Seller finance may seem like the bottom of the mortgage loan sieve, but it is also a sieve in its own right. To save yourself from a lot of headaches, you need to be clear upfront about whether your borrowers will qualify for a Dodd-Frank compliant loan or not. Pre-screening your borrowers can save you a lot of time in this process. Listen in as Dan Deppen brings in Max Bailey from Call the Underwriter to share some of his tips about this on the podcast. Max also talks a bit about loan origination.
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How To Save Yourself From Headaches During The Seller Finance Process With Max Bailey
I‘m joined by Max Bailey from Call The Underwriter to talk about seller finance and originating notes. Max, how are you doing?
I’m doing well, Dan. Thank you for having me. How are you?
I’m good. Welcome and thanks for coming on. I appreciate it. Seller finance is an area that I get a lot of questions about. There’s a lot of interest in it and I‘ve done a few of them myself, but I‘m no means the expert, so it’s great to have you on to fill us all in on how we should be doing this.
Thank you, I appreciate it. I’m by no means an expert either. This is like medical stuff that we’re practicing, everybody is feeding off one another and we keep getting sharper as we go. There’s a whole lot of folks in this industry now. Everybody started sharing tips, techniques and we’re all making each other sharper as we go.
That’s how note investing works in general for me. I‘m learning new stuff every day even in the core part of the business. Give us an overview of who you are, what Call The Underwriter is and what you guys do.
I’m new in the Call The Underwriter place. For those of you who don’t know yet, after working with Russ for a period of time, we asked them to buy the business, we finally put something together, and got that done. The business sale is complete. Russ and I are still friends. We’ll certainly throw work toward each other. From time–to–time, I’m still going to have Russ do a podcast. Our clients will still continue to see him as often as I possibly can make that happen. From day-to-day operations now, he is moving into some other things. He wants to do some vacant land seller finance, and he wants to move out and do some other things himself.
Michelle and I, my wife, are happy to have bought this business and we’re going to take off right where Russ left. We’re not changing anything a whole lot other than a little bit of automation and a few procedural things in terms of how lenders will submit their packages to us and that thing. By way of background, Michelle and I have been involved in real estate off and on since about 1990. I started as a realtor working in a brokerage selling places and that led me into buying my own properties. Throughout the last several years, I worked full-time as well as a firefighter paramedic and the career of firefighting afforded me a lot of time off. I was off during the daytime about five days a week for many years and still had the income to fall back on from the firefighting job.
Seller financing is a bigger industry than a lot of people think, but it’s still a space that’s convoluted and untested in many aspects. Click To TweetThroughout those years, I was buying, maintaining and managing rental properties. I finished a Finance Degree as well, so I get quite a bit over the years with the finance lending, not so much being the lender to other people, but try using my understanding of financing too. I work the most favorable deals I could to leverage myself into as many properties as possible. Most of my background was from the rental and real estate ownership standpoint. Now, this rounds us out because I‘m working on the other side of the table, and I‘m the one helping all of these people put their deals together and seeing everything from the opposite side.
Did you have to then get licensed as a mortgage loan originator at some point in there? How does that work?
I’ve done all the training, I got all the same knowledge but the way mortgage loan originating works is you have to hang your shingle, so to speak, with a brokerage and they expect you to be originating loans. I’m using that knowledge in this business but I‘m not originating any loans. As a private business to underwrite, we couldn’t put our NMLS number out there unless it’s underneath a brokerage. I’m still feeling that out to see. I may still put it underneath the brokerage and advertise that, but my intent is to underwrite these loan packages for all of our lenders who are the loan originators.
I got it, that makes sense. I didn’t think about it that right. I‘ve used you guys before but when I‘m doing that, I‘m the originator.
