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].