Buying a Home With Creative Financing
Dodd-Frank Act Affects Owner-Carried Financing
Creative financing in real estate was a super hot topic in the 1970s. It's hard for me to believe that many of the pioneer legends in creative financing are dead now, but what a crazy ride during its peak.
When interest rates jumped to 18% in the late 1970s, many buyers were forced out of the real estate market and creative financing sprang to life out that need. A lot of homes for sale were advertised with the initials OWC, meaning owner will carry (the owner financing).
During this time period, anything and everything was done under the guise of creative financing. The pace was so frantic that many agents did not stop to consider whether the types of deals they were putting together were legal much less ethical. Just about any process that could be conceived, even if it wasn't a good idea, was often utilized.
Types of Creative Financing Options
- Off-shore foreign trusts. Some people still operate under an off-shore foreign trust today, but if the IRS finds them, these people might end up in jail. The IRS does not look kindly upon off-shore foreign trusts, regardless of what a fast-talking salesman in an expensive Italian suit says. An off-shore foreign trust is a way to secretly move money to another country. Tax dodgers then let the trust domiciled in that foreign country buy property.
- Subject to transactions. Many loans did not carry alienation clauses that called for acceleration, so buyers could take over the payments on an existing loan, leave the seller's name on the loan, and it was OK. Whoa. Banks did not like being locked into a lower interest rate and losing a potential borrower when buyers bought homes with subject-to financing. Subject-to transactions are risky today because lenders can and will call the loan due on sale. Not to mention, most sellers do not want the liability associated with a subject-to transaction.
- Assumable loans. Some types of mortgages openly advertised that a new buyer could assume the existing owner's loan. If the buyer qualified to assume the loan, the bank released the seller from liability. A loan assumption saved a buyer in those days thousands of dollars in lender fees, and many sales could quickly close under these terms. Today, there are few to none assumable loans available.
- Land contracts. A problem with a land contract is finding a title insurance company willing to insure the transaction. Not to mention, a land contract, which delivers equitable title to a buyer, generally does not contain an underlying mortgage because most loans contain an alienation clause. A land contract is best used when a home is owned free-and-clear by the seller.
- Seller-carried mortgage or trust deed. If a seller owns a property outright and wishes to carry the financing for the borrower, an easy-to-use instrument is a mortgage or a trust deed. Each state has its own laws about whether it is customary to record a mortgage or a trust deed. In California, for example, grant deeds to convey title and trust deeds to secure promissory notes are commonly used.
Dodd-Frank Act and Creative Financing Terms for Home Buying
The Dodd-Frank Act is a shortened term for the Dodd-Frank Wall Street Consumer Reform and Protection Act, signed into law in July of 2010. Penned by former Congressman Barnett Barney Frank and then-Senator Christopher John Dodd, the Dodd-Frank Act brought about sweeping changes to financial regulations and amended the Truth In Lending Act. This comprehensive transformation created new agencies and changed many laws. You can't swing a dead cat in financing without hitting the Dodd-Frank Act. I apologize to the poor cat for this reference; it's that the phrase fits so well.
Part of the Dodd-Frank Act pertains to seller financing. It regulates and disallows certain types of financing that was easily allowed in the past. Unlike the free-swinging days of the 1970s when anybody could arrange a loan and get paid for it as long as the person had a real estate license, now an individual must be licensed as a mortgage loan originator. Sellers are exempt providing they don't extend owner financing terms on more than 3 properties a year. Other rules are:
- The seller can offer owner financing as long as the seller did not build the home. This eliminates home builders from offering owner financing.
- There is no balloon payment. A favorite way to offer creative financing was generally a short-term loan, say 3 or 5 years, with a balloon at the end, meaning the entire balance would be due and payable. Owner-financed loans must now be amortized.
- The seller can't offer owner financing to just any buyer who happens along. The seller has a responsibility to determine that the buyer is qualified to buy the home and pay back the loan. This could mean the seller would need to run a credit report on the buyer, which would probably eliminate all home buyers with bad credit.
- The loan must be fixed rate or adjustable after 5 years subject to reasonable annual increases, and a reasonable lifetime cap.
- The owner-financed loan must meet other criteria established by the Federal Reserve Board. However, it's the no-balloon requirement that will put a stop to many creative financing endeavors. A solution for some sellers and buyers might be a lease-option sale.
Before buying a home through creative financing, get legal advice.