As the underwriter in the documentation, there’s that arm’s length arrangement they talk about in business finance where the loan originator shouldn’t be underwriting their own work. In this case, all of you out there are the loan originators and I‘m in that virtual backroom down the hall where underwriters sit, and after you’ve originated the loan, that package comes down to us. We’re that neutral third party that is vetting this borrower from an ability to pay standpoint, and acting as your insurance policy that there’s no predatory lending going on. That this borrower will meet all of the Dodd-Frank requirements spelled out in ability to repay the legislation.
What are some of those requirements that have to be met that lenders might not be familiar with? I know Dodd-Frank generally, but what kinds of things are you looking for to make sure that the loan is compliant?
There are eight different factors that Dodd-Frank says we’re required to take into consideration when vetting a borrower. Those deal with two–year work history, adequate income, certainly a good hard look at their credit, and a certain amount to deal with the nature of the loan, whether it meets all the parameters for a legal loan. What we do is once the lender, who would be you, takes that application and collects all of the borrower’s income documentation, they then submit that to us and we dive in, start vetting their income against the DTI requirement to ensure that they meet debt–to–income ratio standards, and vetting this thing to be sure that they meet the residual income requirement.
Each state has a different residual income requirement, which is all factored based on what state they’re in, what the taxes in that state look like, and what cost of living index for that state is. We punch all of this stuff in and when we’re done, we’re able to spit out a yay or a nay on whether this individual is going to meet Dodd-Frank’s compliance requirements. The purpose of that is down the road, if this borrower let’s say has a negative life event and defaults on this loan, then they may go get an attorney and say, “I want to challenge the legitimacy of this lien because that surprised me. I never knew it was going to be that much. I‘m not prepared to pay that much. This was a predatory loan.”
Our process creates this documented paper trail showing that we have followed best practices in the underwriting industry. That allows that lender, if the need be heaven forbid, but to go to court and on the rebuttable presumption, which is how they challenge one of these. In other words, making the presumption that this loan was a bad loan and that this individual never could pay, we’re able to submit all of the documentation showing that this loan meets Dodd-Frank requirements. We did all of the things in our standard practice for vetting this individual. We’re not putting people into loans that the factors say that they’re not qualified to pay.
As a lender, I‘m always happy when I‘m selling an REO if I find somebody who wants to buy it. I‘m not good at scrubbing borrowers. For me, as a note investor, I‘m typically buying notes that have already been originated, so I’m not doing that most of the time. When I‘m buying nonperforming notes, I already know that this borrower is delinquent at some point. I know their credit is garbage. I’m not generally in the mode of vetting the borrower, but when you’re originating on the other side, it’s a completely different animal.
It is different for two reasons. Number one, obviously the liability issue because you’re now the one putting your name down as the LO, you’re the Loan Originator. If it’s a non-compliant loan, you’re liable. Number two, because you’re the loan originator on a non-compliant loan, it could affect your marketability of that note in the future. Thirdly and this is important, even though this is a business and everybody is trying to make money, I like to not ever forget about the fact either that there’s the human factor in this. The third piece of this is we’re talking about somebody who could potentially default and lose their owner-occupied home for them and their family.
The intent behind Dodd-Frank and all of the ability to repay legislation is that we never have another mortgage bubble burst where half of the country loses their homes due to predatory lending. From my standpoint, I try to be that neutral third party that’s looking at the interests of both. I’m looking at making sure we’re not putting a borrower in a position that they shouldn’t be in that could end up costing them their home. On the other hand, because I‘m paid and I‘m working for the lender, I‘m also looking at it from a standpoint of if I give this blessing and say, “This family is good to go in here,” you’re going to take that to the bank in the event that they do default and this is challenge. I’m working with your best interest in mind as well.
As you said, you’re providing an insurance policy for the lender. You don’t want them coming back. What are the limits as an individual or an LLC on how many loans you can originate? I always get confused on this myself when I hear different things at different times. What I‘ve heard in the past was you can do three in a year or something like that.
