvements to make it marketable + real estate agent’s commission + current taxes + insurance payments + payments on the superior lien while you try to sell the house + closing costs + the value of your time fooling with all of this…and don’t forget several months of lost income on your note investment during foreclosure.

In case of default, you must be able to pay the costs of foreclosure and pay off the senior lien or make the payments, whichever is required. That’s why virtually nobody will buy a small second behind a million-dollar first lien. Most buyers look for a ratio of 1:3 to 1:5 in the size of the second to the first depending upon the monies involved. there are a few investors who will buy small seconds behind large firsts: They are in THE PAPER SOURCE REGISTRY OF NOTE INVESTORS, sent to all PAPER SOURCE JOURNAL subscribers. See the website for information on obtaining the Registry.

If you couldn’t afford the costs of actually owning the property (including making the payments on the first lien while you are trying to sell or rent it), or wouldn’t know what to do with it if you did own it (such as industrial property), don’t buy the note.

The bottom line: have plenty of equity in any note you buy.

If you couldn’t afford the costs of foreclosure, if you couldn’t pay off the first lien or make the payments on it (only count on doing this if it’s assumable), or if the fees and “hidden costs” of foreclosure would consume your equity in the note, don’t buy it!

If your mortgagor is even one day late, send him a tough warning letter (via certified mail, return receipt requested). Pull no punches with late payors – if you are soft, they’ll pay later and later every month (if they pay at all), you’ll lose more and more money and you’ll end up foreclosing anyway. Remember, the longer you carry them, the deeper in debt they’ll get. By being “kind,” you’re just digging their financial grave.

“Mr. Landlord” newsletter printed “10 Reasons Why You Should Not Feel Guilty About Eviction,” and I’ve modified their list for note holders. If you’re tempted to operate from your heart rather than your head, you need to consider this:

10 Reasons Why You Should Not Feel Guilty About Foreclosing

1. If the payors need extra time, the court will give it to them. Always start foreclosure immediately.

2. Your profit is in owning the mortgage, not the property. Foreclosure and property ownership and sale is expensive and time-consuming.

3. You have already supplied the “needy” payor with free housing. You’ve done your charity work, now give someone else a chance.

4. If the payor doesn’t have a friend or relative to help him out, doesn’t that say a lot about his character?

5. If anyone asks you how you could put someone out on the street, ask them to make the payments for them.

6. The delinquent payor has broken his word, violated his contract and is stealing from you. By remaining in the house but refusing to make his payments he is a thief. Do you see stores letting people come in and take from them?

7. Letting a mortgagor stay in the house who is not making payments is like giving him your charge card or a blank check and saying, “Feel free to spend it, I really don’t care. I like lending money out interest-free, even if I’m not sure I’ll get it back.”

8. How would you feel if you worked all week and your employer told you he couldn’t pay you? Well, your mortgagor has told you that. Do you work for nothing?

9. Your delinquent payor is taking money that keeps you from proving for your family’s needs. And the sad thing is some deadbeat mortgagors live better lifestyles than their mortgagees. It’s easy when the mortgagee lets them live there without paying! Picture yourself telling your child that you cannot give them what they want because you had to make a stranger’s house payment so the stranger could buy a gift for his child!


Assuming this section scares you silly, as it should, know this: I’ve been involved in paper since 1981. I’ve had plenty of defaults, but almost all were cured in time. I’ve only had two go into foreclosure.

You should always make sure you have enough equity in every note you own so that foreclosure, even after all the costs, would be profitable. The time to make sure of that is when you buy the note.

The Cornerstone of Risk Analysis

The investment-to-value ratio (ITV) is about the most important information you can have about a note. It is indispensable when calculating risk. You hear a lot about the loan-to-value ratio (LTV), but not much about the ITV. Both are expressed as a percentage. The LTV is the balance of all outstanding loans against the property divided by the market value of the property. For example, a $100,000 house with one loan of $80,000 against it has an LTV of 80 percent (80,000 divided by 100,000).

The difference is that you use the price you are paying for the note to figure the ITV, not the face balance, since the money you have invested is what’s important. Suppose you bought that $80,000 loan for $50,000. To calculate the ITV, divide the price you pay by the market value. 50,000 divided by 100,000 equals 50 percent. Your ITV, your actual risk (sometimes called “exposure”) is 50 percent.

The higher the ITV, the riskier the investment. Most investors won’t touch a note over 90 percent ITV, and many won’t consider anything over 80 percent. The costs of foreclosure, legal fees, curing the senior lien, property repair costs, holding and marketing the property, opportunity costs (what you could have been making on your money if it hadn’t been tied up in a defaulted note) and other factors, plus the original cost of the note, could eat up that cushion and well exceed the total value of the property!

Conservative ITV guidelines are: no more than 75 percent on a single family house or an apartment building with four or fewer units; 65 percent on larger apartment buildings, commercial or industrial property; 50 percent on raw land or a single family house outside your local area; 40 percent on mature, developed lots in recreational areas. Venture beyond at your own risk.

Improvements made to the property will improve your ITV and thus your security. So will the effects of amortizing the debt against the property, since this produces equity. As the property securing the note appreciates, your risk diminishes. And vice-versa!

There are other ways to reduce the ITV of a note. A powerful technique is to buy part of the note (a “partial”). By purchasing the first sixty payments, for example, of a thirty-year note, you significantly reduce the ITV and your risk.

Another method is to use a blanket mortgage, which covers more than one property. You’ll learn a lot about partials, blanket mortgages and many other techniques as a PAPER SOURCE subscriber.

What is the purpose of the LTV then? It is useful in helping to determine the likelihood that the note payor will default. For example, the LTV of a $98,000 note on a $100,000 house is 98 percent. If you buy that note at the deep discount price of $60,000 your ITV is only 60 percent. Is this a safe note? Possibly not, since the payor has virtually no equity in the house and may decide he has nothing to lose by defaulting.

There Are Appraisals, And There Are…

An appraisal is only an opinion. You hope it is an informed opinion. The more the appraiser knows his business, the closer to “true market value” he can come.

Don’t take anyone’s word for the value of the property. If you aren’t intimately familiar with local values, get a professional appraisal. Don’t rely on real estate sales comparables (and especially not on asking prices for unsold property!).

Get an appraisal in writing. If it’s not in writing, it’s not an appraisal.

