So, you want to sell a house and to get an edge in the market, you decide to sell it under an installment contract. Advertising the property with seller financing opens up the market to buyers who know that they can not purchase property in a conventional manner. The seller needs to proceed with caution in order to accomplish the ultimate goal, that being an actual sale.

The best place to begin is at the end of an installment transaction. Closing the deal means the buyer has obtained the necessary financing to pay you off. In order for that loan to be approved, what does the buyer need? You may have heard of the three "C's" of lending, "credit, collateral and capacity", but I suggest two more  "C's" as well, "cash and character"!

The buyer gains equity in three ways, money down, appreciation and from making improvements to the property. Either one or a combination of these aspects must be present when the buyer applies for the purchase money. While their loan may be viewed as a purchase money loan, after one year lenders view it as a refinance, since the buyer as acquired an equitable interest in the property. Since most installment contracts are made for more than one year, let's go with that assumption.

Generally, the maximum loan to value (LTV) mortgage will be 90% of the appraised value of the property. In a refi-loan the sale price is irrelevant after one year, the LTV is based on the appraised value alone. The loan required may not exceed 90% of the appraised value. 

Careful consideration should be made if the buyer's equity is to be acquired from appreciation. Recent markets have shown that housing prices can be volatile and unreliable in a short period of time. If equity is to be established from improvements made, your analysis of future property value can be a roll of the dice. Allowing a buyer to perform work and make improvements to the property is a risk in itself. The parties to an installment contract should have an agreement as to the plans and specifications of improvements to be made. The seller should consider the quality of materials, but more importantly, the quality of work to be performed. Does the buyer actually have the skills required to perform the work so that the property will be in a marketable condition for the appraisal? Reliance on a buyer to make improvements to a property should be avoided unless the buyer has experience in doing the work required.

The best way to establish a buyer's equity is real "skin in the game", cash down and paid toward the principal amount financed by the contract. This is the safest and most reliable way to make a deal work. While it is possible for equity to be established through appreciation or sweat equity, most fail. Money down not only provides instant equity, but it's a greater incentive for the buyer to stay in the game and not walk away. The installment contract must be designed to provide the necessary equity over the term of the contract in some manner. Initially, money down should be required but from there the rest may by lump sum installments, amortized payments or both. Currently, tax credits are available which can be realized months after contracting and an excellent way to gain the equity required.

Beyond cash in the deal, the due diligence required by the seller rests on underwriting the buyer. As mentioned before, seller financing opens the market to those who can not obtain conventional financing and the first thing to look at is why can't the buyer qualify?  Usually it's a credit issue with the buyer. A professional real estate investor should be able to assess credit issues, but a quick way is to require the buyer to go through the initial loan process with a lender, with the seller present. Ask the lender if a loan can be obtained and if not, when could it be made, what needs to be done to qualify? Take notes of who the lender is and what is said, not so much as trying to keep the lender on the hook for a commitment, but to document your due diligence. This information will be the basis for the terms of your contract and it may become proof in court that you acted in good faith as a seller in the event the buyer fails to perform!

However, the best way to perform due diligence is doing what lenders do. If you use the opinion of a lender as mentioned, the seller should still take a few more steps in processing the deal. Obtain a credit report, this is the best way to analyze someones character. Is there a reason they fell behind in other payments? Is there anything they pay on time? Having no credit can be problematic as well and this is common among younger buyers. Further, the seller should obtain a verification of employment. These forms can be obtained from a lender that you work with.

Another issue is to actually verify cash assets by at least two months bank statements and six months is much better. This will tell you more than you may think. A bank statement that shows frequent small ATM with-drawls is an indication of poor money management! Checks written for small amounts for cash are the same thing. Good personal money management should show up as checks written for living expenses and for purchases as needed, especially for past rents or house payments. The character of a person is reflected in the way they manage their money. Are they punctual, are they impulsive, do they spend money as they receive it with little set aside for end of month requirements? How responsible a person is, is reflected in the way they manage their money. Excessive checks written to bars (especially more than one on the same date) or for fast food will paint a picture of your buyer and their spending habits. If it appears your buyer lives on credit cards, obtain copies of credit card statements.