For the purposes of what most note investors are doing now, they can do up to five in a year without getting into the realm of being considered a commercial–residential loan originator. I can tell you from experience, there are investors all over the country that are doing far more than that even and they’re getting around that. I‘m not necessarily saying it’s good, bad or indifferent. I‘m not an attorney and I‘m not going to give that advice, but I can tell you that it’s happening all over the country. Lenders are feeling comfortable originating a certain number of these under one entity, one LLC and then three months later, originating more under another LLC. I don’t know that there’s any case law precedent or anything on that, but people are doing far more than five per year in the seller finance world.
I‘ll have to have them back on. At one point, I had Bob Repass on where he was talking about the seller finance coalition and they were trying to get those rules changed where it was more clear, where they were going for 24 or something like that and then that would make life a lot easier.
The way to help the seller financing community the most is through education. Click To TweetIt sure would. The seller finance in 2019 was somewhere between $25 billion and $30 billion. This is a bigger industry than a lot of people think that it is. There’s no doubt in my mind. It’s like a snowball rolling down a hill. It’s gaining more momentum every year. This is not going away. It’s only going to keep getting bigger. There are quite a few sharp people that are taking a legislative interest in this. In the future, it is going to be massaged into something that’s a little bit more consistent, user-friendly for seller financers and easier to understand. Right now, a lot of it is still all convoluted and untested.
Especially now, with the low–interest–rate environment, there are a lot of deals that banks won’t lend against with interest rates low. If it’s a smaller dollar amount loan, they’re not going to bother. There’s this big underserved part of the market for seller finance.
In that underserved population, the way I look at it is there’s a fraction within a fraction. If these many people the banks are saying no to, probably half of that number, we need to say no to as well. There’s a sweet spot in the middle where there are people that make ideal borrowers for seller finance lenders, and that’s the group that we’re looking for. One of the big things I want to do is help educate the lenders on how to vet and screen these borrowers on the front end, so that we can sift that little group of people that we’re wanting and not spend too much time, energy or build up the hopes of the borrowers that aren’t prepared.
A lot of my focus is trying to create some repeatable screening processes and provide some investor information out there that enables them to do a real good consistent pre-screen of their borrowers, so that when packages come to us, ideally we get our ratios up. When packages come to us, 90% of them are going to be a go. We’re doing that a couple of different ways. I‘ve created a bunch of information that I‘m sending out to every new investor and requesting that they utilize it in screening their borrowers. The other thing that I‘m going to start talking up more as well is that lenders get onto our website under the Investors tab and there’s a Residual Income Calculator. Run your borrower scenario through that residual income calculator, and if that tells you that they’re likely to meet residual income, then they’re very likely to meet ATR requirements in general.
If every lender at least until they get comfortable looking at a borrower and saying, “This guy got a real chance or this guy doesn’t,” if they would start that process of going to the website and run their borrower through that residual income calculator, ones that aren’t even close, then they can walk away from and we’ll never even see them. That enables us to be more efficient as the volume increases for everybody else, so that we’re not spending days screening and trying to work a miracle on somebody that never should have come to us to begin with. It’s certainly better for the borrower because we don’t get their hopes up to that degree. It’s better for the lender because he doesn’t have near as much of that downtime of taking an application, selecting one, taking the property off the market, and running it all to us. We work on it for a week only to say, “There’s no way we can’t do this.” They have to burst that poor family’s bubble and start all over again.
There’s a lot of churn in there because I‘ve done that before. I’ve done a handful of these in the past. I‘ve had some where I threw the package over to the borrower and said, “Fill all this out.” It was the 1003 form and there’s a lot of stuff in there. They fill all that out and then it’s like, “You’re missing this and that.” You get that from them and then you’ll find out it’s not going to work. It’s a lot of churn on everybody. That would help me out a lot. If I had an easy way to pre-screen, I could ask them some simple questions and then I would have an idea that’s going to follow through or not.
To me, as a note investor, I don’t originate that many of these. I don’t know what the Dodd-Frank requirements are. That’s why I throw it over to you guys to let me know. Pre–screening option would make life a lot easier because I do run into that issue. What I usually end up doing is I leave my ads out there. I don’t completely take it off the market but then as people hit me, I go, “We’re under contract. I’ll let you know. If it falls through, then you’re running back to chase down all these other people.” It’s time-consuming.
