The Critical Element That Takes the Risk Out of Carrying Paper – Protective Equity
I met someone for lunch today who decidedly shuddered at the idea of seller financing. “Aren’t there so many things that can go wrong?” Her expressed sentiment is shared by many: owner financing is inherently hazardous. But it doesn’t have to be. It’s all in how you set the transaction up and the way you evaluate relative risk and reward.
We’re all inundated with news of the mortgage crisis, billion dollar write downs and escalating defaults, but if you stretch your mind and dust off a few brain cells, you’ll be able to remember a time when banks sort of had underwriting guidelines that made sense.
Once upon a time, it was expected that you would save up a 20% down payment before you made an offer to purchase your first home. Why 20%? Because that made it easy to get a cheap loan. Statistically speaking, good credit and a down payment of 20% almost guaranteed the banks that they wouldn’t suffer a loss in making that loan, so they could afford to give you their best rate.
That brings me to the most critical element in structuring a seller carry back transaction: protective equity.
Carrying paper is a fantastic way to meet your financial objectives, but you have to make the switch from thinking like an owner to thinking like a bank. Because when you carry paper, you are becoming the bank on your own property.
So, as the bank, here’s what you should be doing:
- Have the prospective buyer fill out a credit application (and save it)
- Run the buyer’s credit report (and save it)
- Ask for the largest down payment that the buyer can come up with (protective equity)
The larger the down payment, the more protective equity there is. Historically speaking, a 20% down payment (or more) literally takes most of the risk out your seller carry back transaction.
Who is it protecting?
It’s protecting you, the seller, the one offering terms and providing the financing.
What is it protecting you from?
How does protective equity keep you from losing money?
1) 20% is a good chunk of someone’s hard-earned money. A buyer who puts down 20% is going to do everything they can to keep from losing it . . . they have a lot of “skin” in the deal. That means that your loan is the last thing they’re going to default on. Before they let you foreclose on them (taking the house and keeping their down payment), they’re going to beg Aunt Harriet for money or rob a bank (a regular bank, not you). This almost assures you that you will have a performing asset . . . that the payments will always come in as expected, and you can count on that monthly income.
2) If worst comes to worst and you end up taking back the house (which is serving as the collateral for the loan), then that 20% down payment cushions you against the losses you will incur when the payments stop coming in. Chances are that even in this market, the property’s value will not drop more than 20%. Therefore, you can take the house and sell it all over again to a brand new buyer and still be OK.
3) If you carry back a note and get a 20% down payment, you will have a note that will sell for minimum discount. That means that if you ever want to sell all or part of your note to raise instant cash, then you will get a higher price for it than the guy who only asked for 5% down. Why? Because the safer I think your cash flow is, the more I’ll pay for it . . . the less of a yield I need as an investor.
So, is it 20% or nothing? I mean, who has cash like that?
Surprisingly, there are a lot of people out there who have 20% down, but a 10% down payment is considered acceptable. And in certain circumstances even a 5% down payment will work, but you’ll want to make sure there are other strengths in the deal that help compensate for thin protective equity.
Oh, you say, it still just sounds too complicated and risky.
Well, let’s not forget that there are plenty of risks in owning property, and opportunity costs in refusing to find a way to sell right now. Tenants are risky. The threat that they will trash your property is risky. The potential drop in property values is risky. Ever accelerating inflation is risky. Large potential impending repairs are risky. The fact that you could stay chained to your rentals and fail to enjoy your retirement is risky.
Becoming the bank is an excellent way to create cash flow and improve your quality of life. You can sell for top dollar regardless of market conditions by offering terms . . . you just have to structure your seller carry back transaction intelligently.
Banks have whole underwriting departments. You, as the enlightened seller willing to carry paper, need your own underwriting department, and that’s where I come in. Sellers and other agents frequently want me to help them think through the deal to make sure they end up with a note that’s worth holding or selling in the secondary trust deed market.
Often they want me standing by to buy a portion of their newly created note, which I’m happy to do when the transaction has been put together thoughtfully.