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The no-mortgage house -- it can work,
but you're swimming in shark-infested water

When NOT to refinanceBanks? Mortgage lenders? Brokers?

Who needs 'em.

Home buyers without strong credit, a sizable down payment or any of the other things it takes to qualify for conventional loans can use any number of nontraditional methods to purchase property. Same goes for those who don't want to deal with traditional lenders.

Lease-with-an-option plans, contract for deed schemes, seller financing -- are all possibilities for bank-wary consumers.

But people who choose them instead of traditional mortgages need to tread carefully. Often they'll be dealing with private investors, real estate brokers and sellers who know more about these complicated plans than they do.

Consumers who don't take steps to protect themselves from being taken advantage of could get wiped out.

"Homeownership is really the very best thing a family or individual can do for themselves. I really strongly believe in that and if you have to get a little creative to become a homeowner, I'm all for it," says Rick Harper, director of housing for the Consumer Credit Counseling Service of San Francisco.

"But we strongly advise homeowners who are considering any of these seller-financing, lease options to get proper advice before they enter into these arrangements fbecause they're out of the norm and they're different.

"If you go through a screwy way to get a property, you can get burned without some proper advice."

The road less traveled
For most buyers, purchasing a home involves walking a well-trodden path: Contact a real estate agent, look at properties, research lenders, make an offer, obtain a mortgage and close.

Regardless of whether the consumer chooses a mortgage broker, bank or Internet lender, the financing process varies little, too. Lenders check borrowers' credit, verify their employment and request several months' worth of tax forms and bank receipts. In the end, the lender gives the customer pretty much the same loan it gave yesterday's borrower and will give the borrower who walks in the door tomorrow.

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But many consumers don't like being put through the qualification wringer and sharing their standard deductions with loan originators, underwriters and file clerks. Others need specialized arrangements that help them buy on their terms, not the banks'. Still more potential buyers have credit problems and debt loads that would get them laughed out of a lender's office.

For these people, nontraditional purchase methods are either the best, or only, option.

"Every transaction is unique because the needs of the parties are different," says Doug Ottersberg, a private real estate investor with Creative Homebuyers Inc. in Santa Fe, N.M. "Traditional methodology calls for putting down 20 percent, going to the bank and getting the mortgage. But that doesn't always work for everybody."

Buyers have several ways to purchase without a standard bank loan, each of which has benefits and drawbacks. Some of the more complicated plans go by different names in different parts of the country, but the most popular ones are generally called lease options, contracts for a deed, or installment contracts and seller financing.

Consumers can also pay all cash, assume the seller's mortgage or borrow from a relative.

The lease option
A lease option combines features of buying and renting.

The buyer leases the home from the seller under a contract that spells out how much the monthly lease payments are and for how long the buyer will make them. A portion of each payment generally goes into a type of savings account for use toward purchasing the home, which the buyer has the right, but not the obligation, to do at the end of the lease term.

The buyer pays a "consideration" up front for that right and forfeits the money if there's no transaction at the end of the lease period.

"It's great for people who don't have a lot of cash, No. 1. And No. 2, they get to wear the house before they buy it," says Harper. "It gives them the opportunity that most homeowners don't have: You get to move in, you get to live there for a year and if you like it, you buy it. If not, you can walk away from it."

Contract for deed
Contract-for-a-deed plans operate like car loans. The buyer moves in and makes payments to the seller for a number of years spelled out by private contract. If the seller still has a mortgage on the home, the payments generally go to a neutral third-party agent, such as an escrow company, who then forwards them to the sellers' mortgage holder. At the end of the term, the buyer gets the deed to the home the same way car buyers get their titles once they've paid off their lenders.

But buyers who default before they fully own their properties can be treated like tenants and evicted.

"The whole concept is this: you're the seller and I'm the buyer. I want to buy the house and I want to make monthly payments, but you as a seller say, 'I want to stay in control of this deal so in case something happens, I don't have to go through a foreclosure process,'" Ottersberg says.

"Instead of me deeding the title to you, let's you and myself open up an account at an escrow company. I'm going to make a deed out to you. We're going to put it into escrow. You're going to make monthly payments to escrow. If you as a buyer do everything you're supposed to do, when you make the last payment, the escrow company will say, "You have made all your payments, here's the deed.'"

"Now you can go down and record the deed and you own the property."

One on one
With seller financing, the current owner acts like a mortgage lender. A seller who owns a home free and clear might deed the property to the buyer and become a regular first mortgage holder, allowing the buyer to make payments for several years based on any interest rate the two parties set.

In other cases, a buyer can qualify for some financing but not enough. On a $100,000 home, the buyer might have $5,000 to put down and can get an $80,000 loan but not a $95,000 one, for example. In those instances, the seller can agree to "carry back" a $15,000 loan for the remainder of the purchase price. The seller becomes a second mortgage holder against the property, leaving the buyer owing payments to the bank on the $80,000 loan and payments to the seller on the $15,000 loan.

Buyers with enough cash can save money by foregoing a mortgage altogether and just paying cash. That's because sellers are generally willing to cut their asking prices in all cash deals -- especially if they need to sell as soon as possible -- because closing takes much less time.

A buyer may want to ask a seller if the current mortgage is assumable, too. If it is, and if it was made when interest rates are lower than they are now, that can help the buyer cut financing costs while avoiding the hassle of dealing with a new bank or lender.

People with rich enough relatives can even borrow from grandma. That's because a family member can pay a seller cash and then collect payments from a relative, just like any other lender cuts a check to a seller and then collects payments from a borrower.

Extreme caution
While experts say that these plans can help boost homeownership, they caution that consumers need to watch their back whenever they venture outside of the traditional lending world.

Buyers can't complain to bank regulators if they get ripped off, for instance, and sellers have significant leeway when it comes to setting terms on private contracts. That's because many buyers who turn to nontraditional methods do so because they have no other choices.

An unscrupulous lease-option seller could demand a very expensive option consideration from an uneducated buyer who doesn't know any better.

Somebody could draw up contract-for-deed documents that state the buyer can be evicted, even after several years of payments, if that buyer misses just one or two payments.

A lease-option seller could go out and get a home equity loan during the lease period, too, thereby clouding the title before the buyer actually gets a hold of it.

In a worst-case scenario, a lease-option seller might take advantage of an unsophisticated buyer by refusing to use an escrow company to collect the lease payments. The seller could just pocket the buyer's money and let the mortgage go into default. Since foreclosure takes a while, the buyer could end up making payments for months, the seller could just walk away with several hundred or thousand dollars in profit and the buyer would end up with no house at all because the seller's bank would repossess it.

Get professional help
Experts recommend that nontraditional buyers hire competent attorneys or real estate agents to review any contracts before they sign. That should keep people from regretting their decision to buy without using a bank.

"Regarding virtually any type of transaction where you step away from the conventional mortgage sources where you get a deed, there's a whole variety of pitfalls," says Jim Piper, a real estate investor in Kansas City, Mo., who purchases properties and does lease options and contract-for-a-deed plans with buyers.

"If they're not a sophisticated buyer, they need to have an attorney -- for sure."

-- Updated: Jan. 19, 2001
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See Also
Assumable mortgages back in style (4/6/00)
New year mean new mortgage rules (12/21/00)
No-mortgage home-buying strategies (8/24/00)
Now's the time to house shop (11/23/00)


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