I‘m trying to look at this from both sides as well. I work for the lender. I want to help you guys become as efficient as possible. It’s also heartbreaking to me when a borrower gets all excited and it made the feel from the lender that, “Congratulations, this is going to be great. Let’s fill out your application and send it in.” For a week, I have to grind and try to turn it into a miracle, only I finally get ahold of a lender and say, “There’s no way.” That poor lender has to go back to that borrowing family that got their hopes up and say, “Sorry, there were some things that we didn’t know that we’ve now figured out. Sorry, this isn’t going to fly.”
As a team, we can do a better job of uncovering those red flags that will be deal–breakers. We can uncover those real early in the process and not get these people’s hopes up to that degree and save us all a lot of time and energy. One of the things that I‘m in the process of doing now, I added an Investor’s link on our website. Now, I‘ve got a Borrower’s link where you would send your borrower to. That link is going to give them all the information they need as well as all of the documents they would need to submit to become a loan package. I‘ve created an Investor’s tab, and I‘m in the process of filling that with all of the tools and materials that I‘m going to recommend to the lenders to use to pre–screen their borrowers.
In the meantime, I do it all day, every day. I‘m happy to entertain an email with questions or a phone call as well. What I typically do if somebody calls me or emails me, I have a standard package that I send them out. I send it directly to them and say, “Read all this and check this out. This will answer everything that you want to know before you screen your borrower.” Over a period of time of doing this, we’re all going to sharpen ourselves up. The percentage of packages that have to be rejected are going to go way down.
That would be nice. As a lender too, it’s always disappointing when the borrower is ready to go. For me, at least in my model, when I get REOs, I like to try to get rid of them as fast as I can. It’s also a bummer because I’m like, “My REO hasn’t transformed into a note as fast as I thought. Now, I’ve got to go back and find somebody else and this may take a little while.”
A few of them that we get in seems like we get them in and we have to sit on them for days because the lender can’t get them to produce the documents that are required. We can sharpen that up a lot on the front end as well so that a package that isn’t even submitted until that lender says, “I know that given the type of income you’re claiming, these will be the documents that are required. It doesn’t even go from you to me until you’ve gotten those documents from that borrower.” That will save everybody a ton of effort.
I‘ve had a hard time as some of the borrowers, you ask them to submit to fill out the packet. You’re like, “I don’t have a computer. I don’t have a printer.” I’ve had them to fill things out and try to take pictures with their phone. They’re all blurry, you can’t even read it. We’ve got to be able to get the information where they fill it out incompletely. I‘ve had them send it back, missing a bunch of stuff, and I go ask them, “Fill in all this stuff.” They fill in some of it but not all of it.
On the website, we’ve got those fillable forms. In some cases, lenders might want to create a system where they’re literally sitting down at a computer in their office with the borrowers and working that application together. It’s an educational process just like you would if you went to a bank. I see on the lenders that have refined a consistent process, their packages are coming in far cleaner than the ones that appear to tell the borrower, “Go find the channel three, get it filled out, and send it into the underwriter. We’ll see what happens.” Most of the time, those are the ones where we end up producing a need’s list this long and have to shoot it back out to the lender and say, “This is going to be on the shelf collecting dust until you can get this stuff done.” A lot of it comes down to how that lender sits down with the borrowers and works that submission package together.
In the perfect world, I don’t know if you could do it yet through your website. It may not work but it would be great to use. There’s a solution where the borrower could do it on their phone. I found everybody has a phone. When I can where I need this general doc signed, I‘ll use RSign or DocuSign to send stuff to people so they can sign it. If they can sign something from their phone, that always goes a lot smoother, I find.
