Seller Financing and Wraps 101
Hey there investors, Cody here, welcoming you back to another installment of my epic series: The 6 Stages of Investing. We’re still breaking down all the components of Stage 5, which is Strategy and Funding.
In my previous post, we talked about the legalities and ethics surrounding creatively structuring deals. That’s a pretty insightful post, so make sure you’ve read that one. And, if you want to start from the very beginning (highly recommended), here’s Part 1.
As for today, let’s dive back into this series discussing funding and a couple of creative options for funding your deals.
Let’s start with an example for which the property we’re looking at doesn’t have a loan on it. (As discussed in a previous lesson, if there was a loan, you’d likely do a subject-to deal. Although, we will discuss another strategy for a mortgaged property below…)
So, no loan and you’ve offered $100k, but the seller wants $150k. See, they own the property free and clear and they’re not selling it for a penny less than $150,000.
At this point, we take a look at doing this deal with seller financing…
No Loan = Seller Financing
This funding strategy is also known as owner financing or seller carryback. Here’s how this one works…
The seller acts as the bank, that’s their role in this deal. They place a lien on the property at the close of escrow. The terms of your note are whatever you and the seller agreed to.
Common terms for seller financing include a 5- to 15-year note duration, but I also do 30-year notes this way, too. Let’s take a look at how our seller financing scenario might play out with some of the figures…
- Seller wants $150,000.
- I ask the seller how much they think it will rent for. He says: $1,500/month.
- If we did a rent-to-own, we could likely get a down payment of $2,500 to $7,500 (maybe even more), plus the rents as the option deposit.
Knowing this info, you’ll then go to the seller to negotiate:
“What if I paid you, Mr. Seller, $100k cash OR I could talk to my business partner, who might be willing to figure out some creative financing options. I’m thinking that we could do a loan, where you carryback the paper. Would that be something you’re interested in? I mean, I do have to work it out with my partner and we’d have to structure the deal a certain way, but if you’re interested, we’re willing to put in the time and energy to see what’s the best creative solution we can come to, so you are able to sell for $150k.”
See, not only do you have to consider your seller in this situation, you also have to think about your competition from other investors. We know the seller wants $150k, and let’s say 3 other investors have come in and offered $130k or $140k – but you outmaneuver your competition by swooping in, and through creative financing, you’re able to offer $150k.
Who’s the seller gonna play ball with?
So with this financing option, you’ll explain to the seller that by him simply carrying the paper, he’ll get a huge return – $20k more than what the other guys were offering. He’ll only have to wait a little longer for it.
Your seller agrees (yay!).
So, you both agree to these terms: A 30-year note, which amortizes over 30 years, and balloons in 5 years. And you’ll pay the seller “until paid.”
Know what that secret phrase – ‘I will pay you until paid’ – means? (Well, write it down, this is BIG.)
It means: 0% interest (without you having to say, ‘I’m going to give you 0% interest’). To the seller, this means that you’ll make the principal payments until it’s all paid off. In other words, every time you make a monthly payment, it goes toward the principal until the loan is paid down.
At this point, you can hop on a mortgage calculator and input the numbers from our agreed-upon terms, which will show that you’ll owe a principal of $417 for a monthly mortgage payment (plus interest, taxes and insurance). So, with taxes and insurance added in, we’re probably looking at around $800/month. (We did 0% interest, though.)
Just remember – PITI: Principal, Interest, Taxes, Insurance. It’s a common term in this industry.
So, you’ll then explain to your seller that his benefit comes from where our terms say that this loan balloons in 5 years, which means that whatever principal amount is still owed at that time, I, as the buyer, have to either refinance or pay the remainder in cash.
What’s great about this, though, is that by amortizing over 30 years but ballooning at 5 years, provides me a very low monthly payment to create a spread between the asking price of $150k, the rents plus money down and the PITI.
You might be thinking, ‘What if the seller isn’t happy with 0% interest?’ Well, get creative, right?! Ask what they want. If they say 8%, you’ll politely say that that’s even more than conventional money and that won’t work. If 2% is still too low, ask what they think about 4% – after all, they’re getting an extra $20k more than had they gone with another investor. This all about negotiation, people…
Negotiate with the seller to come to an agreement on terms that work for both parties. There’s really not that much that has to be decided:
- Down Payment
- Length of Loan
- Interest Rate
Basically, start from the best and work (negotiate) backwards.
Look, I get it. At first, this may seem a bit confusing, but as you do more and more deals and creatively structure your deals, repeatedly, this will become old hat in no time. What’s great is that we do have the ability to structure our deals creatively, so we need to be sure and take advantage of those options.
Let’s look at another financing option…
These were big in the ’80s, but can certainly still be used today for some deals.
If I see that a property still has a mortgage on it – and I don’t want to do a subject to – I’ll shift to a wraparound mortgage (a.k.a. wrap). Let’s look at this with our numbers…
Let’s say the seller owed $90k to Chase Bank (which carried the mortgage), but I agreed to pay what the seller was asking, which was $150k, because I was planning to hold this long term and add it to my rental portfolio. So, I want to step in and begin to make the payments to Chase – the seller owed Chase $90k and was on year 20 of a 30-year loan.
I put my creative financing hat and came up with this… the seller can carryback the difference between what’s owed: $90k, and what he wants me to buy it for: $150k. I’m okay with that, but the $60k (150-90 = 60) needs to sit there until my deal balloons in 5 years.
So, you’ve got two pieces here that you wrap together:
- The $90k owed to the bank (the underlying lien that we don’t want to get called), which I’ll pay each month.
- The $60k in equity that the seller will carryback, which gets paid back when the deal balloons in 5 years.
You need to know that for the $90k – the money owed to the bank – you’re NOT assuming that loan. You are simply going to make the monthly payments on it to the bank. So, we could create a second mortgage for the difference between what is owed to Chase and the $150k – then wrap those two together.
Instead of deeding the property over to me, they did a Contract for Deed to me. This means I have the rights to the property, which means I have tax benefits and control over it. But, the bank is not notified about any of this.
Let me explain it another way…
The seller gives the buyer (me) a junior mortgage, which wraps around and exists in addition to any superior mortgages already secured by the property. When the last payment is made and the wrap is then closed out – that’s when the bank is notified.
Your closing agent is going to help you structure a wrap deal. It’s best for you to have an understanding of what it is and how it works, but you can definitely rely on your trusted and experienced closing agent on your power team to handle this.
Sure, wholesaling is a financing strategy!
See, wholesaling works when a seller accepts your all-cash offer. Terms work (mortgage or not) when the seller won’t accept your all-cash offer because they’re not motivated enough to sell.
So wholesaling is a financing strategy where the end buyer funds the transaction. Wholesaling is simple. It’s normally the gateway to becoming a full-time investor. The simplest way to explain is that as the investor, you are the middleman/middle woman…
An end cash buyer will come to you as the wholesaler looking to find a deal from your inventory – he’ll want to buy a property’s contract from you, stepping into your position… you’ll sell him the rights to the contract via either an assignment or a double close.
The reason wholesaling is a financing option is because you’re using the end buyer’s money to fund the deal. (I’ve written tons about wholesaling in general on my site, so give those a read for more details.)
In my next post, we’ll continue talking about Stage 5 as we discuss raising private money and how and where to get it.
Catch ya then,
Tags: Assignment, Creative Deal Structuring, Double Close, Negotiate, Seller Financing, Wholesaling
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