If you’re using your own appraisers, make sure they’re certified by one of the nationally-recognized agencies such as the Appraisal Institute, indicated by the designations M.A.I. (Member, American Institute of Real Estate Appraisers or S.R.A. (Senior Residential Appraiser, Society of Real Estate Appraisers) certified (the two organizations merged on January 1, 1991 to form the Appraisal Institute, but their members still use the abbreviations).

The membership directory of the Appraisal Institute is very handy when you need an appraiser. Call 1-312-335-4100 for a free copy.

When you call an appraiser, the first thing you should tell him or her is the type of property to be appraised. Many appraisers only work with one type, such as commercial or residential property.

Typically, residential appraisals cost between $150 for a “drive-by” report of 1-2 pages with no comps, to $300-$400 for a full-blown “walk-through” inspection supported by comps and photographs. You can compromise for about $200 for a drive-by with comps, or about $250 for a walk-through without photos.

If you’re buying a note from a broker, don’t use his in-house appraiser. Insist on your own.

An appraisal on a property that has few or no comparables, or where the last sale was a year or two ago, is at best an educated guess. How do you judge an appraisal? Here are a few tips:

* Be sure the appraisal is current. Don’t accept any appraisal more than 6 months old.

* Look at the values of the comparable properties. If they are all lower than the appraised value of the subject property, it may mean that the area doesn’t support a value that high. In other words, people with that much to spend would probably prefer a better neighborhood.

* Closely related to this is an appraisal showing one comp at one price and several comps a couple of blocks away at significantly higher prices (“comp” is short for “comparably priced property”). They are probably located in a more desirable neighborhood and should be adjusted downward. All other things being equal, the subject property is closer in value to the first comp.

* Discover what the present owner paid for the property. If he bought it relatively recently (within the past year or two) at a price far below the current appraisal, that’s reason for caution.

* Compare the prices of comparable properties that have not sold but have been listed for a long time. If the subject property appraisal is at about the same price as a number of comps that haven’t sold, how likely is it that you could sell the property for the appraisal price if you got it in foreclosure?

* Compare the sold comparable prices. Sometimes one house will sell for far more than market value. A house in my neighborhood recently sold for almost $50,000 more than any comp had ever sold before. The owner of the house next door had his for sale within a week for $20,000 over that price! It sat on the market for 6 months while other houses in the area sold at realistic prices, and he finally gave up.

Why that house sold for so much is anyone’s guess, but to base an appraisal on it would be ridiculous. A good appraiser would ignore it.

* A picture may be worth a thousand words, but it is worth a lot more in dollars if it shows a significant difference in the condition of the subject property and the comps. Be sure the appraiser has adequately adjusted for the condition of the property, up or down.

I cannot stress it enough: the value of a note depends ultimately upon the economic conditions that support the value of the property. Monitor the economy of any area in which you have a property interest. If it’s a depressed area but you still think it’s a good investment, just lower your maximum acceptable ITV levels.

For more information, consult “Tips on Real Estate Appraisals,” available for $1 from the Council of Better Business Bureaus, 4200 Wilson Blvd., Arlington, VA 22203-1804.

Should You Buy Notes Out Of Town?


Unless you are optioning notes for resale to a professional, or you are a seasoned paper investor, buy notes only on properties within a comfortable drive, an hour or two, from your home.

Do not solicit for notes in another state unless you are appropriately licensed in that state (if required – see the section on licensure and solicitation that follows). It’s safest to know your own state’s requirements and only do business there.

Optioning notes for resale is discussed in detail in my guide, “How To Get Started In The Note Business.”

Seasoned paper investors (and I define a seasoned investor as one who has personally negotiated and bought over 100 notes for his own portfolio) should be extremely careful when purchasing notes out of their own area. If you qualify as a seasoned paper investor, there are only two and a half conditions under which I would advise you to buy out-of-town paper (yes, I’ll explain):

1. Paper secured by property in those locales with which you’re very familiar. For example, you may visit certain areas on a regular basis and can keep up with changes in the local economy.

Remember that the value of a note depends ultimately upon the economic conditions that support the value of the property.

You must keep abreast of those conditions in order to properly monitor your investment, and that’s why out-of-town paper isn’t appropriate for most people.

2. As a partnership. If there is someone you trust who is knowledgeable about paper living in the area in which the property is located, you can enter into a partnership agreement to buy paper with the provision that your partner will to step in and buy you out if something goes wrong. The best way to arrange this is to have the buy-out provision in the written contract (do not attempt this without a written contract).

2 1/2. Rock-solid first lien deals (including loads of equity) on desirable owner-occupied homes. Keep your investment small (“small” = whatever you can afford to lose without terrifying yourself) and keep the number of these notes small in relation to your whole portfolio.

For valuable information on each state’s laws, get a copy of “Real Estate Practices – State-by-State.” It’s available at no charge from First American Title Insurance Co., 114 E. Fifth St., Santa Ana, CA 92701, 714-558-3211.

Do You Need A License To Do This?

If you live in California or another highly-regulated state, you will need a license to buy and sell a number of notes. You may even need one to deal in options to buy notes. Since there are 50 different states with laws that are constantly changing, you would need a staff working full-time just to keep up with them.

To determine your state’s licensure requirements, contact your state’s banking, real estate or corporation commission (the appropriate department goes by different names in different states).

When you ask, make sure they understand that you are not originating mortgages, since that’s what “mortgage broker” means to most people. If you will not be actually buying the mortgages before resale – if instead you will be simply assigning purchase contracts – make that clear as well.

If you don’t like the answers you get, or if the person seems unsure, wait a few days, call back and talk to someone else. It wouldn’t surprise me if you get a different answer! If not, try again later. When you have the answer you like, get the name of the person you talked with and write them a letter asking the same question. Your objective is to get the answer you want in writing.

Does this procedure seem strange to you? It is, but that’s how to deal with a bureaucracy. Take it from a former federal bureaucrat.

If your state does regulate what you want to do, Secure a copy of the applicable laws and read them. You may find that they don’t apply to what you are doing. For example, the law may define “mortgage broker” as I did above, someone who originates mortgages, and it may say nothing about buying and selling existing mortgages. Double-check your conclusions with a good attorney.

Here’s something almost everyone forgets to do: Always be certain that any required licenses exist for the people who originate loans you buy.

Use a Note Analysis Worksheet

Whenever you’re offered a note, reach for your note analysis worksheet. This will help you to systematically remember all the questions you need to ask and will tell you almost instantly if this is a note for you.