For some, requiring a buyer to attend a homeowners course may be a good idea. These first time homeowner courses are provided by non-profits and credit organizations that have been approved by HUD. Making such a course is not out of line for first time buyers and could be considered as a requirement under the contract. These classes will also inform your buyer as to the degree of care to be taken in protecting the collateral. Home maintenance is generally the responsibility of the buyer.

The capacity of the buyer to pay as agreed needs to be addressed closely in line with conventional lending requirements. An ideal buyer should not be paying more than 25 to 27% of their monthly income for principal, interest, taxes and insurance and their house payment together with all other installment debt should not exceed 38 to 40%. From the employment verification the seller will receive not only an income verification but the probability of future employment and how long the buyer has held the job. For self employed buyers, at least two years, three is better, tax returns is essential. 

Seasoned real estate investors may say "I've done a hundred Contract-For-Deeds  and never needed to do all this!" My question to them is how many closed? Why a professional real estate investor should go through all of this is two fold. First, to ensure the deal closes as planned and secondly, to be in a position to show a judge that your intent was not to churn the property, just scamming the buyer to get a down payment and future payments, then foreclose and do it all over again.

Currently, there is federal legislation being contemplated that would require investors to underwrite seller financed transactions. Even if it is not passed, which something like that probably will be passed, judges are beginning to take a dim view of poorly conceived seller financing transactions. What could be at steak is more than the deal falling apart, you could well be hit with a judgment against you as the seller. The days of carrying around an installment contract in your pocket and depositing your down payment are over!

Another reason is to better secure your collateral in the event of bankruptcy taken by the buyer. A bankruptcy can force an adjustment or modification of your contract without regard to the seller's obligation to pay an underlying debt. If the seller can show that the contract was conceived in good faith, the seller is much more likely to protect the collateral interest held and be paid off.

Now, after going through this process, if the buyer fails to perform, it can be shown it was not at the fault of the seller, that the buyer did it to themselves!

There are other aspects of servicing these contracts that should be addressed. The seller should provide for the buyer to make deposits directly into the seller's account. If it is the buyer's responsibility to deposit payments and they are not paid as agreed, it will not arise from the seller sandbagging checks or making late deposits that will prevent the buyer from obtaining future financing as mentioned before. This may require an authorization from the depository bank. If a seller can obtain a free checking account and not use the account for any other purpose, it will provide an excellent means of accounting for the installment contract. This would not be an escrow account.

Some investors may think that asking a potential buyer for all of this documentation will kill the deal. My response is, then you shouldn't do the deal! There are plenty of buyers trying to buy their first home. The seller is the bank in an installment contract and just because you need to review the documents, it does not mean that your requirements are the same as a bank. If mutual trust can not be established with a buyer, my advice would be to walk away. 

The seller should also require taxes and hazard insurance to be paid by the buyer. If the investor/seller retains these responsibilities an escrow account could be required and escrow accounting may become an issue for the professional real estate investor. The seller should be listed as a "loss payee" on the hazard insurance policy, in second place to any underlying mortgage holder. The tax notice should be sent to the seller and the seller should promptly forward a copy to the buyer. In the event taxes are not paid, the assessor will be giving the seller notice.

These provisions should be made in an installment contract that conveys a significant equitable interest, namely a contract-for-deed or land contract. While a lease-option can fall into a type of installment contract, the option contract generally conveys a lesser degree of an equitable interest and usually for a shorter term. While the option contract locks up the seller's ability to convey title, it does not represent the aspects of ownership as is customary with these other contracts.

Underwriting by the seller is a process that provides safety and sound investment practices and conditions for success. Consideration should be given to credit, capacity, collateral, cash and character. Addressing these issues limits the liability of the seller and can eliminate objections by underlying mortgage holders having a security interest in the property sold. Entering into an installment contract sets mutual covenants and restrictions for both buyers and sellers. These aspects will be discussed later on as well as to what the buyer should consider in such transactions. 

Bill

American Realty Institute LLC