That’s a great point. That’s the beauty of this community where we’re all freelancing and we’re inventing this machine as we go. Inevitably, we will continue to evolve our processes to accommodate the needs of the borrowers out there as well. This is seller finance for a reason. It doesn’t fit all of the rigid strictures of Freddie Mac and Fannie Mae. Given the nature of our demographic, we have to remain a little bit more flexible and there’s got to be a little bit more discretion put into what we do.
A lot of folks are not tech–savvy whenever I‘ve asked anybody to scan anything. That’s always troublesome. I‘ve done that for some of my seller finance where when we got to the end, we need them to be compliant, you usually end up sending a mobile notary with all the docs, have them sign it right there, and then take it back to make sure you can make it better.
I can certainly rattle off a little laundry list of the black and white things anyway that if a lender will keep these in mind, it’s going to clean up the process a whole lot. The number one thing we find on our end that stalls the process is the two–year work history. These borrowers, even though this is more flexible than Fannie Mae and Freddie Mac, they still need to demonstrate a two–year income history. The number one thing by far that stalls our packages is they take a 1003, they fill it out, it gets sent to us and we open it up. Let’s say they’re a W-2 wage earner. We see that they’ve been on their current job for nine months and we don’t see anything before that. We can’t calculate ability to repay off of such a fractioned income period. We expend a ton of time flagging those kinds and then writing back saying, “We’re going to need a two–year work history on this individual.” If lenders on the front end knew right off the bat when you’re screening your borrowers to say, “Will you be able to provide a two-year work history? Did you have adequate income all through 2019? Do you have adequate income all through 2020?” When you get the ones that can’t come anywhere close to providing a two–year income history, they’re not going to make it.
What if they’re self-employed? What if they don’t have a W-2 but they’re a small business owner or something?
It’s easier. Self-employed is easy. We do them all the time. They have an option. They can either provide us previous year’s tax return or they can provide us twelve months of the most current bank deposits. We run a figure on those gross deposits. We subtract out 25% for business overhead and we run them on 75% of their gross. It’s super easy to do. It’s the same thing. Self-employed, no problem. You find out, “Have you been self-employed for the last two years?” If they have, then you tell them, “Here’s what we need from you.” Ideally, we need both so that we can give you the best run for your money. You would tell them, “We’re going to need last year’s tax return. We’re going to need your most current twelve bank deposits.” If you get that on a self-employed borrower, we’re golden. Piece of cake and those run quick and easy. The W-2 wage earners honestly are far harder because if they’re job–hopping, then you’re talking on a wage earner, “We need the two most current pay stubs and we need the previous year’s W-2.” If they’ve had 3 or 4 jobs in a two-year period, that’s a nightmare to try to track down all that stuff and try to construct a two–year income history.
Do they care if they’re working in the same profession?
Yes, that’s ideal. That’s what we want, the same profession. It’s not going to kill a person if they’re a retail worker and they worked at Walmart for five years but then last year, they quit Walmart and they moved to Target. This year, they’re at Target, no problem. All we need is paint a set to your picture that says, “They’re still doing the same stuff. They took an upgrade, that’s all.” You show us your W-2 from Walmart from 2019 and a couple of those pay stubs. You show us your two newest pay stubs now from Target, and we work it from there.
The big caveat is gaps. When they’ve got a big gap in employment, you can know ahead of time as a lender that if they’re going to fly at the very least, we’re going to have to condition a letter of explanation for that gap. Your pre-screening could look like you’re taking their history for a moment and you’re saying, “Have you worked for 24 months steady?” They tell you, “No. I worked last year then I had a four–month gap where I didn’t work, and now I‘m back to working again.” You could know as a lender to say, “That’s going to be flagged by the underwriter immediately. Explain your gap. What did you do? Why was that gap there?”
Most people have a great explanation. Maybe it was COVID or it was a high-risk pregnancy and she couldn’t work because of that. It doesn’t matter whatever the issue is, but you know as a lender that you can get ahead of this rather than having it lag for days. You can get that letter of explanation right in there and right then that covers that gap in employment. When the package comes into us, that gap in employment is already explained and then most of the time, that enables us to connect the dots, so to speak. The ones that hold us up is when they put down in their work history that shows their current job and they’ve been on it for four months and there’s nothing after that. Those sometimes languish in the inbox for weeks.