A computer program called NoteWorks is now available that makes this task much more efficient. Call 800-526-5588 or visit for information.

Learn About Origination

Learn as much as possible about how the note was originated. Why was the loan made? Was it a homeowner, borrowing from a fly-by-night high interest rate lender, to stop a foreclosure on his home, but the loan was called a “business” loan? (See “The Most Ignored Risk Factor Of All” in this guidebook.)

Was it closed by competent people? Was everything mentioned in this book checked out? If the loan was originated by someone who did not have a required license, your new note could be uncollectable and worthless.

If you’re thinking of buying a newly-created purchase money mortgage at the settlement table, be careful. If your yield (which includes any points paid to you) is above the statutory usury rate and the transaction is determined to be a loan your note would in all likelihood be made null and void by the court.

Here are some steps you can take to protect yourself:

1. Establish via a notarized letter from the seller that your funds are not a loan and that he is ready, willing and able to close the transaction without your purchase of the note. Keep this letter in a safe place.

2. In earlier editions of this book, I said, “Put some distance between you and the property sale. Do not purchase notes at the settlement table. Wait at least a month (or until a payment has been made), preferably longer.” While that’s still good advice – The Associates, the largest consumer finance company in the world, does it – it has no effect on whether or not the transaction may be characterized as a loan. I no longer would advise someone to refrain from purchasing notes at the settlement table as long as their documentation for the transaction was tight and as long as they have not had any communication, directly or indirectly, with the note payors.

3. Do not solicit real estate brokers and agents to buy notes with language — especially in writing — indicating you will “fund” the transaction or otherwise indicating that your monies can be instrumental in closing a property sale. It’s all right to explain how the creation and sale of a note can expedite the sale of the property, but make sure you don’t use language that could be construed to mean that you or your investor would be lending moneyto make the property sale possible.

4. For the above reasons, name your business something other than a “funding” company. That sounds too much like you originate loans: Why make the elementary mistake of giving a name to your business that is a red-flag to regulators? In the same vein, don’t use your own name in your business name. Keep as low-profile as possible. And it should go without saying that unless you have the necessary licenses and trnasaction registrations to solicit and sell securities, don’t use the word “securities” in your company name.

Verify the Payment History

You need to know if you’ll be paid on time. One clue is to see how prompt the payor has been in the past. Since almost every note seller says the payments are always been made on time, if not before, ask him for “third party verification” such as copies of canceled checks, bank deposits or his bank statements showing the dates the checks were deposited.

If he asks, “don’t you trust me?” just say, “of course I trust you, but I may be placing this note with an investor who insists on this information.” If you don’t want to mention that you’ll be using an investor, just tell them that it is your “corporate policy” to get that information. (Jimmy Napier taught me that.) It’s amazing what you can get when it’s not you asking, but your corporate policy. Don’t do business with someone who refuses to cooperate no matter how great the deal sounds.

The task of verifying payments is made easier if a bank or escrow company has been servicing the note, so remember to ask if that is the case.

Here’s a secret that 99 percent of paper buyers – even the professionals – overlook: always check the payment history of the first trust. It’s a litmus test as to the reliability of the payor. The credit check should indicate any serious problems with it, and you can also get the information from the first trust lender if you have a signed authorization from the payor.

Having said that, let me point out that far too much is made of the alleged desirability of notes with payment histories (called “seasoned paper” as opposed to “green paper”). All other things being equal, pick a seasoned note, but remember that the payment history is no guarantee of future performance. It becomes irrelevant if the property is sold and your note is assumed by someone else.

That’s why the best notes have enforceable due-on-sale clauses. It’s your option to enforce the clause, and you can do what you wish within the law; charge an assumption fee, raise the interest rate, demand a lump sum principal payment, whatever your creative mind dreams up, because you are in control.

How Much Down?

Earl Woodell was a good friend of mine, a real estate broker in San Antonio who was also one of the first and certainly one of the most active note buyers in Texas. (Earl passed away a few years ago.) One of many Earl Woodell gems is this: “The amount of the down payment is inversely proportional to the note’s propensity to default.” In other words, the less down, the more likely it is to go belly-up. Earl said that most of the zero down or $1,000 down notes he bought defaulted.

A large down payment is good security for you. It means the note payor has his hard-earned cash invested in the property and is less likely to default on his payments. This is especially true for an owner-occupied property. At the least, it means that sometime in his life he was able to put together a lot of cash, and that says something about him.

Of course, make sure that the downpayment was cash, and not rent credits, a car or anything other than real money. I once was offered a note where the downpayment was “valuable gemstones.” I passed.

Get a Credit Report

If you buy mortgages or trust deeds, you’re in the credit business. You’re lending your money, and you should take every precaution available to you to protect your capital. Just because you may be an individual or small business is no excuse to be lax in this responsibility.

In fact, if you have investors or partners you have a fiduciary responsibility – a legal and moral obligation — to use every avenue at your disposal to insure that their funds are invested prudently. Reviewing the credit reports of note payors is an important part of that responsibility.

It’s vital to get a credit report on the payor before you decide on the note. Does he pay his bills on time? Have any creditors turned him over for collection? Any judgments against him? Any unpaid judgments? Is there any pattern to late payments? What is his occupation? Job stability? Cash flow? How long has he lived at his current and previous addresses? What is his income pattern? How old is he? Does he engage in high liability enterprises, i.e. land developer, builder, property pyramider, etc?

Questions like these will help you decide if he is the kind of person you want to trust with your money, since that is what you are doing. Remember, even though you gave your money to someone else for the note, the payor is indebted to you.

But do you know who is legally allowed access to credit records? Are there restrictions on what the information in a credit report is to be used for? What are they? Can you check someone’s credit for any reason at all? Do you have to have their written permission? Are there exceptions?

The Fair Credit Reporting Act (P.L. 91-508) is the law that governs these issues and others. Here’s what Sec. 604 says:

“A consumer reporting agency may furnish a consumer report under the following circumstances and no other:

1. In response to the order of a court having jurisdiction to issue such an order.

2. In accordance with the written instructions of the consumer to whom

it related.

3. To a person which it has reason to believe —

A. intends to use the information in connection with a credit transaction involving the consumer on whom the information is to be furnished and involving the extension of credit to, or review or collection of an account of, the consumer; or

B. intends to use the information for employment purposes; or

C. intends to use the information in connection with the underwriting of insurance involving the consumer; or

D. intends to use the information in connection with a determination of the consumer’s eligibility for a license or other benefit granted by a governmental instrumentality required by law to consider an applicant’s financial responsibility or status; or

E. otherwise has a legitimate business need for the information in connection with a business transaction involving the consumer.”

