Vendor Take-Back Mortgages: An Alternative Home Financing Route
With stricter mortgage rules in place and the housing market shifting to a more buyer-friendly version, we may begin to notice a resurgence in vendor take-back (VTB) mortgages. Although more commonly used in commercial real estate transactions, a VTB mortgage can used as a creative financing strategy in residential deals as well. Prospective purchasers having trouble securing a mortgage with a traditional lender due to their poor credit or inability to make a large enough downpayment are prime candidates for a VTB mortgage.
With a VTB mortgage, the vendor becomes a mortgage lender for the purchaser/borrower with respect to the purchase of the vendor’s home. The vendor lends a certain amount of money to the purchaser – usually an amount to cover a shortfall the purchaser’s bank needs in order satisfy its mortgage lending requirements – and then the purchaser repays the vendor over time with an agreed upon interest rate that is typically higher than a normal mortgage rate, but lower than borrowing from a private lender.
There are some limitations to when a VTB mortgage can be used, however. As the vendor, if there is an existing mortgage on the property you are selling, you may not be able to offer a VTB mortgage to the purchaser unless the lender holding such mortgage allows for it. As the purchaser, most institutional lenders will typically not allow for any secondary financing, which would include a VTB mortgage. Therefore, finding lenders on both sides that will support such a financing strategy can be a challenge.
Besides the obvious benefits to the purchaser (i.e., securing enough financing to purchase the home, not being charged penalties for prepayments on the VTB mortgage, etc.), the benefits of a VTB mortgage for the vendor can be numerous. Such potential benefits include a faster sale of the property in a slower market, a higher sale price as investors sometimes prefer to pay a premium on a property that they don’t have to finance using bank funds, and a higher overall return on investment due to the high interest rate. As long as the purchaser repays the vendor on schedule as agreed, the vendor would end up with the money loaned as well as the interest accrued. Moreover, this means of financing would defer some of the capital gains tax that is payable by the vendor on such sale.
But, with greater reward comes greater risk. Despite all the attractive benefits to vendors from VTB mortgages, vendors are taking on a much greater risk than if they sold their home free and clear, without a VTB mortgage. With VTB mortgages, the vendor has agreed to take a stake in the loan and is thus tied to the borrower. Thus, the vendor should ensure he/she conducts the appropriate due diligence against the purchaser. In addition, because such mortgages are typically always second in line to the purchaser’s first mortgage with a bank, it creates a risk that the vendor will be left with nothing if the purchaser defaults on this first mortgage. If the purchaser/borrower defaults on the first mortgage, the vendor holding the VTB mortgage would have to buy the first mortgage lender out or accept the risk of not recovering the loan if the first mortgage lender sells for less than the amount of the first mortgage plus legal fees and real estate commission. If the purchaser defaults on the VTB mortgage, it can be very difficult, time-consuming and expensive to enforce such mortgage terms (e.g., through foreclosure) against such purchaser.
For purchasers, a risk of getting a VTB mortgage is that he/she may be obligated to pay off such mortgage immediately in a lump sum should the vendor pass away, go bankrupt or liquidate his/her estate.
With all this in mind, it is crucial that both purchasers and vendors looking to use a VTB mortgage financing option discuss the risks with their real estate lawyers and have their lawyers carefully review the VTB mortgage agreement terms.