By Prashant Gopal – May 10, 2011
Bloomberg News

Sue and Douglas Reed knew no bank would give them a mortgage — not with a bankruptcy and two foreclosures fresh in their credit history.

They turned to Hilarie Walters, whose childhood home on 15 acres (6 hectares) in Marshall, Michigan, had been on the market since 2009. The unemployed single mother of twins agreed in December to sell the property to the Reeds for $105,000. She also consented to a risky payment plan that in effect makes her the couple’s mortgage lender.

Financing provided by home sellers, popular in the 1980s when mortgage rates reached 18 percent, is making a comeback in markets such as Michigan that have been hit hard by foreclosures and where tightening lending standards and years of economic distress have drained the pool of creditworthy buyers. For a small but growing number of people, it’s the only way to get a deal done.

“This is the American dream, and we’re going for it no matter what,” said Sue Reed, 56, who sells snacks from a trailer at estate auctions and going-out-of-business sales. “We’ll either make it or it will break us.”

Michigan, where unemployment is 10.3 percent, leads the nation with about 1,600 home listings advertising seller financing, according to Trulia Inc., a San Francisco-based real estate information company. It is followed by Florida, Ohio, California, Wisconsin, Minnesota andTexas.

Last year, 52,991 U.S. homes were purchased with various forms of owner financing, up 56 percent from 2008, said Realtors Property Resource LLC, a subsidiary of the Chicago-based National Association of Realtors, citing data collected from county-record offices. Such deals accounted for 1.5 percent of all transactions in 2010.

Coping Mechanism

“Anytime the market is in this much trouble, people have to find ways to get it to function,” said Dennis Capozza, a professor of finance at the University of Michigan in Ann Arbor. Capozza has direct experience with seller financing: He purchased a friend’s foreclosed home a couple years ago and allowed him to buy it back in installments.

Home sales, weighed down by a 9 percent national jobless rate and tight credit, have languished even as 30-year mortgage rates remain below 5 percent. Loans insured by the Federal Housing Administration carried an average FICO score of 703 in March, compared with 629 two years earlier, highlighting that lenders are requiring stronger credit histories. FICO scores range from 300, the least creditworthy, to 850 for the best borrowers.

“The market is locked up because there’s no financing,” said Gordon Albrecht, executive vice president of FCI Lender Services Inc., an Anaheim Hills, California-based firm that oversees mortgages for private investors. “This is moving houses.”

Land Contracts

The Reeds are using an increasingly popular form of seller financing known as a land contract, also called a contract for deed, in which the buyer takes immediate possession of the house and the seller holds legal title until the debt is paid. Land contracts were used in 319 sales in Michigan in the first quarter, or 2.4 percent of the total, compared with 252 sales, or 1.2 percent, a year earlier, according to Realcomp II Ltd., a Farmington Hills, Michigan, multiple-listing service operator. One land contract was recorded in the first quarter of 2005.

Down payments, interest rates and other terms of land contracts are subject to negotiation. There is often a balloon payment in five or 10 years, at which time the buyer must find a way to pay back the seller or risk losing the house and the money already put in.

$565 A Month

The Reeds put down $25,000 and make monthly payments of $565, reflecting a 7 percent interest rate amortized over 30 years, with the full balance due in five years. Walters, who lost her job as an automobile engineer in 2008, the same year she inherited the ranch, hopes the Reeds can pay off the loan sooner.

“They’re paying me interest every month, but I’d rather have the money and be done with it,” said Walters, who is using their payments to cover the mortgage on her Battle Creek, Michigan, residence. “It does make me nervous.”

The Reeds, who earn a combined $20,000 a year, fell behind on mortgage payments for two homes they had borrowed against after inheriting them from Douglas’s father, and went into bankruptcy in 2007. They later spent $10,000 to make their daughter’s home wheelchair accessible after she was severely injured in a 2009 car crash, Sue Reed said.

They’re hoping for a settlement from a lawsuit stemming from the accident to make the balloon payment to Walters, she said. Their daughter, 33, died last year from her injuries.

“In five years we hope to get everything straightened out enough to have a good credit ratingagain,” Sue Reed said.

Hope, Opportunity

The risks in such deals are significant for both buyer and seller, said Jason P. Hoffman, a Faribault, Minnesota, real estate attorney, who calls the participants “hope-ortunists.”

“Each of them is seeking an advantage in an otherwise difficult situation, and they’re hoping everything will work out as envisioned,” Hoffman said. “It’s an act of faith.”

The riskiest gambles involve sellers who — unlike Walters — have bank loans on the properties, Hoffman said.

