The sub-prime forum: Contract for deed - A diamond in the roughRichard Bitnersub-prime lending, contract for deed, financing
Welcome to "The sub-prime forum," a column designed to help
improve your knowledge of alt-A lending and offer tips to increase
your share of this lucrative market. As a 12-year veteran of the
industry, Richard Bitner has a wealth of experience working in
retail, wholesale and correspondent sub-prime lending. He has
served as the president of Kellner Mortgage
Investments for the past five years.
If you've been around sub-prime mortgage origination for any
significant period of time, you've probably come to learn there are
a number of "tricks" to this trade. Whether it's working to
establish positive credit for a consumer with few trade lines, or
challenging items on a credit report to improve a borrower's FICO
score, there is more than one way to get a sub-prime borrower into
a home.
One of the greatest challenges in completing a mortgage for a
sub-prime borrower is bridging the gap between relatively poor or
weak credit and the lack of funds available for a down payment.
Since most sub-prime lenders don't require down payment funds to be
seasoned, it's a good bet that at least some of the dollars brought
to the closing table come in the form of an undisclosed family loan
or gift. Yet, for those borrowers who don't have the funds or
resources from which to bring a down payment, the alternative has
been to simply continue down the path of renting.
While building credit or disputing collections can occasionally
increase a borrower's score to the point of qualifying for 100
percent financing, it's difficult to accomplish this for the
borrower who has a lengthy history of collections and charge-offs.
Since many collection agencies continue to report these
delinquencies on a monthly basis, it's challenging for a borrower,
who's working to rebuild credit, to offset the negative impact from
these accounts. The key to homeownership for these borrowers lies
with one of the greatest "tricks" in the sub-prime arena the
contract for deed.
A contract for deed, also referred to as a land contract or
lease-purchase agreement, has been used for years as one of the
most effective methods to bridge the gap for these types of
borrowers. In a typical contract-for-deed scenario, a prospective
homebuyer discovers that because of his tarnished credit, he is
required to provide a down payment (let's assume 10 percent, in
order to qualify). Lacking the necessary funds to complete the
transaction, the buyer, under normal circumstances, would have
little option but to continue renting. However, a contract for deed
creates an opportunity for homeownership that wouldn't otherwise be
available.
Here is how the deal works. In such a situation, the seller
signs a contract for deed with the buyer, which gives the buyer the
ability to buy the home at some point in the future at an agreed
upon price. The time period can vary, but the key is for at least a
12-month period of time to lapse before exercising this option. As
indicated in the previous paragraph, this transaction is also
referred to as a lease purchase, which is exactly what this deal is
accomplishing. The buyer is leasing the property from the seller,
with an option to purchase it at an agreed-to price in the future,
not unlike an automobile lease. However, unlike leasing an
automobile, the contract for deed helps to bridge the down payment
gap by giving the buyer the ability to benefit from the
appreciation of the property.
In order to understand the mechanics in depth, let's assume that
a buyer signs a contract for deed with a prospective seller. The
terms of the contract call for the buyer to purchase the home, any
time after 12 months from now, at an agreed-to price of $150,000.
Depending on the terms agreed to by both parties, the buyer may be
asked to provide a down payment. In many instances, the amount is
much smaller than the required down payment to purchase the home.
For our purposes, assume the buyer provides a $2,000 down payment
to the seller. At the time the agreement is signed, the home is
valued at approximately $155,000.
You might wonder why a seller would agree to sell a property to
someone in the future for a figure that is below the present market
value. While every seller is different, a scenario such as this one
is easy to explain. If a property is valued at $155,000, and most
sellers in the area are frequently selling homes and providing for
three percent in seller concessions, the net effect is about the
same. The difference here is the seller is delaying the actual sale
and walking away with a portion of the proceeds (in this case,
$2,000) immediately.
The beauty of a contract for deed, from the buyer's perspective,
comes once a full year has passed after signing the agreement. The
time period of 12 months is significant, because once a full year
has passed, most lenders will allow you to utilize the appraised
value and treat the loan as a refinance.
