'The New Subprime' Mortgage: Risky Loans Emerge in Twist on Seller Financing
"Seller financing is the new subprime," said Wayne Sanford, a consultant who helps some seller financiers vet borrowers. It's a "trend," one top regulator said, that he's "definitely watching very closely" because the mortgages have the trappings of risky pre-crisis loans: They charge sky-high interest rates, often turn a blind eye to credit scores and force refinances within a short period of time.
And borrowers only months out of foreclosure are able to qualify for them.
'The New Subprime'
Seller financing -- in which the seller of a property lends money to a buyer to purchase it -- isn't new. It was common in previous eras, then was mostly used by individual sellers unable to find buyers who qualified for conventional mortgages.
Now a growing number of real estate investment firms specialize in these transactions. They snap up foreclosures and sell them -- along with home loans -- to borrowers with less-than-stellar credit. The financing has flown mostly under the radar since the financial collapse, perhaps accounting for the widespread belief that a person who has been in foreclosure must wait three years to qualify for a mortgage again. Tim Dwyer, president of title insurance company Entitle Direct, estimates that fewer than 10 percent of current mortgages are seller-financed.
That may change. Investors who have been rushing to buy foreclosed homes over the last few years may want to cash out on their investments as housing values rebound. One way is to sell to subprime borrowers who lost their homes in the foreclosure crisis but are eager to buy again.
The foreclosure crisis has "dramatically reduced the universe of people who can buy homes," said Guy Cecela, publisher of Inside Mortgage Finance. Borrowers who are locked out of the mortgage market, he said, represent a gaping window of opportunity to investment firms that are willing to lend (and simultaneously sell) to them.
Underwriting – With Your Gut
Capital Blueprints started offering seller-financing in 2008, according to the company's founder and CEO Kevin Kaczmarek. The Indianapolis-based real estate investment firm has bought, rehabbed and sold 250 homes using seller financing over the past four years, he said.
He estimates that about half of the buyers of those homes have been through foreclosure. "Part of it ... is you kind of get a gut feel," he said about Capital Blueprint's underwriting process. "We're willing to take that chance."
That often means overlooking subpar credit scores when evaluating borrowers, Kaczmarek said. In fact, one of Capital's best clients was a man with a 425 credit score who borrowed and bought from the company in 2008, he said. In contrast, the average credit score of a borrower who closed a primary mortgage in October was 750, according to Ellie Mae, a mortgage software provider.
Filling a Credit Void?
The mortgages can offer borrowers potential savings in a market where rental rates are soaring. Marty Boardman, chief financial officer of Rising Sun Capital Group, said the typical home that his company sells would cost $1,100 to rent, but only $900 to own if a borrower uses the company's seller financing.
Sanford said that seller financing "if used properly, can be a huge benefit to families." They are filling a lending void that consumer advocates and real estate professionals have lamented for years by extending credit to people who would otherwise have no hope of purchasing property, he said.
Triple Interest Rate, Double the Default Rate
But Sanford cautioned that seller financing also sets up some vulnerable borrowers for foreclosure.
The risk partly stems from the terms of the loans. Typically, they carry an interest rate that is sometimes as high as 10 percent, about three times the current average rate of a conventional 30-year-fixed rate mortgage. They also typically require a down paymen of about 10 percent.
A 10 percent down payment is not remarkably low (Federal Housing Administration-insured mortgages only require a 3.5 percent down payment), but it is still less than half of todays' average, which was 22 percent in October, according to Ellie Mae.
The mortgage's most exotic -- and risky -- feature, however, is probably its brief length. Though a seller-financed loan is frequently structured like a 30-year loan, it often forces a borrower to pay off the outstanding balance of his mortgage in from three to seven years in a "balloon payment."
Capital Blueprints usually requires a balloon payment after seven years, Kaczmarek said. That could be one reason why Capital Blueprints mortgages' have a default rate of what Kaczmarek says is about 8 percent.
That's about twice the average default rate for conventional home loans, according to Cecela, publisher of Inside Mortgage Finance.
Seller-financiers often require balloon payments so that they can cash out their investments more quickly. "They don't want to take a long-term commitment to recoup their money," said David Crump, director of legal research for the National Home Builders Association.
Boardman claims that the loans still give homeowners "ample time to become credit-worthy again" and obtain a conventional mortgage to pay off the seller-financed one, however. Rising Sun Capital Group offers a seller-financed mortgage that requires a balloon payment after 5 years, he said.
'A Recipe for Disaster?'
Some critics say that using a seller-financed mortgage to transition into a long-term and more sustainable mortgage is fraught with hazards. Kathleen Day, a spokeswoman for the Center for Responsible Lending, said the balloon payment is "predatory." If a homeowner slips on any sort of debt payment, Day noted, he or she probably won't be able to qualify for a conventional mortgage when it comes time to make the balloon payment.
"When the balloon hits, then guess what, you violated this contract, 'Get out.' " Sanford added. "You lose all your equity no matter what."
Cecela called seller-financed loans offered by some investment firms "a recipe for disaster." "A huge number of these loans are going to default," he said.
Despite similarities between the notorious subprime mortgages of the housing boom and today's seller-financed loans by investment firms, there's an important difference: Even if they become more common, they wouldn't pose a risk to the financial system.
That's because seller financiers do not sell their mortgages to major lenders or government-sponsored entities whose failure could require bailouts. Seller financiers assume the full risk of the loans.
But that's acceptable to some real estate firms, in part, because they typically can complete foreclosures much more quickly than banks. The main reason why? They don't have enormous backlogs of foreclosures like major lenders do, Sanford said. As buyers and sellers of real estate, they also can flip repossessed homes much more efficiently than banks.
And Sanford said that the firms are also able to absorb foreclosure-related losses because they may "pad their pockets a little more" in the first place, by selling their properties at above-market prices.
Why are they able to sell at above-market prices? Because they've cornered the market on subprime borrowers.
Dodd-Frank's Potential Impact
Experts say that new mortgage rules that are part of Dodd-Frank Wall Street Reform and the Consumer Protection Act that may be introduced later this month could make seller financing at least marginally more difficult. One rule will require a license of any entity that originates more than three mortgages in one year, and another would ban balloon payments on loans whose interest rates exceed a market rate by 6.5 percentage points.
Capital Blueprints and Rising Sun Capital Group's rates fall just short of that threshold, however.
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