How Does the Dodd Frank Act Affect Seller Financing for Investors?

If you’re in the real estate industry, then you are probably familiar with the Dodd Frank legislation that went into effect on January 10, 2014. Dodd Frank and the Consumer Financial Protection Bureau were enacted to protect consumers from the predatory loan practices of institutions and lenders. While seller financing is only a small fraction of the legislation, it has greatly impacted investors who turn to seller financing and selling real estate notes as an exit strategy. Short-term seller financing is a vital part of many investment businesses, and the new legislation has impacted the way investors must structure those kinds of deals.

Investors face significant changes to seller financing

The Dodd-Frank restrictions on seller financing have been most limiting for investors who finance multiple properties per year. Here are some of the major changes to seller financing brought on by Dodd Frank (with exceptions):

1. Lenders must consider the borrower’s ability to repay the loan

2. Lenders must consider at least 8 factors applied against reasonable underwriting guidelines

3. The lender must write a qualified loan

4. Lenders must wait at least 120 days of delinquency before foreclosing

5. Prohibits builders from selling with owner financing

6. Eliminates balloons and negative amortizing loans and requires fixed rates for 5 years with no prepayment penalties

7. Combined with the SAFE Act in several states, Frank Dodd requires seller finance transactions to be originated by Residential Mortgage Loan Originator (licensed in that state in which the property is located)

8. Forced arbitration clauses are not allowed in the buyer’s note

Three owner-occupant groups under Dodd Frank

The Dodd Frank law separates sellers into three separate groups and has specific guidelines for each group. These guidelines only apply to seller financing to an owner-occupant in a 1-4 family property. They do not apply to lending a commercial property or to an investor who is not going to occupy the property over 1-4 family units.

1. Individuals and Trusts that seller finance one property or less per year

Under this group, the note can contain a balloon payment, and the seller does not have to prove the buyer’s ability to pay. The interest rate has to be based on the index and be fixed for the first 5 years. After the first 5 years, the interest rate can only change 2 points per year to a maximum of 6 points above the original rate.

2. Individuals and Trusts that seller finance one to three properties per year and a LLC, partnership or corporation that seller finances less than three properties per year

Under this group, the note cannot contain a balloon payment, which can be problematic for investors who don’t want to hold the note over the whole amortization schedule. The seller has to prove the borrower’s ability to pay. The interest rate must be based on an index and be fixed for the first 5 years. After the first 5 years, the interest rate can only change 2 points per year to a maximum of 6 points above the original rate.

3. Any individual or entity that seller finances more than three properties per year

The loan requirements for this category are the same as the previous group, but a Mortgage Loan Originator is required to be involved to complete the transaction.

To make sure you are adhering to the new Dodd Frank regulations, it’s smart to consult a good lawyer and/or mortgage loan originator to oversee your deals before brokering or purchasing a loan on the secondary mortgage market.

When Does the Dodd-Frank Act Apply to Residential Mortgage Loans?

The Dodd-Frank Wall Street Reform and Consumer Protection Act applies to seller-financed residential mortgage loans when the buyer intends to live on the property—specifically, when the loan involves a 1-4 unit dwelling used as a primary residence. In these cases, seller financers must follow Truth-in-Lending Act rules and meet the disclosure requirements and underwriting standards outlined by the Consumer Financial Protection Bureau.

This means the seller must determine in good faith that the buyer has the reasonable ability to repay. The loan must follow specific credit terms: it must be a fixed rate or an adjustable rate that is fixed for five or more years, and any interest rate increase must be subject to reasonable annual and lifetime limits—typically no more than a rate increase of 2 points annually and a maximum increase of 6 points over the original rate.

These Dodd-Frank requirements do not apply if the buyer is purchasing for investment purposes, or the property is not intended for personal residence. In addition, exemptions apply to sellers who provide financing for only one property per 12-month period, though even then, the loan must meet certain structural standards, like avoiding negative amortization.

If you’re a seller financer providing financing to a buyer who will live in the home, the Dodd-Frank Act likely applies. To ensure full compliance with these federal lending act rules, work with a licensed mortgage originator or qualified legal professional.

Cited article sources

1. CFPB Consumer Laws and Regulations SAFE Act. Retrieved from:

https://files.consumerfinance.gov/f/201203_cfpb_update_SAFE_Act_Exam_Procedures.pdf