Something that causes IMMENSE confusion for many real estate investors is the issue of seller financing.
Whenever I talk with other investors around the country, I consistently encounter two things that trip people up:
Issue #1: What's the appropriate loan instrument to use in the closing process (Land Contract? Promissory Note & Deed of Trust? Mortgage? Something else?)
Issue #2: If a borrower stops paying, how does the foreclosure process work in each state? What's the standard procedure? How much does it cost? How long does it take? etc.
These are two separate issues, but they go hand-in-hand for several reasons.
The financing instrument used in a seller financed transaction (along with the state's laws and statues that govern these types of financing arrangements) has EVERYTHING to do with how the foreclosure process will work, how easy it will be, how much time it will take and how much it will cost.
When a borrower defaults on their loan payments to you (which is bound to happen eventually) – these are some very real issues you will be confronted with.
If you chose the right document, with the right language included, and if the state's laws work in the seller's favor, the process can be relatively fast, easy and inexpensive.
On the flip side, if you chose the wrong document, without the right language, and/or if the state's laws don't allow for a non-judicial foreclosure under any circumstance… then the process can be slow, difficult, costly, and if the loan documents weren't drafted properly, it may even be impossible.
Why It Matters
Now, it's usually not difficult to understand how seller financing works in one particular state.
With a quick phone call to a local real estate attorney, you can get a pretty good idea for what the proper document are and what the foreclosure procedure looks like.
On the other hand, if you're buying and selling properties in several different states (all of which have different laws and statutes), things can get confusing fast – because the rules that apply in one state won't necessarily apply elsewhere.
This is why it's important to proceed with caution when you're venturing into the realm of seller financing. Don't try to learn the process in a dozen different states at the same time. Get intimately familiar with how every aspect of seller financing works in ONE state, and once you know it inside and out, THEN you can start exploring other areas.
Using The Right Loan Documents
When a seller is offering owner financing for a piece of real estate, there are three potential types of loan documents to choose from:
- Land Contract (aka – Contract for Deed)
- Promissory Note & Deed of Trust (aka – Trust Deed)
What's the right choice for your deal? It depends greatly on where your property is located, because every state has different laws, statutes and procedures to follow in the event that a buyer defaults on their payments.
It's also worth mentioning that in several states, some of these options aren't used or recognized at all… so it's important to do your homework and understand the boundaries you need to work within.
Land Contract vs. Deed of Trust
When we're talking strictly about seller financing (where the seller is also the lender), one of the inherent goals is to give the seller the maximum control over the property until the loan is paid off. One way to accomplish this is to make the foreclosure/forfeiture process as simple as possible if the borrower ever defaults on their payments.
While it's possible to use a Mortgage… this instrument isn't used very often for this purpose, because foreclosing on a Mortgage typically requires a lawsuit in most states (which means the lender must to go through a court procedure in order to take back the property).
This may be fine for a bank or conventional lender, but this is the kind of hassle a seller wants to AVOID. For this reason, most (but not all) of the seller financed deals across the country don't involve mortgages. Instead, these sellers use either a Land Contract or a Deed of Trust.
In some states, the Land Contract (aka – “Contract for Deed”, “Articles of Agreement for Deed”, “Land Installment Contract”, “Installment Sale Agreement”) is hands down, the most commonly used document, because it allows the seller to repossess the property with relative ease if the borrower defaults on their payments.
In other states, the Deed of Trust (aka – Trust Deed) is a much better option, because the state laws make it much easier for the seller to exercise their foreclosure rights and be made whole if the borrower defaults on their payments.
Let's do a quick recap of how each option works…
How a Land Contract Works
With a Land Contract (aka – Contract for Deed in some states), there are two parties involved…
- The Buyer/Borrower
- The Seller/Lender
When a Land Contract is closed, the seller continues to hold legal title to the property for the entire term of the loan (i.e. – the deed doesn't transfer to the buyer until after the loan is paid in full). However, even though the buyer doesn't hold legal title, they can still take possession of the property and start using it immediately after signing the land contract.
A Land Contract generally offers more benefits to the seller because of the way title is held during the term of the loan, which arguably provides more security for the seller and less security for the buyer. However, fundamentally speaking, it’s not a huge variation from what usually happens in a typical lending/borrowing relationship. Even though the legal title doesn't change hands until the loan is paid in full, both parties still have the same general rights to the property during the term of the loan.
In some states, the benefit of using a Land Contract (assuming the proper language is included) is that it will allow the Lender to repossess the property without going to court, after following a state-specified notification process.
However, not every state will allow the Lender to do a non-judicial foreclosure with a Land Contract, and in many of those states, that's when a Deed of Trust may be a better option.
How a Deed of Trust Works
With a Deed of Trust (aka – Trust Deed in some states), there are technically three parties involved…
- The Buyer (Borrower)
- The Seller (Lender)
- The Trustee
When a Deed of Trust is closed, the property's equitable title (i.e. – the right to obtain full ownership of the property) is transferred to the borrower, while the legal title is transferred to a third party trustee.
Essentially, the Trustee (which is usually designated by the lender as a title company or attorney) is empowered to step in and handle the foreclosure process if the borrower ever defaults on their payments.
A Deed of Trust is also paired with a Promissory Note – and both documents work together to provide security for the Lender to protect their interests in the property until the loan is paid off.