The other big one is that group of people and you see it quite a bit in seller finance. Let’s say that there’s a reason why most of our borrowers and seller finance didn’t go with a traditional lender and get a regular Fannie Mae, Freddie Mac loan. One of the most common reasons for that is this group of people that are not using banks. They’re handyman under the table and they have no method of documenting their income. If they have no method of documenting their income, this could be drug money from a cartel, we can’t use it either.
As a lender, you want to be savvy enough to explain to your borrowers long before they ever fill out a Channel 3, “I‘ve got to be able to construct a two–year work history for you. You have to have some method of reasonably, reliable, third party records that prove what you’re telling us. If you’re a handyman, no problem. Are you putting it in a bank? Do you have deposits? Do you have invoices that show that you invoiced your work and copies of the checks where they sent them back to you?” No matter how you do it, you’ve got to be able to prove your income somehow. When you see one of those borrowers that can’t, that’s the one that should never even come in a submission package.
In those cases too, they probably weren’t paying taxes. They might enjoy that for a while but there’s always a consequence for that even if you don’t. There are people out there who I consider off the grid, but there’s a price you pay.
To me, that’s what differentiates that stratification layer we were talking about. Here’s the group that the banks want, below them is this group that the banks won’t quite take but we want, and then below that is the group that you want to be able to pre-screen and say, “This person cannot meet requirements.” That would be the group that can’t document their income, the group that hasn’t had the same job for six weeks in four years. They have many starts and stops on their jobs that you can’t even connect the dots when you put it together. If you can’t, we can’t. The other one would be the group that is when you’re asking them questions in the pre-screening, they’ve got current judgments against them like they are in the middle of bankruptcy right now that hasn’t yet been discharged. There are those types as well. It’s amazing how many of those still squeak by and they show up on our desk. We have to put on our investigator hat, start trying to paint the picture, and connect the dots only to find out that, “This one never should have come through.”
They’re a serial BK file or something like that. Max, thanks so much for coming on. I appreciate it. We’ll have to do this more at some point. Hopefully, you ended up doing more of these in the coming year and get deeper into the seller finance world.
In the future, I‘d be happy to do one, if nothing else, where we build some visual charts or something that demonstrate the tools that a lender could use to pre–screen a borrower. We could do ones where we break down income. Income seems to be the big one that trips everybody upon how we vet borrowers, and how we know good income and bad income. On my end, I‘m thinking where we can help this community the most is on the education side.
I’m definitely happy to help you distribute that as you want to put those together if you want to do a webinar. I‘ve got a pretty decent size list of folks who are into this. I’m happy to push that out. I know people are looking for the info. Thanks a lot. I appreciate it.
Likewise, good talking, Dan. I appreciate it.
Important Links:
- Call The Underwriter
- Bob Repass – Previous episode
- Residual Income Calculator
- Investor’s tab
About Max Bailey
Max Bailey has been involved in Real Estate for over 30 years. He began as a Realtor in the early 90’s, and then began buying rental properties after that. He worked full time as a Firefighter/Paramedic for 25 years and continued building a rental property business on the side. He completed a Bachelor’s degree in Business finance and has vast experience with traditional lending. His passion and understanding of the Real Estate markets led him to the author and publish his first book on Rental property buying and management in 2020.
He now brings his 30 plus years of real estate experience to the Seller Finance world and is excited to help sellers create notes that are Dodd-Frank compliant. Max understands the ins and outs of the SAFE ACT and follows a proven process for vetting borrowers and ensuring they meet Ability to Repay (ATR) requirements for each deal. Additionally, Max has a knack for creatively approaching financing challenges; he regularly analyzes borrower’s situations and is able to suggest creative alternatives to help them meet requirements.
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