In my last article, I gave 6 Reasons I Prefer Creative Financing to Bank Financing.
Bank financing isn’t bad, of course. There are many times when it’s very appropriate.
My main problem with bank financing is that it can be limiting when depended upon too much. Instead, I like to have a large, flexible, creative toolbox of many ways to finance both my purchases and my sales.
What is my creative financing toolbox? Let me unpack it for you.
CREATIVE TOOLBOX FOR SELLING REAL ESTATE
Here are just a few of the creative financing tools I keep handy to sell properties faster and for higher prices:
1. Lease Options
This is a great tool to help tenants become homeowners. Basically, you lease the property to a tenant while also giving them a right to buy it within a certain period of time. This allows the tenant time to control a property’s price while working on their loan qualifications (credit, down payment, income, etc).
A lease option is beneficial to you as a seller because you often get top price without expensive commissions. You also fill up your property quickly and receive rent while waiting on your buyer to qualify for a loan. This is financially much more pleasant than the normal process of sitting on a vacant house and paying interest, taxes, insurance, and utilities for months until you find a buyer.
There is a risk that some tenant-buyers may not qualify or may choose not to buy the house, but heavily prescreening prospects and requiring large option deposits can reduce this risk significantly.
2. Seller Carry-Back Financing – 1st Mortgage
If you want to create passive, profitable income streams, selling and carrying back the financing is a great tool.
This tool just means that you become the bank for your buyer. Usually the buyer pays 10-20% down, they get the deed, and you “carry-back” the remaining purchase price as a promissory note and mortgage (or deed of trust).
As “the bank” you receive interest on your outstanding principal. The rates are usually higher than conventional bank loans, so your returns can be very attractive.
This tool is especially beneficial for retiring landlords who want to transition out of the rental business without losing the income. For landlords with big profits (capital gains), seller carry-back financing also lets them defer and save on taxes using the installment sale method.
Once you own these seller-financing notes, you can also use them as currency for trades and you can raise cash by selling part or all of your note to other investors.
3. Seller Carry-Back Financing – 2nd Mortgage
This tool is like #2, except that the buyer gets a bank mortgage for 70-80% of the purchase price and you as the seller carry-back a 2nd mortgage for the balance.
This process is often done in commercial real estate transactions, but it can also be very beneficial when selling residential real estate. It opens up a much larger pool of buyers who have good credit but small down payments.
A friend of mine once developed 25 lots, built houses, and then sold-out the entire subdivision using this method. He advertised “Brand New Houses – 100% Financing.” His phone rang off the hook.
The buyers were prescreened for good credit through a local bank where my friend had a good relationship. If their credit was approved, the bank financed 80% and my friend financed 20%. The cash from the bank loan was more than enough to get all of my friend’s invested capital back, so these 2nd mortgages were all profit.
My friend usually kept his interest rate low or even let it accrue to keep payments affordable. After five years, the house owners began refinancing or selling the houses. My friend got paid off and received periodic big chunks of cash for years.
4. Contract-for-Deed (aka Bond for Title or Land Contract)
This tool is very similar to #2, seller carry-back financing. The main difference is that the deed (title) to the property is not transferred until the buyer has paid all principal and interest payments.
The benefits of selling with this tool vs seller carry-back financing vary from state to state, so as always you should consult with a local attorney.
I have used a contract-for-deed to sell many properties in my state of South Carolina. My primary reason for using a Contract-for-Deed was that it preserved the integrity of the title when compared to seller carry-back financing.
This benefit only matters if the buyer goes into default and I want to give them cash-for-keys to get the property back. Because the legal title is still in my name, any judgements or liens in their name would not attach to the property. So they could just cancel their contract and deed their interest back to me without a problem.
If, instead, I had a carry-back mortgage, I could not do cash-for-keys because of the other liens. I would have to foreclose to clean up the title, and this could take months and thousands of dollars in attorneys fees.
5. Wrap-around Mortgages (aka All-Inclusive Trust Deeds)
Have you noticed that banks and insurance companies have the most expensive buildings on busy corners in towns and cities across America. It’s not a coincidence. They have made BIG profits for a long time.
Do you want to know their “secret” profit model?
1. Leverage other people’s money (i.e. checking accounts, CDs, insurance premiums, etc)
2. Lock in a low cost to use that money (interest)
3. Invest that money at a higher return than the cost
Warren Buffett’s billions of dollars came in large part from this exact strategy (Forbes article explains Buffett’s secret to success).
Wrap-around mortgages are a creative financing tool that uses the same profit model employed by banks, insurance companies, and Buffett.
Essentially, you borrow on a mortgage at a low interest rate and then “wrap” this mortgage, i.e. keep it in place, while selling with carry-back financing at a higher interest rate.
Here’s an example for illustration:
I buy a house for $100,000, put $10,000 down, and get seller carry-back financing for $90,000 at 3% for 20 years at $500/month
I then sell for $100,000, get $10,000 down, and provide seller carry-back financing for $90,000 at 8% for 20 years at $753/month
The 3% mortgage stay in control in first position
My 8% mortgage is in second position and wraps the first mortgage.
A wrap second mortgage is different from a normal second because my buyer only owes $90,000 and not $90,000 + $90,000 = $180,000. The terms of the first mortgage are wrapped into the terms of the second.
I (or a servicing company) collect $753/month, pay out $500/month, and keep $253/month as profit.
Using a wrap, I have basically built a $253/month profit out of thin air by leveraging the financing of my original seller. This is analogous to the bank paying you 3% on a $90,000 CD and loaning someone else $90,000 at 8%. We are both making money on a margin.
As always, there are caveats.
This is not a beginner strategy. Good paperwork, education, and cash reserves are key to successful wrap deals.
PURCHASING REAL ESTATE
I have just explained my favorite creative financing tools when selling properties. But, some of those same tools and more can also be used when purchasing properties.
Here are 5 creative financing tools I pull out of the toolbox most for purchases.
Seller carry-back financing
Self-directed IRA loans
I don’t want this article to turn into a book, so instead I’ll unpack each of these purchase creative financing tools in much more detail in my next 5 articles. So stay tuned.
Thank you for letting me be your coach for a few minutes today. It’s a privilege.