How To Set Up Your Real Estate Contract For Maximum Safety and Value

Part 2 – Analyzing Risk

Suppose a buyer wants to buy your property from you. You’ve agreed on a sale price and down payment, and you’ve agreed to “carry the paper” for the balance. If this same buyer asked you to borrow the same balance in cash from you, would you lend it to him or her? There is, of course, a difference between lending cash and giving a loan in the form of a real estate contract. However, in either case, you are extending credit, probably a significant amount, to someone you probably don’t even know. Regardless of the form of the loan you are about to give, you should protect your money by understanding the risk you are about to take. Decide on the terms of the contract according to the risk.

Here are some important factors to consider when deciding on terms: Down payment amount, credit rating, possibly credit references, and verification of income (ability to pay). A brief discussion of each of these factors follows.

Down Payment: How much CASH down payment does the purchaser have? The bigger the CASH down, the more likely it is that the buyer will make payments to you. There is no perfect formula for an acceptable down payment, but generally speaking, less than 10% down is very risky, 10% - 20% is low to moderate risk depending on the buyer's credit, and a down payment of more than 20% reduces risk substantially even when the buyer has less than stellar credit. Individuals with low down payment statistically have less cash, so it follows that low down payment contracts are typically quite risky.

Credit Record and References: How well does the buyer make payments for other debts they have? A person who pays other debts on time is likely to pay YOU on time. Conversely, someone who never pays their bills on time likely won’t pay you on time either. You can verify this by looking at a credit report. Your potential buyer can get their credit report over the internet (search for “Credit Reports”) cheaply for you to review. Credit reports often have information about debts that the buyer has which enables you to obtain 3rd party information verification about debts. It is good practice to compare the debts listed on the credit report with those listed on the credit application to make sure they match up. Be aware, however, that some debts don't show on a credit report.

Some people check credit references. I have found that buyers rarely give references that would provide negative information about the buyer. As a result, I don't ask for references.

Ability to Pay (income verification): Does the purchaser make enough money to deal with the obligations that go along with property ownership? Obligations not only include the monthly payment, but also taxes, insurance, and property maintenance. Their income has to cover all their debts including your real estate contract, and there has to be some income left over to cover unexpected issues such as roof replacement. A common measurement is called a "Debt to Income Ratio (DTI)" and many banks use 40% - 50% DTI as a threshold. In other words, lenders often decline to lend if a buyers total monthly payment obligations exceed 40% - 50% of the buyer's income. Another ratio is called the "Front End Ratio (FER)" which is the ratio of the house payment (in other words the contract payment that you are considering in your sale to the buyer). Typical acceptable FER's are 25% - 35%. You can search the internet using (for example) "typical mortgage lending ratios" to see how lenders analyze these and other important ratios. Few seller's go through this process, but all should!

Verify their income, debts, and assets before you close the sale. You can do this by having an applicant fill in a simple one page Credit Application. (you need Adobe PDF reader to view/print this form). You should also ask the buyer to provide you copies of tax returns for the most recent two years. All conventional lenders do this! You should too. Calculate the ratios and make a decision using these rations.

The next article this series will take into account other factors that are important in deciding what terms should be. But, it’s important to recognize rating risk on a contract is not an exact science. Contracts go into default even though the risk rating is 10. And, some contracts with very low risk ratings pay perfectly. As mentioned in part 1 of this series, hundreds of investors have spent thousands of hours trying to find a way to measure how reliable a buyer will be in making payments. No one has ever built a formula that can perfectly predict how reliable those monthly payments will arrive in your mailbox.

Once again, the information provided here is my opinion and only that! There is no advice contained herein. You should consult with legal, financial and real estate professionals to form your own opinion.