In our scenario, let's assume that the buyer has been making
payments to the seller for a period of 36 months. During that
period, the property has appreciated and the appraised value has
increased to $170,000. By virtue of the fact a contract for deed
was signed, the lender will allow the buyer to utilize the
difference between the appraised value and the purchase price (in
this case, $20,000) as his own equity.
If we assume that the buyer has the same credit rating he did
two years ago and has not signed a contract for deed, he would
still be required to bring a 10 percent down payment in order to
purchase a home, even if he had been living there the entire time.
But with a contract for deed in hand, he will have the 10 percent
equity position built into his loan. What makes this transaction
unique is that it's typically treated as a rate-and-term
refinance.
Another unique feature of a contract for deed lies in the
ability to go one step further and allow the borrower to take cash
out of his home. In the same scenario, let's assume that the
borrower qualified for 100 percent financing. With a payoff of
$150,000 and an appraised value of $170,000, the borrower could
utilize the $20,000 difference to cover closing costs, pay debt or
just get cash. When you consider the borrower was able to move into
the home for little money down (or, in some cases, no money), it's
amazing to think that, within 12 months, he can refinance the home
and put some of the equity back into his pocket.
However, like any good deal, to effectively execute the contract
for deed, one must do some up-front planning. For our purposes, "to
execute" the agreement means to have the buyer take complete
control of the property by putting the mortgage into his name.
There are several steps that every contract for deed should
follow in order to facilitate a smooth execution. Over the years,
it's become standard operating procedure in the mortgage industry
to ask for a copy of 12 months of canceled rent checks to validate
the housing history. The greatest concern for the lending community
has been that a prospective buyer has just been put into the
seller's home, while claiming to have lived there, during the
previous 12 months. By asking for canceled rent checks, lenders all
but guarantee that the borrower has been in the home for at least
12 months.
Another common catch phrase utilized in the world of contract
for deeds is "to backdate the agreement." In such a scenario, a
prospective buyer leases a home, with the intention of purchasing
it some time in the future, but doesn't sign a specific agreement
with the owner indicating the terms of the sale. By backdating an
agreement that effectively fills in the blanks, the deal takes on
the appearance of being valid in the eyes of the lender. Since
backdating contracts has become commonplace over the years, many
lenders now require that the agreements be recorded on title in
order to utilize the appraised value.
While the requirement to record a land contract is not universal
in the lending community, taking the extra step up front will open
up your options with respect to the number of investors interested
in securing the mortgage. In some instances, lenders won't allow
the buyer to take any cash out of the property, unless proof can be
provided that the contract was recorded.
A business associate of mine, who focuses his efforts on real
estate investments, recently learned the importance of this lesson,
the hard way. For the last 18 months, he had been buying a large
number of residential properties and renting them to sub-prime
borrowers, who had all signed lease-purchase agreements. While most
of the prospective borrowers paid their rent on time, a significant
percentage of them paid in cash, not by check. In addition, none of
the agreements were initially recorded with the county. As he
started to work with the renters, to execute the agreements by
refinancing the properties, he quickly discovered that he didn't
have just one, but two challenges to overcome. Without being able
to provide canceled rent checks and by holding several dozen
unrecorded lease-purchase agreements, he was forced to back track,
in order to get these deals to work. In many of these cases, he'll
need to wait an additional year, as he records the contracts and
starts requiring canceled checks from his renters.
With sub-prime borrowers facing a potential host of challenges,
contract for deeds can provide a unique alternative to bridging the
gap to down payment. While it often means your income from the deal
is delayed, it's an excellent approach to gaining borrower loyalty
and building your pipeline. It's also a great way to take that
borrower, who's a "diamond in the rough," and turn him into a
homeowner.
Richard Bitner is president of Kellner Mortgage
Investments, a nationwide wholesale sub-prime lender based in
Plano, Texas. He may be reached at (866) 416-9995 or e-mail
[email protected].