The federal Fair Credit Reporting Act (“FCRA”) was amended by the Consumer Credit Reporting Reform Act of 1996. Section 604 (a) (3) (E) has been added to “Permissible Purposes of Reports.” It states that a permissible purpose is given to a person who “intends to use the information, as a potential investor or servicer, or current insurer, in connection with a valuation of, or an assessment of the credit or prepayment risks associated with, an existing credit obligation…”

Therefore, this section gives a permissible purpose for potential investors, servicers or insurers of credit obligations to obtain a report on a payor for the purpose of evaluating or assessing the credit or prepayment risks involved in existing credit obligations of the payor.

For example, an entity which plans to buy a note and trust deed would have a permissible purpose under this section to obtain a consumer report on the payor for that particular transaction.

For the text of the law, see

Lorelei Stevens, president of Wall Street Brokers (206-448-1160, has been spearheading the credit issue on behalf of the note industry for years – unofficially, of course, since there is no organized “note industry.” (Reminds me of Will Rogers’ comment, “I’m not a member of any organized political party. I’m a Democrat.”) She’s corresponded with credit bureaus, state regulators, hired attorneys and has engaged in a continuing dialogue with the Federal Trade Commission over the legalities.

Lorelei obtained the Associated Credit Bureau’s analysis of the changes to the law. It says:

“Section 604(a)(3)(E) creates a permissible purpose for potential investors, servicers or insurers of credit obligations to obtain consumer reports for the purpose of evaluating or assessing the credit or prepayment risks involved in existing credit obligations of consumers. For example, an entity that plans to invest in a mortgage loan transaction would have a permissible purpose under this section to obtain a consumer report on the borrower in that transaction.”

Legally you don’t have to have a signed authorization from someone to check their credit if your need for the information falls under one of the above criteria. However, take the prudent course: even if you don’t think you legally need it, secure their written authorization whenever possible.

Of course, your investment-to-value ratio is more important than the credit of the payors. If there is a large equity in the property and the payors put down a large amount of cash you may wish to proceed with buying the note despite a poor credit history. Be forewarned, however, that someone with bad credit is more likely to declare bankruptcy (see “The Worst Thing That Can Happen” section in this manual).

The Cheapest Insurance You Can Get

Unless you are very experienced in buying notes, the best way to reduce your risk is by having an attorney who specializes in mortgages and real estate involved in the note transaction from the outset. the best attoney for this is one who buys notes for his or her own portfolio, if you can find such a rarity.

Why should you spend money on a lawyer when you’re buying a mortgage?

You shouldn’t. Unless you want to avoid situations such as:

* The note seller doesn’t own the note.

* This is the fifth time this week the note’s been sold.

* The note isn’t properly recorded as a lien against the property.

* What you think is a first mortgage or trust deed is actually a second (or third, fourth or tenth).

* There is an IRS lien against the property (which is superior to even a first mortgage in the chain of title).

* There are judgments, mechanics liens, property taxes owed, private and/or public assessments clouding the title.

* There are easements and/or deed covenants which may limit the use of the property and thus the value.

* There are easements and/or deed covenants which may grant rights to others who are not owners.

* Truth in Lending laws were violated when the note was created.

* The payor has declared bankruptcy.

* The loan documents look fine but violate some law you know nothing about.

If you invest in mortgages without an attorney’s advice, especially when you’re a novice, you’re just asking for trouble. Case in point: if a Virginia trust deed is secured by an owner-occupied property, the due-on-sale clause must be printed in capital letters in the note. It can be worded exactly correctly, but if it’s not in capitals, it’s not enforceable. A good attorney will alert you to pitfalls like this that could cost you thousands or even tens of thousands of dollars if you missed it.

The survey will disclose any violations or encroachments within the boundary lines of the property. The survey should be compared to the facts revealed in the land records.

Finally, mortgagee title insurance should be placed in your name as the note buyer (if it already exists there should be no additional cost) to protect you from any long-buried problems that were not revealed by the title search, such as forged signatures, single people who were actually married but no spouse signed the deed, undiscovered liens against the property, Truth in Lending violations in a prior sale, “off-record” occurrences, judicial enforcement of covenants, conditions and restrictions [“CC&R’s”], etc.

I’ve heard it many times before: “But here (in California, Nevada, etc.) we don’t use lawyers for real estate escrows, we use title companies.” No, you use lawyers, too. The difference is, you pay them and they work for somebody else (the title company). When we pay a lawyer, he works for us.

(Please don’t quote the lawyer’s “fiduciary responsibility to both parties.” I maintain that’s a fiction. A lawyer cannot represent both sides in a potentially adversarial transaction, as this is. Besides, there are three parties: the seller, the buyer and the title company, who retains the lawyer and is thus his client).

When you hire a lawyer, his sole concern is to protect you: not so for a title company. There’s nothing inherently wrong with using a title company to process the paperwork, but have your own attorney review everything beforehand.

A good attorney familiar with the real estate laws of the jurisdiction in which the property is located is the cheapest insurance you can get. Just as having a doctor who prevents health problems is better than getting sick, having a lawyer who prevents legal problems is better than getting sued!

Few attorneys are paper specialists. If you don’t know of one, ask other investors who they use. Ask the same of mortgage companies, paper and real estate brokers and apartment associations in your area. See what names are mentioned most often. Call and ask what their fees are to do what you need. Visit them and pick the one you’re most comfortable with.

Here’s a secret not known to many: one of the best ways to get a top attorney is to call the local real estate board and ask who their lawyer is.

It should make no difference what “they” do transactions in your area. When your money is at risk, get representation.

Check The Documentation

Even with an attorney, it is vital that you get, read and understand all the documents relative to the transaction. Never sign something until you know what it says. You’d be surprised how many people violate this rule every day.

If you don’t understand something in the documents, ask your lawyer; if he doesn’t understand it, don’t buy the note; if he wrote it and doesn’t understand it, find another lawyer!

Are the note and security instruments in proper legal form? Are all the requirements for a note and mortgage or deed of trust in the documents?

