It all began following the collapse of the housing market. The same Congress that over the years systematically deregulated the financial industry to the point where underqualified buyers were allowed to purchase homes they couldn’t afford spun a 180 and imposed new regulations designed to prevent similar occurrences in the future. The legislation, formally known as the Dodd-Frank Wall Street Reform and Consumer Protection Act, was signed into law on July 21, 2010.
The act placed substantial regulations on the entire financial industry, including the mortgage lending sector. In an effort to prevent homebuyers from once again getting in over their heads, the legislation amended the Truth in Lending Act in 2014 to require that mortgage loan originators, commonly referred to as loan officers, make absolutely sure that the homebuyers they make loans to demonstrate the ability to pay for the homes they purchase. Significant penalties hang over the heads of originators and their companies who fail to do their “ability-to-repay” due diligence.
In its most pure form, the law now considers anyone who performs activities associated with the origination of a residential mortgage loan to be a “mortgage loan originator”, which requires a license. Thank goodness there are exceptions to the rule that exempt certain property owners.
First and foremost, the owner-finance regulations apply only to the sale of residential properties that are to be occupied by the buyers. The definition of residential properties includes one-to-four-unit buildings, houses, townhouses, condos, apartments, co-op units and even boats, trailers and mobile homes used as residences. Sales to investors and some vacation and second-home buyers are exempt from the rules, as are buyers of vacant land and most commercial properties.
It’s interesting to note that sellers who finance their own properties don’t actually make loans. Instead, they typically accept a down payment and extend credit to the buyer, who then makes payments on the remaining balance. For example, an owner might sell a home for $200,000, accept a down payment of $20,000, and allow the buyer to pay the remaining $180,000 in monthly installments.
The two exceptions to the owner-finance rules that affect most typical transactions are the One-in-Twelve and Three-in-Twelve exclusions. The 1-in-12 exclusion is available to natural persons, estates and trusts, and pertains to owners who complete only one owner-financed transaction in any 12-month period. It is not available to corporations, LLCs, or builders who construct a home in the normal course of their business. Allowable financing terms include fixed and adjustable interest rates, fully amortized loans (where the payments eventually pay the loan in full), and balloon payments. A balloon payment is defined as one that is more than two times the normal agreed-upon payment.
If the interest rate is fixed, it must remain so throughout the term of the agreement. If the rate is to be adjusted for inflation, it must be fixed for the first 5-years and may not increase more than 2 percent over the start rate in any given year after that. There’s also a lifetime adjustment cap that may not exceed 6 percentage points over the original rate, as long as the rate doesn’t violate usury laws. In our $200,000 sale example, the $180,000 balance could be amortized over 15, 20 or 30 years, with a balloon payment of the remaining unpaid balance due and payable at the end of an agreed-upon number of years.
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The 3-in-12 exclusion is much like the 1-in-12 carve-out, with the addition of also being available to corporations and LLCs. Builders are once again excluded from this provision. The rule allows qualified owners to complete up to three owner-financed transactions per year, none of which can include a balloon payment. In addition, this provision burdens the seller with the obligation to make a good faith effort to determine that the buyers can afford the payments, which is not the case in the 1-in-12 exception. Sellers subject to this provision should at the very least make an effort to determine that the buyers have a steady job or other income to support the payments, are not overloaded with excessive debt, and in general, have the wherewithal to afford the home.
The rules associated with owner-financed transactions are far more complex than alluded to here, so it would behoove prospective owner-finance candidates to consult with a Realtor, attorney or other qualified professional before structuring their transaction.
See you at closing.
Gary Sandler is a full-time Realtor and owner of Gary Sandler Inc., Realtors in Las Cruces. He loves to answer questions and can be reached at (575) 642-2292 or [email protected].