Friday, March 21, 2014

Dodd-Frank: Are Investors Who Offer Seller Financing Too Big to Fail?

Our latest post talked about lease-options and how they worked. Lease-options can offer home ownership to people who may otherwise not qualify for traditional financing when they want to buy a home. Many, if not most, lease-option deals today include seller financing. Moreover, in many rural areas, sellers often use land contracts, which are also a form of seller financing.

But seller financing had some pitfalls. Many contracts contained interest rate adjustments that were punitive, while others featured balloon payment clauses that most buyer-borrowers couldn't pay. The Wall Street Reform and Consumer Protection Act, affectionately know as Dodd-Frank, has something to say about the issue. This law is the most significant piece of lending oversight legislation passed since the Great Depression.

Lease-option-type investors who offer seller financing are deemed to be "loan originators" under the statute and therefore must abide by the same underwriting rules that mortgage brokers and lenders have to follow. They must verify, for example, that their buyer-borrower customers fall within prescribed debt-to-income limits and, in general, have the ability to pay the loan. Loan originators must also abide by the Truth-in-Lending Act (TILA).

All seller-carryback loans must be fully amortizing, that is, they may not have balloon payments. If the interest rate is adjustable, the  index it adjusts to must be "reasonable," such as LIBOR, and adjustments are subject to both annual and lifetime limits. While most investors who offer seller financing are fair and legitimate business people, some are unscrupulous and have employed onerous loan terms that would, in effect, cause borrowers to default and lose their option and loan payments.

The law makes exceptions for certain small investors that allow for relief of some of the rules. However, even these investors must abide by the rules in the preceding paragraph, even as they are exempt from SAFE (see below).

Lay people and most real estate professionals don't realize that Dodd-Frank isn't regulatory, that is, it can't come in and shut down seller-finance investors who abuse the rules. All Dodd Frank does is give consumers grounds for litigation. The relief granted, though, is significant and pretty much gives consumers all their money back plus some. Who wins and loses the suit is pretty clear cut, but the aggrieved party still has to litigate.

However, the state SAFE Act (Secure and Fair Enforcement of Mortgage Licensing Act), signed by President Bush in 2008, is regulatory. This law requires state licensing of mortgage originators under state laws that meet federal standards. Since this law is regulatory, its enforcers can shut down violators.

All this may seem kind of complex. That's because it is. Questions? Give me a shout.

Wednesday, March 19, 2014

Lease-Option, Seller Financing and We Buy Homes

The Captain's warning: Nerdgasm alert, so this post won't apply to everyone.  There. I said it.

Post-Great Recession meltdown, a lot of people got bounced from their homes, both voluntarily and otherwise. Most of them became renters. Other stuff happened and still is, such as financing becoming difficult to get unless you have a credit score the size of Barry Bonds' home run total. And oh, a proliferation of hand-painted signs that said, "We Buy Homes" began decorating light posts.

What's that all about? It's investors great and small, some flaky, some traditional. Heck, the largest buyer of single family homes right now is the Blackstone Group, which, if you're looking for a house, is one of your greatest obstacles.

But with the advent of investors, low rates, low home prices, and limited access to loan, comes seller financing, very often with a lease-option. How does it work? Let's take a buyer with a low-to-middling credit score who wants to buy a house, can't get traditional financing, and who meets an investor offering a lease-option. The investor sells the buyer an option--that is, the right to buy the house at a certain price and within a specified time--and leases the house to the buyer until the option is exercised.

For example, a buyer pays $3,000 for the option to buy the investor's house for $200,000 and has three years to exercise the option. The investor also rents the house to the buyer for the three years, during which time, the buyer pays the rent on time and otherwise improves his credit score in order to get financing at the end of three years.

A common variation is to have the amount necessary for the buyer's down payment (if he exercises the option) to be added to the monthly rent. At the end of the three years, for example, the buyer may want to apply for a 5%-down loan, or $10,000 on a $190,000 loan, when he exercises his option to buy the house for $200,000. Many investors allow the option fee--in this case, the $3,000--to apply towards the down payment, meaning the buyer only needs to come up with $7,000. Over three years, he'd pay an extra $194 per month--$7,000 divided by 36. Slick, huh?

If the buyer does not exercise the option at the end of three years, the investor keeps the extra $194 monthly payments. If the buyer obtains a loan, the investor sells him the house, likely at a decent profit. That's what investors do.

But many investors also provide the financing themselves. When the buyer exercises the option, the investor carries back the deed on the house, and the payments become principal and interest payments instead of lease payments. The buyer gets title ("equitable title," in this case) and the investor gets a trust deed.

Usually, though, investors don't want to carry a loan for thirty years and insert a balloon payment into the contract. The buyer makes payments as though they serviced a traditional mortgage, but the whole loan balance becomes due--balloons--at a certain point, usually five years. If the buyer can't pay, the lender forecloses.

But the federal Dodd-Frank Law and the state SAFE Acts have something to say about this. Just what will be the topic of the next post.