Some of the recommended clauses that often are missing from note documentation:

* Statement of the method and type of advertising for a foreclosure to allow a minimum time period;

* The right, but not the requirement, to make advancements to pay superior liens and have all such advancements automatically added to principal and draw interest;

* If interest is unpaid for a month, it should get added to principal and then draw interest (if permitted by state law;

* If payments are not made, a higher default interest rate should come into effect (within legal limits).

If you are going to be a successful investor in a substantial number of notes, you should become very familiar with note legal terminology. Larger book stores carry (or can order) books that are glossaries of real estate legal terms. This is an excellent way of familiarizing yourself with the subject.

Look at the face interest rate of the note. Most states enforce usury laws: know what those are and make sure the note doesn’t exceed it. You can get into major trouble if you own a note that violates the usury law. Points and fees that effectively boost the interest rate beyond the usury ceiling may not be legal.

For a useful summary of state usury laws, consult the last volume of the current edition of the Martindale-Hubble Law Directory. You can find it in a law library or in many attorneys’ offices.

Buying a note at a discount that gives you a yield above the usury ceiling may or may not be a violation of the law, depending upon the state. Different states have different laws. For example, Florida requires three parties to a discounted mortgage transaction (the mortgagor (payor), the note seller and the buyer). Virginia restricts certain loans to business purposes only. States have many laws that define usury based upon the property and the purpose of a loan. There may be one usury law for loans against mobile homes, another for home mortgages, etc. In the state in which you are doing business a loan made for business purposes may be exempt from usury altogether. Check the state laws through an attorney before you act!

Find out who holds the first lien; if it’s not a commercial institution, why not? That could mean the property and/or the borrower couldn’t qualify. It also is likely the first lien documents are non-standard and possibly faulty. That would put your whole position in jeopardy.

Also, an individual first lien holder may see default as an opportunity to profit and insist on you cashing him out. In short, there are plenty of good seconds available that are behind commercial firsts. Be extremely cautious about seconds behind private first liens.

You reduce your risk if the first lien is at a low fixed rate; that makes it easier for the mortgagor to pay you on your second note.

Similarly, be wary of second position notes behind firsts with “creative” financing: big balloons, adjustable rates with no or high caps, negative amortization, shared equity, blanket encumbrances, subordination clauses, substitution of collateral, etc. Again, you’re most likely to find such contorted financing in private loans.

You can reduce your risk in such cases by purchasing just part of the second, but unless you’re an expert, well-experienced note investor, avoid such notes entirely.

The safest route is to only buy notes in the first lien position. I rarely consider seconds for my own portfolio, for several reasons. Purchasing a first is a simpler and cleaner transaction (you don’t have to review any senior liens, you don’t have to notify senior lienholders, etc.). You don’t have to check every month with senior lienholders to see if they have been paid. You don’t have to worry that a senior lienholder is foreclosing (which could wipe you out). You are in the most powerful position possible in case of default.

If you want to buy seconds, realize that first liens may be subject to call in the event of foreclosure. In some areas, custom, not law, governs this. Since “custom” comes down to whatever the lenders feel like doing today, I prefer to hang my hat on the law.

Whenever you. buy a second position note, send the first lien mortgagee a letter informing them that you hold the second lien and would like notification in the event a payment is late on the first lien (for a sample letter, see the THE PAPER SOURCE’S OWN CONTRACTS, WORKSHEETS, CHECKLISTS, FORMS AND SAMPLE LETTERS VOLUME I

FHA loans may not be assumable. It depends upon when they were created. It is therefore vital that you determine when the loan was originated and check with your lawyer on the assumability of that loan under the foreclosure laws of your particular state.

Another little-known trick is to run an amortization schedule on the first lien (even when you’re buying the second) and compare the current balance on the paperwork to what your schedule shows. Any differences may mean there have been late or missed payments (you received the computer software to do this as part of your PAPER SOURCE JOURNAL subscription).

Make sure there is an “acceleration clause” in the first and second lien documents requiring the immediate payment of the balance due in case the property is sold, the payor fails to make his payment, or fails to pay the taxes or insurance. The best acceleration clause gives the note holder the option to accelerate the balance due, since, if the property is sold, you will then be able to decide if you want your money or perhaps want to restructure the note, charge an assumption fee or play banker in some other way.

If you’re buying a first position note, it’s additional protection for you if it is in front of a solid second mortgage (or trust deed). In case of default, the second lienholder must keep the payments coming to you or risk losing his security.

Ditto if you’re buying a second in front of a third position note, especially if the third is held by the person who sold the property. If the mortgagor defaults, lienholders behind you must take over payments to you or risk being wiped out in foreclosure.

Before you buy the first lien, thoroughly investigate the financial stability of the second lienholder. Now, given the preceding paragraphs, why should you care about the financial situation of the second lienholder? Again, a little-known fact: The junior lienholder can declare bankruptcy and shelter his assets from foreclosure, and guess what: one of his assets is the property in which you both have an interest!

I haven’t discussed investing in third lien notes. That’s because most investors shouldn’t buy them. There’s a reason the yields are higher, and the reason is increased risk. Stay in the second or preferably first position.

A Twist

In 1990, the New Jersey Superior Court (The Howard Savings Bank v. Brunson) created yet another risk factor. It ruled that a mortgage that is placed in the record book but not properly indexed (filed for reference) is not legally recorded.

That means that, at least in New Jersey, don’t assume that a mortgage is recorded by relying on a copy of the mortgage showing the clerk’s stamp with the deed book and page number. The safest route, whether in New Jersey or anywhere else, is to do a title search on every note you buy. And if you originate mortgages, you must make it a practice to order a title bring down after you have sent the mortgage for recordation to insure that it has been indexed properly.

The Most Ignored Risk Factor Of All

If there is one risk factor more ignored by note investors than truth-in-lending requirements, I don’t know what it is. Congress passed the Truth in Lending Act in response to shady lenders who were deceiving borrowers by hiding the true costs of their loans. Now all lenders are required to disclose to borrowers the amount and terms of a loan, including the total cost over the life of the loan, where the borrower is a homeowner borrowing on his house for non-business reasons. There is a standard disclosure form that is completed by the lender, signed by the borrower to prove he received it and filed as part of the loan documents.

This has a tremendous impact upon the way mortgage and trust deed investors do business. Unfortunately, most of them don’t know it, and may not know it until their notes are declared null and void by the court.

When you are considering a note, you must discover the circumstances under which the note was created. If the mortgagee, such as a property seller, is a lender covered by the law and the note is subject to the law but there is no truth-in-lending disclosure statement among the loan documents, and if the mortgagor is an owner-occupant, the note violates the Truth-in-Lending Act and may be unenforceable.

