The following is an excerpt from The Paper Source
SETTING THE STAGE
The following applies to transactions on or after January 1, 2014.
None of it applies to any seller-carryback transactions where the buyer will not use the property as their personal residence.
When Dodd-Frank (“The Dodd–Frank Wall Street Reform and Consumer Protection Act”) was enacted into law on July 21, 2010, it said that you could only do three seller carryback transactions a year, and those transactions had to meet certain requirements:
- The note could not have a balloon.
- It had to have a fixed interest rate for five years, then it could adjust.
- You had to prove and document the buyer’s “ability to repay” in accordance with the Qualified Mortgage Rule (QM), which is quite restrictive. That’s the same rule that banks have to use if they want a safe harbor and not get sued for making a loan that didn’t fit the QM.
The Consumer Financial Protection Bureau (CFPB), which was writing the regulations to implement Dodd-Frank, asked for public comments. I told Bill Mencarow about this, and he immediately (and repeatedly) alerted PAPER SOURCE JOURNAL subscribers and everyone else he could think of, urging them to submit their comments.
I also alerted members of Congress and got the National Association of Realtors on board and helped them write their comments to the CFPB.
Because so many people wrote comments to the CFPB —- and THE PAPER SOURCE took the lead — the bureau relaxed the seller financing restrictions. They came out with something that was a lot more relaxed than the Dodd-Frank law was originally.
The CFPB subsequently issued the following regulations. They apply to seller carryback notes created on or after January 1, 2014.
THE ONE PER YEAR CATEGORY
The CFPB broke seller financing into two different categories. One category is for those individuals, trusts or estates who do just one seller carryback transaction a year on a property that has a dwelling that the buyer will use as their primary residence.
Let me repeat that, because there has been so much misinformation circulated about it: this category is for those individuals, trusts or estates who do just one seller carryback transaction a year on a property that has a dwelling that the buyer will use as their primary residence.
- You can have a balloon in your note with the buyer.
- You do not have to prove or document their ability to repay.
- The note must have a fixed interest rate for five years, and at the end of five years the interest rate can increase no more than two points per year with a cap of six points above whatever you started at. You have to tie it to an index like a T-bill or the prime rate in the beginning.
That’s probably going to affect all but three to five percent of individuals who carry back notes.
Remember that these restrictions only apply to seller-carryback transactions on properties that have a dwelling that the buyer will use as their primary residence. A transaction on a lot or vacant land is exempt, even if the buyers plan to build a primary residence.
If the property has a dwelling, but the buyer is not going to use it as their primary residence — say they’re going to rent it or use it as a second home — then none of this applies, and you can offer seller financing with no restrictions.
Commercial property and multifamily that is five units or larger is also exempt from the restrictions.
Again, the one seller carryback transaction per year category applies to individuals, trusts and estates. It does NOT apply to corporations, LLCs, partnerships or other legal entities. In that case the second category applies (below).
Again, these rules only apply to what the CFPB refers to as a residential mortgage loan where the note is secured by a dwelling or residential real property that includes a dwelling.
Most people only carry back a note once in their lifetime, when they sell the big house, retire and move somewhere else. Some might do it a few more times. Even many real estate investors only do it once a year. These regulations are not a huge change for most people.
THE MORE THAN ONE PER YEAR CATEGORY
The second category applies to individuals, trusts and estates that do more than one seller carryback transaction per year when the buyers will use the dwelling as their primary residence.
It also applies to any seller-carryback transaction — even one — where the seller is a corporation, LLC, partnership or other legal entity and when the buyers will use the dwelling as their primary residence.
- The note cannot have a balloon.
- The note must have a fixed interest rate for five years, and at the end of five years the interest rate can increase no more than two points per year after the fifth year with a cap of six points above whatever you started at. You have to tie it to an index like a T-bill or the prime rate in the beginning. This is the same restriction as the first category.
- You must determine the buyer’s ability to repay.
- If you do no more than three seller-financed transactions per year you do not have to become a Mortgage Loan Originator (MLO).
- * If you do more than three you must become an MLO — or find an MLO who is willing to be the go-between.
Just as in the “one per year” category, these restrictions only apply to seller-carryback transactions on properties that have a dwelling that the buyer will use as their primary residence.
If you have a rental house and the renters want to buy the house to use as their primary residence, and you want to carry back a note with a balloon (and you don’t do more than one seller carryback transaction per year), and that rental property is in a corporation, LLC, partnership or other legal entity, you’re going to have to move the property into a trust or into your personal name. Otherwise, you’re going to fall into the second category which says you cannot have a balloon unless you are an individual, trust or estate.
If you think about it, not having a balloon but being able to do an adjustable rate almost serves the same purpose. Let’s say you start out with an interest rate of 6% on the note and then after five years it goes to 8%, then it goes to 10% and then it goes to 12%. That’s a huge incentive for the buyer to refinance out of the property and pay you off. If they don’t, then you’re rewarded for your risk in carrying that paper; you’re now getting 12% for holding that paper, and there is no balloon.
ABILITY TO REPAY
The second category requires you to determine the buyer’s ability to repay, but the rules and the regs don’t specify any standards for doing it (such as the qualified mortgage standard, a 43% debt to income ratio, etc.). You don’t have to do any of that; you can just ask them if they have a job, can you see a paystub, can you see their tax return (which they may or may not give to you). All you are required to do is to make some good-faith determination that they’re able to afford that payment, and you do not have to document it.
It would be prudent to have some documentation in case there’s a default and the buyer’s attorney says “where’s the documentation?” and tries to create a legal defense against paying you. But there is no requirement that you have to document. All it says is that you should determine the buyer’s ability to repay.
I asked an attorney at the CFPB about how one should determine the buyer’s ability to repay. He said that if you fall under category two you have to determine the ability to repay, but he admitted that there are no set guidelines. You just have to show that you used good faith in determining, for example, that the buyer has a job, his rent was $1,000 per month, but the payment on the note is $900 a month and you think in good faith he can afford this property because he could afford the rental house he was in before.
WHEN YOU’RE BUYING A NOTE CREATED ON OR AFTER JAN. 1, 2014
You’re going to be able to tell from the note if the mortgagee is a private individual or an entity. If it is a private individual, trust, or estate, then ask them to sign an affidavit saying that they have not done more than three of these in a 12-month period and how many of them had balloons. If it’s an entity, an LLC, or a corporation, etc., ask for an affidavit saying how many it has done and how many of them had balloons.
If there is a balloon in that note that you’re buying from an LLC, corporation or partnership, etc., you know there’s not supposed to be one (again, if that note was created on or after January 1, 2014). You’ll have to have the note modified to remove the balloon before you buy it. Otherwise at some point the mortgagor could use the fact that the note was not in compliance when it was written as a defense against paying the debt or foreclosure.
In the Federal Register the CFPB wrote that they relaxed the rules on seller financing because of the numerous comments they received.