Sellers who carry-back mortgages agree to make a loan to help a homebuyer buy a home. When sellers agree to finance part of the purchase price, they receive documents that serve as evidence of the terms and conditions of the loan. Seller carry-backs can be in the form of a mortgage, trust deed, land contract, or even a lease-purchase, and most are secured by promissory notes.
How Carry-Back Mortgages Work
When interest rates are high, or credit guidelines are tightened, buyers ask sellers to act in place of the bank and carry the financing for them. If the home is free of any existing loans, the seller might carry all the financing, or the buyer might get a conventional fixed-rate loan for part of the purchase price and ask the seller to finance the balance. If there is an existing loan secured to the home, sellers may let buyers take over the existing loan payments, although the loan will remain in the seller's name. The difference between the sales price minus the down payment and the existing loan is the equity the seller would carry as a loan.
Reasons Sellers Carry-Back Mortgages
Sellers tend to agree more to carry-back mortgages when it's a soft or down real estate market because owner-carried financing will attract a greater pool of buyers. It also widens the pool of buyers because it allows people who otherwise wouldn't qualify for a conventional loan to get financing. The buyer gets access to the financing they need, and the seller often gets a better rate of return than a money market account or similar investment.
Sellers can receive a higher sales price in exchange for offering owner financing. Many buyers are willing to pay more if it's their only feasible option. The monthly payments also give the seller an additional stream of income until the loan is paid off. If they were facing capital gains taxes on the sale of the property, they can defer the portion that is financed.
Drawbacks of Seller Carry-Back Mortgages
The main disadvantage of carry-back mortgages is the possibility that the buyer might default on the payments and cause the seller to initiate foreclosure proceedings. After foreclosure, making up back payments to the existing lender, if there is an existing loan, paying closings costs and real estate commissions, the seller might not be left with any equity. Sellers who carry back mortgages also have tied up cash by securing it to the property. They are still involved with the property and cannot walk away.
Converting the Seller Carry-Back Into Cash
There is a large pool of private investors in the marketplace who regularly buy seller carry-back instruments, but they do not pay face value. Investors look at the yield they will receive over the term of the investment, and this yield can be increased if the investor pays less than the outstanding balance due. The discounts vary across the board, but sellers can expect to lose 10–30% of the unpaid balance, depending on the following:
- Seasoning: This is how long the seller has been receiving payments on the carry-back financing. A seller who has received timely payments over a 12-month period will receive more cash than a seller holding a brand new mortgage.
- Interest rate: The higher the interest rate, the lower the discount. A lower interest rate will attract investors who want a higher discount.
- Mortgage term: Long-term mortgages such as a 30-year mortgage are not as attractive to an investor as a short-term mortgage, so they are typically sold at higher discounts than short-term ones.
- Prepayment penalties and late charges: Carry-back mortgages that contain a prepayment penalty and a late charge are also more attractive to investors, which affects the discount rate applied.
- Loan-to-Value Ratio: Lower loan-to-value ratios receive more favorable discounts. Higher ratios are considered a greater risk, and the discounts are steeper.
Investors also consider the type of security, its appraised value, location, amenities, condition, and the credit-worthiness, if known, of the buyers.
The investor may ask the seller of a carry-back mortgage to pick up all costs associated with the sale of the note and mortgage. These fees may include the following:
- Title Policy
- Escrow Fee
- Document Preparation
- Beneficiary Statement
- Courier and Wire Transfers