It’s not hard to be legally classified as a lender. All the property seller has to do is make a couple of loans a year. If you are ignorant of the truth-in-lending law, or fail to investigate the origins of a note, you may well find yourself owning an uncollectable, worthless obligation.

Loans for business purposes are often exempt from the Truth in Lending Act, but this is a tricky area full of pitfalls.

Servicing Your Notes

Most investors prefer to keep total control over their note collections and bookkeeping, and that’s what I recommend. However, some leave these tasks to a competent professional. There are escrow companies you can hire for a nominal fee to service your notes.

A good escrow company will track principal and interest payments, send late notices, accept and disburse payments, hold documents in escrow, provide annual IRS reports to you of interest earned and paid, escrow and disburse taxes and insurance and serve as an impartial third party focal point for privacy or other reasons.

Even if you’re buying the note from a broker, don’t let him service the note. Either service it yourself, or hire a third party.

Once you own several notes it becomes a chore to service them and you should consider computerizing that task. NoteSmith is the best note servicing software available for note investors and brokers. Call 800-526-5588 or visit for information.

Buying Notes From Note Brokers

Some people prefer to deal only with private sellers, believing they can negotiate better deals with them than they could with note brokers. Some people prefer to invest through brokers, since a good one will take care of all the details.

There are brokers, and there are brokers. Some brokers unknowingly sell unenforceable notes (see the previous section on Truth-In-Lending). Licensing doesn’t guarantee competence. In fact, government licensure functions simply to restrict competition (licensure), but that’s another book. Ask the broker these questions:

* How long has your firm been in business?

* Is the firm insured? Bonded?

* How many employees do you have?

* Is your firm a member of a state or national mortgage broker’s association?

* Who appraises the properties?

* Are your appraisers certified? By what agency?

* Are the appraisals reviewed by a senior appraiser?

* Do you offer recourse (guarantee the notes)? If not, why not?

* Can you give me the names, addresses and phone

numbers of your bank, a creditor and two of your clients?

* Do you have direct control, either via ownership or a contract with the owner, of the notes you advertise for sale?

* What do you do to check out the safety, soundness and legality of the notes you broker?

Check with the county in which the broker is headquartered. Most have consumer protection agencies that at the least can tell you how many, if any, complaints have been filed against him. Also call the local office of the Better Business Bureau.

The safest approach is to confirm everything the broker says by hiring your own lawyer, appraiser and credit agency: it’s more expensive, but it’s cheap insurance.

If the broker seems anxious, if you are under pressure or are made to feel any obligation to go through with a transaction, just walk away. There are plenty of ethical brokers with good notes out there. A list of them is THE PAPER SOURCE REGISTRY OF NOTE INVESTORS.

A Word On “Hard Money Loans”

Sooner or later you’ll discover the first cousin to the discounted note, called a “hard money” note. These are popular investments in California.

A hard money loan, also known as an equity loan, is nothing more than a note that is created when a homeowner borrows against his equity. The classic hard money borrower is either in a hurry and cannot wait for conventional sources or he cannot get a loan through such sources. He may have bad credit, may be unemployed or earn very little, may be a senior citizen on a small fixed income, may have a ton of consumer debt that he’s behind on, may have declared bankruptcy in recent years and/or may even be in foreclosure. The only asset he has is the equity in his house, so he sees an ad and goes to a hard money lender to borrow against his home.

The hard money lender is primarily or solely interested in the home’s equity and has less concern about the financials on the borrower. He charges high interest rates (sometimes the highest the law allows), points and other fees, usually writes the note for a few years interest-only with a balloon, includes a pre-payment penalty, and sells the note for the face balance (called “selling at par”) to an investor. The investor’s yield is the interest rate at which the note is written.

Hard money loans can be good investments, but you have to be very careful. The integrity of the broker is key. The note is not discounted, so an early pay-off won’t increase your yield (excepting the effect of the pre-payment penalty). That’s not a big deal because these loans are rarely paid off early. The reasons are: 1) the pre-payment penalty discourages it and 2) the borrower usually has no prospects of getting any money.

The real danger of hard money loans is when the borrower defaults on the note and takes the lender to court. The court can rule that the lender, (even though he followed all the rules) took unconscionable advantage of the borrower, wipe out the debt (your note) and punish the lender.

Get Title Insurance

Some people confuse title insurance with fire or hazard insurance, which it is not. Title insurance is a specialized type of insurance that protects an investment in real estate. Also, some think that when you buy a house the title insurance you buy covers you — that’s not true either unless you pay even more for owner’s coverage. What you’re buying initially is lender’s coverage. I’ve always thought lenders pull a pretty neat trick by getting somebody else to buy their insurance.

Lender’s title insurance is only for the amount of the loan. The equity in the property is not covered. In addition, the lender’s policy expires when the loan is paid off.

When you buy a note, you want a mortgagee’s title insurance policy, which protects against loss due to any defects in the title, and loss due to liens and/or encumbrances upon the property at the date of the policy.

Always make sure to get mortgagee’s title insurance to protect your investment in the note from any title problems, such as a forged deed, a mistake in the documents, errors in the title search, unrecorded liens, or hundreds of other potential problems.

Additional protection is available, at a cost, to protect you from a myriad of possible difficulties that may not be covered by basic title insurance — from insuring a modification of the mortgage, to securing future advances, to protection against mechanics liens filed after the transaction was completed (on the theory that the contractor’s work was completed before the transaction), to just about anything you can think of.

“Endorsements – Their Uses and Availability” is a very useful booklet describing many of the available additions to a standard title insurance policy that expand coverage to fulfill specific requirements you may have. It’s available at no charge from First American Title Insurance Co., 714-558-3211.

With larger notes, you can also insist, as do institutional lenders, that the title company issue you an “insured closing letter,” insuring you against the malfeasance of the closing agent. If the funds are not disbursed properly, the title company will cover it. Anyone wiring funds to buy mortgages or real estate should always have an insured closing letter in hand, backed by a national title company, before any monies are transferred.

In many states, if a title policy was issued when the note was created it remains in force when the note is sold. Be sure to order a “title bring-down,” or update, to determine if any liens have attached to the property since the policy was issued. Liens junior to yours won’t affect your equity in the note, but it tells you something about the mortgagor if he has a bunch of liens on his property.