Most mortgages contain a “due on sale clause,” meaning the lender can call the loan if the home is transferred. While community banks sometimes grant exceptions, many homeowners take their chances, hoping lenders won’t ask questions as long as the payments stream in, he said.

A buyer in this arrangement has little protection if the seller goes into bankruptcy or loses the property to foreclosure, Hoffman said. The seller’s risk is that the borrower won’t qualify for a bank mortgage when the land contract comes due, he said. And a continuing drop in home pricescan imperil the deal for both sides, he said.

Hand Holding

Rafik Moore, an investor in Minneapolis who offers seller financing for his properties, said he seeks to help buyers rebuild their credit. He counsels them to start making payments on time and open secured credit-card accounts.

“I hold their hand until they’re able to finance me out,” Moore said. “The problem is this is someone who lost their home, never understood credit to begin with and has always been struggling.”

Not all buyers are broke.

Michael Fazio, broker and owner of American Real Estate Services in Roseville, Michigan, said he’s helping one couple with a combined annual income of $100,000. They owe $450,000 on a four-bedroom house in a Detroit suburb that is now valued at $250,000. They plan to walk away from the mortgage if they find a home to buy with a land contract, he said.

Finding a qualified buyer requires careful scrutiny of credit and job histories, especially if the price of the home is too low to extract a significant down payment, he said.

“It’s gut-check time,” Fazio said. “Do you really think these people are good, credible people?”

Amenable Laws

Real estate investors prefer land contracts to private mortgages in states such as Michigan, Ohioand Minnesota, where the laws allow for forfeiture actions against delinquent borrowers, said Dale Whitman, a professor of law at University of Missouri in Columbia. Forfeiture is usually faster and less expensive than foreclosure.

Sellers may provide other forms of financing, such as leases with the option to purchase or private mortgages, in states such as Florida, where land contract laws are less favorable, according to Jeff Riddell, a real estate attorney in Sarasota, Florida.

“This has been going on for 100 years or more in Michigan,” said Allan D. Daniels, 46, whose family has been buying land contracts for three generations beginning with his grandfather in the 1930s.

Underwater Borrowers

Daniels, president of Dr. Daniels & Son in Bloomfield Hills, Michigan, said business picked up in the past two years after a two-decade lull when low interest rates made traditional financing attractive. Land contracts aren’t as popular as they were during the 1980s because many underwater homeowners –those owing more than their properties are worth — can’t finance the transaction, he said.

More than 28 percent of U.S. homeowners with mortgages were underwater in the first quarter, Zillow Inc., a Seattle real estate data company, said on May 9.

Daniels often hears from sellers when they’re having second thoughts about the risks or the paperwork involved in servicing the loan. The seller must prepare an amortization schedule, send the borrower interest statements and make certain property taxes and insurance are being paid, he said.

“For some people, at first it sounded great,” Daniels said. “Then they realized there was more than they like doing.”

Market Segment

Mark Cook, 30, a real estate agent in Lake City, Florida, said he sees an untapped market in the millions of homeowners who have had their credit ruined by a foreclosure or short sale. More than 3 million homes have been repossessed since 2006, according to RealtyTrac Inc., an Irvine, California-based data seller.

Cook said he is working with a Canadian investor who bought and renovated four homes in Florida’s Cape Coral and Fort Myers areas since September, selling them for a premium to buyers needing financing. One more is on the market, another is under renovation and they have contracts to buy another handful of homes.

They market homes to buyers with foreclosures in their credit history, along with second-home purchasers and self- employed borrowers who don’t show enough income on their tax returns to qualify for traditional financing, he said. Cook offers an interest rate of 9.95 percent and balloon payment after seven years to buyers who can put down 20 percent in cash.

“We are advertising in markets that are cheap and we’re satisfying the consumer’s appetite for a bargain,” Cook said. “Assuming you’re not creditworthy and have cash, we are your avenue for buying a home.”

Time Is Right

Rebecca Hill, a 33-year-old high school science teacher, and her fiancé, Nicholas Lehman, bought an almost 2,000-square- foot (186-square-meter) house in Cape Coral through Cook for $107,000 on May 4. Her credit was damaged a year ago when her ex-husband lost a home they they had purchased together to foreclosure, according to Hill.

While they paid a premium for a seller-financed home, the monthly mortgage costs are $175 less than the rent they previously paid for a unit half the size, she said.

“If I wait for my credit to be restored and then purchase, I’m not going to get a $107,000 four-bedroom home,” Hill said. “That’s not going to exist anymore.”