A look at the down payment from the sellers and buyer perspective
By: Stephen J. Nash
Nash Law Firm
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With more sellers turning to contract for deeds to sell their property, in the next few issues we are going to continue to look at contract for deed issues. Last month we looked at the need for title insurance, this month we will look at the down payment made in connection with a contract for deed.
While it would seem that this is a pretty straight forward issue, the fact is, we are seeing contract for deeds with down payments that are all over the board. In many cases, to the severe detriment of the buyer or seller.
The Traditional Downpayment Standard
Traditionally, the goal was to have the buyer pay 20 percent down. Obviously, the more down, the more security the seller has since the buyer loses any more paid if they default down the road and the contract is canceled. A second, factor is not so obvious. In the 1980's and early 1990's when contract for deeds were common, a secondary market arose where sellers could sell their contract f at a discount. What sellers found out was the single most important factor in determining the discount was the amount of the down payment. In order to protect themselves from the extra risk, investors would not buy a contract with less than 20 percent down without significantly increasing the discount.
While we do not have such a secondary market today, one may arise in the future if the number of contract for deeds keep increasing. Even if such a market does not arise in the future, we certainly should not forget the lessens of the past. If investors then determined that the amount of down payment was the most important risk factor to them, why would we believe that somehow today that it is less important?
From the Sellers Perspective
In today's economy it is often difficult, if not impossible, to find a buyer that has or is willing to put twenty percent down. If that is the case, the seller is going to have to look at other factors to determine how low they are willing to go. If the seller does not have to sell by a contract for deed, they may not be willing to accept less than 20 percent down. If the seller is on the verge of defaulting and will lose the property by foreclosure, the seller may be willing to substantially lower their down payment requirement if it gives them a chance to avoid foreclosure.
The lower the down payment, the more due diligence the seller needs to exercise to determine that the buyers are a good risk. Require and review the buyers financial statement, their credit and their housing history. If I'm the seller, I want to meet the buyers, talk to them and try to get a “gut” feeling as to whether I'm willing to trust their intentions.
An important consideration with respect to the down payment for the seller is how much actually goes into the sellers pocket. If it all goes to expenses, there is no money to bank to cover future costs. You can never guarantee that there will not be a default or an issue with the buyers. Disputes cost money to deal with. If the buyer walks or is kicked out, where is the money going to come from to legally get rid of the buy and to begin making the monthly payments associated with the home?
This problem can be offset somewhat by having a monthly payment that is higher than the monthly payments that the seller has associated with the property. If the buyers' monthly payment just covers the sellers monthly costs, the seller is not accruing any additional money to help cover future problems.
Another way in which the seller can provide themselves with additional protection, is to require periodic balloon payments. While most everyone knows that there is going to be a final balloon payment, many do not realize that the contract can be structure to require smaller balloon payments during the life of the contract.
From the Buyers Perspective
A buyer wants as little down as possible since that is the buyers' main risk when purchasing on a contract for deed. The buyer is much more attractive to the potential seller is they are able to provide a substantial down payment. It demonstrates a greater commitment on the part of the buyer and also demonstrates that whatever economic situation put the buyer into this position, the buyer has turned things around and has demonstrated that they can manage their finances.
If the buyer lost a home through foreclosure, they would have had at least 12 months in which to save money since they did not pay their mortgage, taxes and other housing costs. Quite often, they have actually had many more months to save money since the lenders are so slow in going through the foreclosure process.
If the buyers monthly cost on the contract is $1,600 and the buyers did not make a housing payment for 15 months (the length of time it took the lender to start and complete the foreclosure), then they should have been able to save $24,0000.00. If they only have $8,000.00 to pay down, where did the rest of the money go? How can the buyer convince the seller that they can make the contract for deed payment?
Just like for sellers, not all situations are the same for the buyer. If the seller has an existing mortgage that is not going to be paid off upon closing on the contract for deed, does that mortgage have a due-on-sale clause? Almost inevitably it does. Is the mortgage current? Is more owed on the mortgage than the property is worth? How much money is the buyer going to invest in the property for repairs and maintenance? These all represent potential risks to the buyer. The more risks that the buyer cannot control, the less the buyer should invest in the property.
It's Not Black and White; It's a Balancing of Risks
Since both the buyer and seller have concerns that are directly tied to the down payment, both have to balance those risks with a structure and clauses that help minimize or manage those risks. Everyone's risk tolerance is different so it is impossible to generalize as to what is acceptable for every buyer and seller. They key is negotiating and finding a balance that both the buyer and seller can live with.
Practice Tip for Real Estate Professionals: Contract for deeds can be a very viable tool for sellers and buyers but do not get sucked into advising your clients as to whether they should enter into such deals. Many legal and financial issues have to be considered and, ultimately, the seller and buyer must determine whether they are willing to accept the inherent risks associated with contract for deeds. The time for the seller and buyer to go through the advantages and disadvantages of using a contract for deed in their specific situation is before the purchase agreement is presented.