In other states you will have to purchase a new policy when you buy the note. It doesn’t cost much, and won’t cost you anything if you’re buying a purchase money note created at settlement, because you are simply added to the insurance as a loss payee.

Don’t underestimate the importance of title insurance. The likelihood of a loss due to a defect in the title is statistically very slight, but if there is a defect it could be very costly without title insurance. For example, a PAPER SOURCE subscriber once bought a second lien note that turned out to be a third lien. Because he had title insurance, the company paid him the full face amount for the note he had bought at a deep discount.

Hazard Insurance

You wouldn’t buy a house and fail to insure it against fire and other hazards, would you? Then don’t buy a note secured by a house and fail to be insured against the same losses.

All you need to do after you become the owner of a note is to write a letter to the insurance company (or better, have the note seller do it) informing them that you are now the mortgagor and asking them to place you on the policy as an additional loss payee. It costs nothing and may pay huge dividends some day.

Recording Your Interest

Once you’ve bought the note, recording your interest at the county courthouse where the property is located puts your position on the public record. If the person who sold you the paper turns out to be a crook and tries to sell the same note to multiple parties, or tries to create other encumbrances on the property, this will help to protect you.

Who Pays For All Of This?

When you’re buying a note, you should pay all the fees. When you’re selling a note, you should pay all the fees. That’s no misprint. The only way you can keep total control of the situation is to have all third parties working for and reporting to you.

Factor those costs into what you’re willing to pay for a note, and quote a price that is net to the seller. It’s a selling point if you can advertise, as I do, that “I never charge extra for points, fees, commission or any other “hidden costs.” My quote is the exact amount you will receive.”

Your contract to purchase the note should specify that the note seller will pay all the fees up-front, and that the attorney will reimburse him for these costs immediately after the note has been transferred and recorded (you, of course, reimburse the attorney). That way, if the transaction falls apart after costs have been incurred, you don’t end up paying bills for a note you never bought.

Dishonest Sellers

We live in a sinful world. Dishonest note sellers exist. Take the Lord’s advice and be “wise as a serpent and harmless as a dove” (Matt. 10:16). Pay attention to your initial impression of the seller. Avoid those exhibiting pressure tactics or who seem anxious.

Get written documentation for every assertion the seller makes — remember, he’s the one trying to impress you. Do the math on every figure he gives you. When you get the documents, compare the signatures. Discrepancies could mean forgeries.

As evidence of the seller’s ownership of the note, he should provide you with a copy of his title policy insuring his interest in the note (if he has it), a copy of the recorded assignment with the clerk’s stamp showing where and when it was recorded and a copy of the back of the note showing assignment to him (if he was not the original mortgagee) or a copy of the recorded assignment form.

On Selling Notes To Private Investors

I’m often asked about selling paper to private investors. Unless the inquirer is a very experienced note buyer, I answer in one word: don’t. It’s not just that individual investors are often unreliable, although that’s a major annoyance. The biggest drawback is that if you sell notes to private parties or, worse, take them in as partners, you are opening your door to government regulators, IRS auditors, process servers, and all sorts of people you’d just as soon not meet.

Before we proceed, let’s define “private investor.” By it I mean someone who is relatively ignorant of paper and who isn’t interested in learning. A private investor simply wants to increase the yield on his money. The people who would respond to an ad in the paper promoting double-digit yields would all be private investors (and the ad might be illegal – more on that later).

Many people ask me why I recommend that you sell notes only to professional note buyers and not to private investors. There are at least 4 reasons for this:

1. As long as the note is exactly what you’ve said it is and the documentation is in order, a professional’s bid is a commitment to buy. This is not the case with a private individual. He may run out of money, find a better deal or change his mind for whatever reason, and you will have wasted your time, effort and possibly money for nothing.

2. If you sell a note to a private investor and it goes bad, the investor may want you to make it good. A professional note buyer will not.

3. The law presumes the professional knows more than you do about paper. In the very remote chance that a dispute occurs, this presumption would work in your favor. However, the presumption might be reversed if you sell to investors, and you as one who has been trained in paper would be presumed to know more than a private individual.

4. If you sell notes to private investors without a state or federal securities registration you may be in violation of securities laws. The vast majority of paper investors – even those who’ve been in the business for years – have never heard anything about securities laws. I know. They tell me so constantly. Most of the others have heard something about it but don’t know if it applies to them or not.

Let me set the record straight, once and for all, so you don’t run afoul of the law. There are both federal and state securities laws. Federal securities laws regulate transactions that cross state lines. For example, the property secured by a note is in one state and the investor to whom you sell the note is in another state. Or, you and the property are in the same state and the investor is in another state. If the investor and the property are in the same state and you as the broker are in another state federal securities laws could still apply.

Remember, though, that even if you know and follow the federal laws, and your advertising, collateral, buyers and sellers all come from within your state, you could still violate laws of that state. In fact, state regulators are more likely than federal ones to go after you simply because they don’t have 50 states to monitor.

There are four criteria that determine whether you are selling notes or securities. If you do all four there’s little question that the law will define your sale as a securities transaction. If you do just one, that may not happen, but any time you trigger even one criteria you are putting yourself at risk:

It Coould Be A Security, Not A Note, If…

1. You sell a note to a private individual as opposed to a licensed mortgage broker, bank or some other financial institution.

2. You sell parts of notes as opposed to whole notes. You compound this mistake by selling parts of notes to multiple investors .

3. You guarantee the investment. For example, if you promise to buy back the note from the investor or replace it with another if it defaults.

4. You service the note. That is, if you collect the payments on the note and send payments to the investor and/or send late notices, escrow taxes and insurance, handle defaults, etc.

YOU DO NOT HAVE TO CROSS STATE LINES OR TRIGGER ALL FOUR TO HAVE YOUR NOTE SALE BE DEEMED A SECURITIES TRANSACTION. How many qualify? No one can say with authority, since it is somewhat up to the discretion of securities regulators.

You would ring all the bells if you sold part of a mortgage secured by property in your state to a private individual living in another state and you serviced the note and guaranteed his investment in case of default. In this case the law says you didn’t sell a mortgage, you sold a security. Unless you are licensed to sell securities and what you’re selling is registered as a security you are in major trouble.

The bottom line is, you can’t cross state lines to sell what the law defines as securities without having state and federal registrations. If you’re a note investor and you give your money to someone else and they do all the work and all you do is cash the checks, you’ve bought a security, even if no state lines were crossed.

