Sellers often find there is a difference between the appraised value of a home and its potential market, or selling price. This creates a problem, since a low appraisal will limit mortgage financing.
Suppose a seller has a home with a market value of $60,000 and an existing mortgage of $40,000 that can be assumed. The house is appraised at $55,000. From the lender's viewpoint a mortgage based on the appraised value of the home represents a good risk. For a conventional loan with 20 per cent down the lender will provide a $44,000 mortgage if the buyer will put up $11,000 in cash.
With private mortgage insurance, changes in the money market, or through the federally-backed programs the amount down and the rate of interest will change but only on the basis of the $55,000 valuation.
At this point two factors become important: buyer demand and seller flexibility. If a buyer believes that a property is worth more than the appraised value, the best way to increase buyer demand is to either have several buyers competing for a property or to create the illusion of competition. A seller, after all, can always suggest that there may be a better offer in the future.
Sellers in this example know that the $55,000 appraisal figure is easily obtainable with standard financing. The real question concerns money above the $55,000 plateau. To get additional profit sellers will have to determine their level of flexibility. Do they require all cash from the sale? Can they accept a second trust? Is there a combination of cash and financing from which sellers can benefit?
There are several different methods to "beat" the problem of a low appraisal. Consider these alternatives for the case above:
The buyer assumes the old mortgage and pays the balance in cash.
The buyer assumes the old mortgage and the seller takes back a second trust. In effect the seller finances the deal by making a loan to the buyer. Typical second trusts have equal monthly payments for several years and then a balloon, or lump sum, payment is due.
The buyer obtains new financing based on the $55,000 valuation. The balance of the $60,000 purchase price is then paid with cash or a second trust note.
The buyer assumes the old mortgage or gets new financing. The balance of the deal is then divided between a cash payment from the buyer and a note from the seller.
The buyer and the seller have equally desirable properties which they trade. If this is an exchange of like values there may not a be a tax in this case. Check with a CPA or tax attorney prior to such an exchange.
A seller's flexibility will largely be determined by the need for cash. If a seller has a strong cash requirement, say for the purchase of another home, it may not be possible to offer a second trust. However, a second trust may represent "extra" profit if the best alternative deal is to sell a home at a lower value.
Second trusts can be used to create income for the seller, as a selling device to build a more acceptable deal, and in some cases to postpone taxation. Sellers should also be aware that second trusts have a higher level of risk than first mortgages and a low level of liquidity. A second trust with a face value of $10,000 may have a substantially reduced cash value on the open market.
It is in a seller's best interest when offering a second trust to require some cash payment from the buyer. In the event of default the value of the seller's note will then be protected by the cash investment of the buyer, principal reductions, and rising worth of the property caused by time and inflation.