Creative Financing
Method #3: Subject-To
“Subject-To” is a more advanced creative financing strategy because you really need to understand how real estate lending works, However, once you do, it’s a powerful strategy.
Understanding Liens
When someone buys a property and gets financing from a lending institution to pay for some or all of the purchase, that lender puts a mortgage or deed of trust lien on the property.
This is how the lender is protected because not only does the owner have to pay off the lien in order to sell the property but in the event that the owner defaults on the loan, the lender can foreclose and take back the property.
Now remember how with seller financing the owner sells you the property and becomes the lender for you on some or all of the purchase? Well seller financing only works if the owner owns the property free and clear because he can’t technically be the lender if there is already a lender who holds a lien position.
For example, let’s say that Wells Fargo is the lender and there is a mortgage lien on the property in the amount of $100,000. In this case, the seller couldn’t do a seller finance loan with you for $100,000 because the existing loan with Wells Fargo takes precedence.
So what alternative creating financing solution do we have when the seller has an existing mortgage on the property? This is where the subject-to strategy comes in.
Subject-To Explained
Subject-to is short for subject to the existing financing. Sometimes it’s even abbreviated to sub-to. The simplest way to explain this is rather than buying the property and paying off the existing loan, instead you’re going to assume or take over the existing loan payments that are already in place.
By taking over the payments, the seller is able to walk from the property and is relieved of making the loan payments, insurance, taxes and any/all other costs of ownership because you’re assuming all of those costs and responsibilities.
Sounds simple enough in theory but here’s where it gets tricky. Remember I said that the owner can’t sell the property without paying off the existing loan? That means even though you take over the payments, the loan stays in the owner’s name. The bank will not transfer the liability or loan into your name.
This is a risk to the owner because in the event you stop making the loan payments, for whatever reason, who is the bank going to hold responsible? The original owner not you. So how does the investor get ownership without transferring liability of the loan?
What most investors do is create a contract that transfers the deed to them but not the liability. This allows the investor to control the property and rent it or sell it and realize any upside equity. Of course, when the investor sells the property, the original existing loan will get paid off at that time.
Technically, transferring the deed triggers a clause in the loan called “due on sale,” where the lender could call the loan due but the reality is the lender has no way of knowing that you and the owner did a sub-to deal and honestly, as long as the lender is getting the monthly payment, they really don’t care….why would they?
6-Step Process to Structure Subject-To Deals
So here are the 6 steps to structuring a subject-to deal:
- Step #1: Find Out Existing Loan Terms:
Find out the terms of the existing loan including the principal balance, interest rate, monthly payment and if there is a balloon or early due date to pay off the loan. This is easy to find out. just ask the home owner to provide the most recent mortgage statement or even better, have the owner get a pay-off letter from the lender. Lenders provide these all the time and can email it to the owner right away.
- Step #2: Determine Equity:
Find out how much equity is in the deal. In other words, how much do they owe compared to how much it’s worth. If their current balance due on the loan is $70,000 and its current as-is value is $100,000, then there is 30% or $30,000 in equity.
- Step #3: Determine Exit Strategy:
Determine your exit strategy. If there is enough equity, you could turn around and flip it which is what I like to do. You could also keep it long term as a rental. Some investors will do this with no equity if they can still cash flow.
For example. Let’s say the loan balance is $100,000 and the as-is value is $100,000 so there’s no equity on the deal. Normally this would be a no-deal situation but what if the interest rate is really low and the total monthly payment is only $700 and the property will rent for $1000/month? For a buy and hold investor, no equity is off-set by $300/mo cash flow and hopefully over time, the property appreciates in value.
- Step #4: Factor in Out-of-Pocket Expenses:
Factor in all any/all out of pockets expenses to do the deal. Sometimes the owner is behind on payments or hasn’t paid the property taxes. These costs will require out-of-pocket cash at the closing to bring everything current and these costs will need factored into the deal.
- Step #5: Factor in Cash to Seller:
Consider giving the owner cash at closing. Sometimes it’s enough for the owner to just be rid of the headache the property is causing them but often if you can get the seller some cash in his pocket, it makes the deal go much smoother. It all depends on the exit and the numbers but if possible, build into the deal getting the seller some cash at closing (i.e. - $5,000 to $10,000).
- Step #6: Hire An Attorney To Do The Paperwork:
Get a specialized sub-to attorney to put the paperwork together. This is something I highly recommend you don’t do yourself. It may cost you $500 -$1000 but it’s well worth it to make sure everything is done correctly.
- **Pro Tip:
One of the concerns an owner has with doing a sub-to deal is making sure you make the payments on time every month because remember, the owner is still liable. To ease their concerns, offer to have a 3rd party servicing company do the payments every month. That way the owner would get notified if a payment was ever late or missed.
