Most of you know what a big fan I am of using vendor financing to get into a property. Many of you may also know that I used vendor financing myself to get started in real estate investing. (More on that in a moment.) What many of you may not realize is that vendor financing comes with terrific advantages. And here’s the best part: the advantages work both ways, for both buyers and sellers.
The “typical” vendor financing scenario—if there is one—is where banks are not too keen on lending money to the buyer, and so he or she must rely on the seller to offer financing options. But there are actually several ways to arrange a vendor financing deal. Now remember, with all types of vendor financing, the buyer may pay the seller of the property an option or rent or otherwise make the mortgage payments. In these cases, however, the title to the property remains with the seller as long as the vendor financing is in place.
In the typical vendor financing situation, the buyer makes mortgage payments to the seller for a year or two. He will do this in order to improve his credit and/or build a history of mortgage payments in order to qualify to refinance the vendor financing into a lower interest rate from the bank. At that point, the seller is paid off and the bank will hold the mortgage.
The Seller Carryback
But this situation is just one of many vendor financing strategies you can use. There are others that can either get you into a property with a low interest rate conventional loan or create a nice chunk deal for yourself. Say, for instance, that you qualify for a loan, but don’t have the money for a down payment or want to use that money to put down on a second property. Where do you get the down payment?
This is where you have the seller do a “carryback” for you, which is an American term for the seller holding a second mortgage for you. The vendor financed second mortgage becomes the down payment on the property. This is exactly what I did with my first investment property. I used vendor financing for my down payment. The seller “carried back” 20 per cent of the purchase price. I was then able to take out a conventional bank mortgage for 80 per cent loan to valuation, which meant I got the best interest rate available.
The Lease Option
A lease option, as the name suggests, is where you lease the property but also have that one extra bit of paper that says you have the right to buy the property for a certain price. It’s just like an option in the share market, except it pertains to a house instead. This process goes by other terms, such as ‘rent-to-own’, but it’s the same thing. Usually, ‘lease option’ is used for more legalistic purposes, whilst ‘rent-to-own’ is more descriptive of what’s actually involved, but there is really no difference between the two.
Sandwich Lease Option
A sandwich lease option is where you actually take the ‘option to buy’ part of the lease option agreement on the one side, then turn around and sell the property to another buyer for a higher price than what you’re paying for it in your lease option agreement. In effect, the seller offering you the lease option is one slice of the bread, your buyer is the other slice, and you’re in the middle of the sandwich!
This is a very clever way to generate some cash with very little money up front. In this strategy, you’re only paying rent on the subject property. When you find a buyer, you exercise the option to buy, sell the property to the new buyer and payoff the original seller. You keep the difference in the two selling prices.
This can mean tens of thousands of dollars in your pocket in a rather short period of time with very little money up front. Think about it; you’re paying rent on the property, but you’re not paying holding costs, closing fees, stamp duties, or property taxes! How clever is that?
Vendor financing is good for the seller, too
On the other side of the deal, vendor financing can be very profitable for the seller as well. For instance, one of the reasons that property owners will offer vendor financing is that it opens up the property to a much larger market. If you as a seller require only conventional financing, you’re limiting who your buyers can be: bank-qualified buyers.
But what about the bloke who makes a good living working for himself but doesn’t show the income on his taxes? Or how about the person who may have had credit problems or lost a job a couple years back, but now earns good money? Either of these buyers can afford to buy, they just don’t qualify by banks’ standards. And believe me, there are many more of these kinds of buyers than the first.
Now consider this: between the bank-qualified buyers and non-bank-qualified buyers, which do you think will be willing to pay more interest on a loan or pay more for a property?
The fact is that buyers seeking vendor financing are also willing and usually expect to pay a 5-10% premium to get into a property. These buyers know that they can’t qualify for a bank loan and understand what that means from a property pricing perspective. Why wouldn’t you take advantage of this opportunity?
One of the best ways to do just that is to be smart about how you offer the property for sale. When you advertise your property for sale with vendor financing, don’t feel like you have to advertise the price. Advertise the weekly mortgage costs instead. That way, your potential buyers won’t be scared off by the high price. More than likely, they will know right away if they can afford your property. If they’re paying $500 per week in rent, and your mortgage costs are $600, it’s easy to determine the affordability of buying from you.
The same price rationale applies to the mortgage rates. Vendor mortgage financing rates will usually be 2-5 points, or even higher, than the interest rates on conventional loans. But don’t quote the rate; again, quote the weekly payment. Also, be sure to add the taxes and insurance costs onto weekly mortgage costs and collect the total from the buyer and pay them yourself. That way, you will know that the property remains insured and taxes are paid.
As you can see, regardless of which side of a vendor financing deal you’re on, both can means more money in your pocket or a chance to start over if you’ve had credit problems, work for yourself, or are a new immigrant to Australia. Or, if you’re like me, it can be the start of something really big!