Knowing Which Document To Use
So which option are you supposed to use when selling a property with seller financing?
The answer hinges greatly on which state your property is located in. When you talk with an attorney and they understand what you're trying to do, there will almost always be one clear choice to use for the purpose of seller financing.
For the average investor, it's easy to speculate what the best option might be, but it's not easy to know the right answer with total confidence until you speak with someone who understands the laws in the state where your property is located. Before you close a deal with seller financing, it is VERY important to do this research.
Knowing how each state works is a crucial component of handling seller financing correctly. One of the biggest underlying advantages of seller financing is the presumption that the seller can get their property back with relative ease if/when the borrower decides to stop paying… but if the wrong instrument is used (or if the proper language isn't included in the right document), this whole benefit can go right out the window.
Getting the Right Answers
Knowing how confusing this subject can be, here are a few guidelines you can follow in order to figure out which document to use for seller financing in your state.
As a recap, here are some questions you can ask once you get a hold of an experienced real estate attorney in your area…
If I’m selling a property in <<INSERT STATE NAME>> with seller financing, what type of loan instrument would you recommend I use (Land Contract, Deed of Trust, something else)?
They may ask for some clarification on the type of property you're selling. When they respond with their thoughts and opinions, you can dig deeper by asking something like this:
If I use your recommended documentation and the buyer ever stops paying, is it possible for me to do a non-judicial foreclosure in this state to repossess my property? Will I need to include any specific language in order to take advantage of this option?
Note: Some states will allow for a non-judicial foreclosure if the right documents and language is used. Others won't allow it at all.
If they say, “YES, non-judicial foreclosures are allowed here”, ask this:
Assuming I understand the proper procedure, is this something I can handle by myself, or do I have to work with an attorney (or a Trustee) to complete this?
If I am required to work with an attorney (or the Trustee) to complete the process, how much does it typically cost (and how much time does it take) to complete the foreclosure?
If they say “NO, this is a judicial foreclosure state“, ask this:
How much does it typically cost (and how much time does it take) to get through the foreclosure process and get my property back in this state?
However they answer these questions, this information should give you a good idea for what the consequences will be (in terms of time and money) if/when you ever encounter a borrower who defaults on their payments to you. This should help you decide whether or not it's worth the risk to offer seller financing on the specific property you're working with.
Sometimes, the risk will be worth it, because you will significantly increase your profits over the long term… and even if the borrower does default, the cost of foreclosing or repossessing the property will be nominal (and considering that you can then re-sell the property all over again and keep the payments from the defaulting borrower, you could make even more money in the process – especially on larger deals that offer a huge profit margin).
Other times, the risk won't be worth it – especially on smaller deals where you only stand to make a few thousand dollars of profit… because if the foreclosure process is time-consuming and expensive, it could easily chew up all the profit you stand to make (and possibly even more).
The only way to accurately assess this is to have these conversations with an attorney in your state and thoroughly understand what's involved. Then you can determine if/when seller financing is a worthwhile pursuit for the properties you're selling.
A Note on Non-Judicial Foreclosures
In many states around the country, it is perfectly legal to use EITHER a Land Contract or a Deed of Trust… but even though they're both “legal”, there's a reason why a Deed of Trust is more commonly used in some states, and a Land Contract is more commonly used in others.
As mentioned earlier, it usually comes down to a process known as non-judicial foreclosure.
If a buyer ever stops paying and the seller wants to repossess the property (so they can sell it to another buyer) or get paid off altogether (so they can take their cash and move on), many states will allow the lender to avoid working through the court system as long as they prepared their loan document correctly in the first place.
A non-judicial foreclosure (also known as a “forfeiture” in many states) still requires that certain steps be carried out (and of course, these specific steps differ from state to state), but in the areas where it's an option, it tends to be very much preferred over working through the courts.
In the states were non-judicial foreclosures are allowed (with either a Land Contract or a Deed of Trust), it's only going to work if the original loan document includes some very specific language that gives the lender the legal right to take this route.
In a Land Contract, this language is typically referred to as the “Right to Forfeit” or the “Remedies on Default” section.
In a Deed of Trust, this language is often referred to as the “Power of Sale” clause.
This special language spells out the fact that if the borrower stops paying, the lender will be able to take the property back (or auction it off) if the borrower doesn't meet their obligations within a specified period of time. Those parameters vary from state to state (and some states don't allow this option at all), but in the areas where it's relevant – the language conveys the same basic concept.
If you want to take full advantage of whatever powers your state laws and statutes will afford you, talk with an attorney in your state and ask them a few questions…
- Which document should I be using?
- Will this allow me to do a non-judicial foreclosure (and if not, how does the foreclosure process work)?
- How does the non-judicial foreclosure process work in my state?
- What specific language needs to be included in order to give the lender the easiest path through foreclosure?
Do Your Homework
Again, knowing what documentation to use has everything to do with understanding what is allowed in the state where you're working and getting the right legal help from an experienced attorney who has dealt with their share of seller financed transactions in your state.
Sometimes it will require more than one phone call to find the answers you're looking for. In my experience calling real estate attorneys in all 50 states, I found that some attorneys are MUCH less helpful, knowledgable and experienced than others. Be your own advocate and don't put the phone down until you're confident in what it will take to move forward with your transaction properly.