What You Need to Know about Creative Real Estate Financing

The bursting of the “housing bubble” in 2008 and the resulting credit freeze have made it harder for everyday Americans to qualify for residential loans. As a result, many prospective buyers are turning to creative financing options in their quests to purchase homes.

This scenario is not new. According to Arizona State University Professor Anthony Sanders, “Many of the new mortgage products that are surfacing are […] variations of mortgages that were popular during the high-inflation, high-interest-rate period of the late 1970s and early 1980s.” At that time, many people simply couldn’t qualify for a home loan from a traditional banking institution. High mortgage payments required greater cash flow and a larger down payment – not to mention increased mortgage origination fees – which most people, especially first-time home owners, simply couldn’t afford.

In 1982, the Federal Reserve Bank of Atlanta funded a Georgia State University Department of Economics survey of realtors across the American Southeast. These realtors provided information on more than 300 home sales that had closed that year. Upon reviewing the data, the authors of the study, Donald L. Koch, Delores W. Steinhauser, and Keith R. Ihlanfeldt, discovered that a stunning 53 percent of all transactions involved creative financing.

What is creative financing?

A popular choice during economic downturns, creative financing refers to any financial arrangement regarding a real estate transaction that doesn’t involve a traditional financial institution. The most common form of creative financing is a seller carrying a home loan for the buyer at a below-market interest rate.

Sellers who own their home outright and want to finance borrowers themselves can use a mortgage or a trust deed, although laws differ in each state about whether to record a mortgage or a trust deed. For example, in California, people use grant deeds for titles and trust deeds for promissory notes.

History of creative financing

In the 1960s, 1970s, and early 1980s, creative funding scenarios could include a developer or builder, or a buyer’s employer, providing the money. Less frequently, a realtor could hold the mortgage. Sellers could also rent or lease their homes with an option to buy.

The trouble with creative financing during this period was that in providing financing, sellers tended to focus more on just making a sale than they did on making a smart investment. This led them to ignore many of the basic principles of lending when constructing the deals.

However, since the passage of the Dodd-Frank Act in 2010, many creative financing options are no longer legal. Realtors today must possess a mortgage loan originator license in order to arrange a loan. Although sellers can still hold a loan, they must now follow these guidelines:

– Sellers cannot offer financing on more than three homes per year.

– They can’t extend a loan if they built the property.

– The financing terms cannot include a balloon payment. All loans have to be amortized.

– Lenders must first ascertain whether the borrower is capable of paying back the loan.

– Loans must have a fixed rate for at least five years, with sensible annual increases thereafter, as well as a reasonable lifetime cap.

Why people should avoid creative financing

Even with these preventative measures in place, creative financing carries significant risks for both buyers and sellers. Many of these loans have a very slim margin of error and rely upon the home continuing to gain in value in order to qualify for refinancing down the road. However, homes can and do lose value, which can result in a mortgage that is larger than the value of the property.

The quality of these loans can also be questionable because most lenders lack the experience and knowledge to be experts on credit analysis. For example, they often don’t take into account the borrower’s net worth or character. Further, if a borrower defaults on his or her payments, the seller must initiate collection processes or foreclose on the property – both of which involve a significant time period without any payments from the buyer. This can lead to a dire cash-flow problem for the lender, especially if he or she needs this money to pay down a first mortgage.

Sellers can also experience significant losses if they have to foreclose or sell a low-rate home loan on the secondary market. This could happen for a variety of reasons; for example, sellers might experience a life event that requires them to access the loaned money before the loan term is up. They might also decide to recoup their money to invest in a financial instrument with a higher rate of return.

Creative financing also distorts property values. Houses with attractive financing terms tend to sell for a higher price than properties with traditional financing do. Often, these exorbitant sales prices cancel out any savings achieved through cheaper financing terms.

The NABE Certified Business Economist Program

Certified Business Economist Program pic

Certified Business Economist Program
Image: nabe.org

The founder and CEO of Koch Asset Management, Donald L. Koch is active in several professional organizations, including the National Association for Business Economics (NABE). Donald L. Koch previously served as the associate editor of Business Economics, a publication affiliated with NABE.

NABE offers a wide range of resources to the economics community, including the Certified Business Economist (CBE) program. Available to NABE members working to advance their careers, the CBE program focuses on applied economics and data analysis in order to bridge the gap between academic and practical knowledge.

Candidates are required to have a four-year degree and a minimum of two years of practical work experience in economics or a related field to be accepted into the program. Candidates must then complete the coursework and pass a comprehensive exam to receive the CBE designation. Completion of no less than 30 hours of continuing education is required every two years for renewal.

NABE to Hold 58th Annual Meeting in Atlanta

National Association for Business Economists pic

National Association for Business Economists
Image: nabe.com

A finance professional for more than four decades, Donald L. Koch brings a wealth of expertise to the disciplines of finance and commercial banking. In addition to heading multiple institutions over the years, Donald L. Koch is a member of a number of professional associations, including the Jacksonville, Florida, branch of the National Association for Business Economists, of which he serves as the founder.

The National Association for Business Economists (NABE) was started in 1959 as a means to provide professionals with networking opportunities and guidance in leadership and economics in the business sector. The 58th NABE Annual Meeting will take place September 10-13, 2016 in Atlanta, Georgia, at the Loews Atlanta Hotel in midtown. Exploring the theme, Global Businesses, Domestic Complexities: Navigating the World Economy, participants will examine the impact of the current world economy as it relates to a variety of themes. These themes include big data, data visualizations, demographics, immigration, productivity, structural economic change, the “GIG Economy,” neuroeconomics, and others.