Should you never sell a note across state lines? Should you never guarantee a note? Or service a note? No, that’s not what I mean. You can do any of these, but be careful of combining them.

If you’re selling to a party in another state, sell the whole note, lock, stock and barrel, with no guarantees and no servicing. You can sell a note, even to a private individual, across state lines (as long as you don’t violate the laws of either state), but don’t sell a partial, don’t service it and don’t guarantee it. You can sell a partial, service it and guarantee it, but don’t cross state lines. If you’re considering this, do yourself a favor and have a lawyer who knows securities laws watch over your shoulder.

Your safest approach is to sell notes only to professional buyers and never service or guarantee them (which a pro would never expect or want you to do anyway).

If you sell partials, even within your own state, never, ever sell to more than one other party. Don’t split up a note into two, three or more investors. That’s just asking for trouble, even if they’re all in-state. The owners of partials should be strictly limited to two: you and one other party. Beginners often discover they can make even more money by splitting a note into a bunch of parts and selling each part to a different investor. This is a serious mistake. Don’t you make it.

I teach a course on how to sell notes to private investors. It is quite advanced and we study the laws and many court cases. The idea is for you to be able to leave the course knowing what to do and what not to do when selling notes to private investors. I usually teach it once a year, sometimes not that often. E-mail me at or call 830-895-5025 if you are interested in it.


Advertising and mailings to buy notes aimed at prospective note sellers across state lines is not a violation of federal securities law, but a few states prohibit out-of-state solicitations by parties unless they are registered in those states.

However, if your solicitation seeks investors, the laws are more restrictive. In addition to state and federal laws, you must comply with federal postal regulations governing the content of such solicitations.

Even if you hold the proper registrations, you can be charged with fraud and/or misrepresentation if you fail to abide by the laws governing the content of advertising and solicitations. A huge mistake is to guarantee yields. Regulators scan publications looking for such ads as “15% Return Guaranteed.” It’s best not to solicit for investors.

Unless you are an experienced note broker and have been trained to work with private investors you should avoid all of these potential problems by dealing exclusively with professional institutional note investors.

The Worst Thing That Can Happen

If your note payor declares bankruptcy, you are in trouble. The subject of bankruptcy and the paper investor would make a book in itself (see the section on bankruptcy in George Coats’ book “Smart Trust Deed Investment (in California).” If you don’t have the book, get it right away. It’s indispensable whether or not you live in California. Call 1-800-542-2270 to order it).

The best way to deal with bankruptcy is never to be caught by a defaulting payor. Guard yourself by learning to predict candidates for bankruptcy. Review the questions you should ask about a credit report with the possibility of bankruptcy in mind.

If your payor is in default, do not hesitate to begin foreclosure. Depending upon where you live and the type of property, if you initiate the foreclosure process before he files for bankruptcy you may be able to continue foreclosure.

Since this is a complex area and because the laws differ in each state, it is vital that you consult an attorney who is well-versed in bankruptcy and the rights of lienholders. If you don’t know of one, call David Nielsen at 1-800-635-6128. He runs the U.S. Foreclosure Network, a national referral service of attorneys specializing in the subject. Be sure to tell him you’re a PAPER SOURCE subscriber.

Some people are “professional bankrupts” with a history of running up obligations and then declaring bankruptcy. Even the legal limit of one bankruptcy every seven years doesn’t stop them. They just sell part interest in their property to someone else who goes bankrupt, tying up the property. Or, they do business corporately, exempting them from the 7-year rule. Even the 7-year rule does not stop them from FILING for bankruptcy (although they won’t be successful), and it is the filing that prevents you from taking action.

The best advice is to do everything in your power to avoid the situation before it happens. Once you’re involved, what options you have are time-consuming and costly. If it looks like your mortgagor is about to declare bankruptcy – if he ever even mentions the word – get competent legal counsel at once.

I hope I haven’t scared you away from paper by warning you of the pitfalls; that wasn’t my intention. If I have tempered your enthusiasm with sound advice that has kept you from losing money — or worse — then I’ve accomplished my goal.

Naturally, in paper, as in any investment, risk will always be a key factor. Applying the field-tested methods of risk management as outlined in this manual will help you to drive down the risk and work toward making your portfolio as risk-proof as possible.

My hope for you is that if you make a mistake, let it be because you didn’t buy a good note: not because you bought a bad one.

Copyright 1999, The Paper Source, Inc.  All Rights Reserved.

W. J. Mencarow, Jr. has been investing in notes since 1981. He is the editor of THE PAPER SOURCE newsletter, the first and largest national publication exclusively devoted to notes. He is also president of The Paper Source, Inc., which he co-founded with his business partner and wife, Alison, in 1987. In addition to countless articles in his newsletter and others, he is the author of How To Get Started In Notes Without Using Your Own Funds and Almost Everything That Could Go Wrong With A Note (and How to Prevent It!),

and several courses. In 1997 he received the Note Industry’s Founder’s Award for founding the first nationwide note publication and national convention, and was inducted into both the Mortgage Report Hall of Fame and Metropolitan Mortgage’s Note Industry Hall of Fame.

He previously served for a decade with the U.S. House of Representatives in Washington, D.C. He was Minority Counsel and Staff Director of a subcommittee a congressional press secretary and legislative director, where he had the responsibility of drafting and shepherding many bills through Congress. He and Alison met on Capitol Hill, where they were both Congressional press secretaries.

Before coming to Washington, D.C. in 1978 he managed a dozen political campaigns, was a Field Director for Ronald Reagan’s presidential campaign, served as the coordinator for all Reagan volunteers at the Republican National Convention, and served as an advisor to the Presidential Transition Committee. In addition, he was a television and radio talk show host for eight years in the Chicago area and producer of the number two morning radio progam in Chicago.

During his political career he appeared on many radio and TV programs including Good Morning America and was interviewed on many networks and major newspapers. He has debated Jane Fonda, Gore Vidal, Paul Ehrlich, a dumptruck load of left-wing lawyers, socialist college professors and numerous other slugs. He believes his highest political honor came when a speech he wrote was attacked by Pravda, the official newspaper of the Communist Party of the Soviet Union.

He is ordained in the Presbyterian Church (OPC) as a Ruling Elder and is currently studying for a Masters in Reformed Theology. He and Alison give glory to the Lord for The Paper Source and all He has done in their lives.

Contact him at notes@PaperSourceOnline

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