Short-Term Greedy: Subject-To Financing Gone Wrong

One of the most important lessons I learned from the book The Richest Man in Babylon – was the lesson that you must always keep your promise. This also means that before you make a promise, you must be in a position to keep your word no matter what happens. In my previous post about an investor's Subject-To Deal – he made a promise to the seller when he set-up the deal to continue to pay his mortgage. In real estate, stuff happens all the time. It happened to the investor in Austin, TX I wrote about.

Subject To Financing Agreements

Getting into agreements where you know that there is a high propensity for failure just because of the opportunity to grab fast, easy cash upfront is an example of short-term greedy, and short-term greedy strategies rarely end in win-win scenarios. Let’s see how his example easily fall apart.

As I said, the investor received $10,000 as a down payment. Like most of these no money, no credit investors, this investor got into this type of transaction because he had no money; and because he had no money, he used that $10,000 as income or personal revenue.

This action now means that if the new buyer defaults, the investor has no protection and no way of keeping his promise to the original owner. If the house is one of the 7 in 10 that defaults, the investor must come out of pocket for the monthly mortgage—money he doesn’t have. Spending this down payment money and not having any reserves is as safe as playing a game of Russian roulette.

What the investor should have done is taken the down payment of $10,000 and set aside four months of mortgage payments plus make-ready expenses and kept it in an account in case the new buyer defaulted. The investor has promised the original seller that he will cover the mortgage payments of the existing note until the note is refinanced. When investors make promises, they must be ready and willing to keep them.

Subject To Trouble Begins

Here’s where trouble begins. One year later, the new buyer misses a payment. The investor calls the new buyer and the new buyer says she just lost her job and is struggling but has some good job leads and will hopefully catch up the payments at the end of the month. Now the investor has to make this house payment.

The investor in this case is a good guy with a wife and two kids living off these types of deals. He got involved in this transaction with all the right intentions to perform. However, he has no cash reserves and cannot afford to make the payment for the seller if the buyer continues to default. That $10,000 earned last year was spent last year.

The bank won’t notify the seller nor will the seller’s credit be affected for thirty days, so maybe the new buyer will come through and no one will have to know.

The end of the month comes, and the buyer still hasn’t found a job. She can’t make this month’s mortgage but she will have a job soon and is taking a loan from her parents. “Please, please, please, move this one missed payment to the back of the note and everything will be caught up next month,” she begs.

The investor believes the new buyer because he wants to believe the new buyer. But the investor, with no cash reserves in place, has a tough financial decision to make: either pay the seller’s mortgage or pay his own mortgage. The investor did not anticipate having to keep money in reserve to pay for both. What does this husband and father of two choose to do? In this scenario and in many other scenarios like it, he chooses to take care of his family over the original seller and pay his own mortgage.

Now he is thirty days late on his obligation for the mortgage he promised to pay for the original seller. The investor didn’t get into this deal to screw the original seller, but times are tough and he has to take care of his family. He’s just making one little tough decision, but when the buyer comes through next month, everything will be taken care of and the seller won’t have to know, right?

Subject To Financing Default

The next month comes, and when it’s time for rent, no check comes in. The new buyer isn’t answering her phone. It’s now the fifteenth of the month. The bank is calling. The note is sixty days past due. The bank is calling the note due. The investor is in panic mode. Finally, by the end of the month, the investor drives to the property and talks to the buyer. She hasn’t found a job and couldn’t get a loan from her family. She’s just going to give the deed back to the investor and move on with her life.

The note is now ninety days late. The bank is calling the investor every day. The investor cannot pay both his mortgage and the seller’s mortgage. The investor has rationalized that he’s doing the right thing putting his family first. He, however, hasn’t communicated with the original seller yet to tell him this. The investor panics and does nothing. After four months, the property is sold at auction.

The consequence to the seller is that his credit score is damaged. It has fallen 200 points due to missed payments and now he has a foreclosure on his record, which will haunt him for the next seven years. His insurance rates have increased. His credit card limits have been cut and his APR has mysteriously been raised.

Subject To Financing Seller Consequences

The house, which had a mortgage with the bank for $126,000, sold at auction for $100,000, causing a deficiency of $26,000. The original seller is notified by the bank that the bank is suing him for deficiencies for the difference of $26,000. The seller is mortified as he had no idea that his mortgage wasn’t being paid. He sold the deed, but the debt obligation was still in his name. Now he’s being sued.

To make matters worse, anytime a bank writes off debt, it has to notify the IRS. The IRS then sends the original seller a 1099C form, which shows that the $26,000 is counted as income. Even though the homeowner never received financial benefit from the sale, the forgiveness of debt is counted as income by the IRS. This person makes $80,000 per year. With this additional “income,” he is now in the 28% tax bracket and is on the hook with the IRS for an additional $7,280.

No money, no credit strategies have a failure rate near 70%  for one main reason: the short-term greedy philosophy of all parties involved. Anytime the short-term greedy philosophy permeates a decision, it will have a high failure rate.

If all people and businesses would focus on the long-term ramifications of creating mutually beneficial business transactions, then this country would not be in the tough economic situation that it currently faces. Instead of focusing on the short-term greedy approach, this country would be better off with a Long-Term Greedy mind-set.