The problem with buying a property at a below-market price is that
lenders tend to "penalize" you with their loan regulations. Fannie Mae
conforming loan guidelines usually require that an investor put up 20%
of his own cash as a down payment. The 20% rule applies even if the
purchase price is half of the property’s appraised value. Thus,
the loan-to-value (LTV) rules are based on appraised value or purchase
price, whichever is less.
A common, but illegal, practice is for the buyer to put up the down
payment and for the seller to give it back to the buyer after closing
"under the table." An even dumber method is to over-appraise a property,
effectively financing a property for 100% of its value. People may get
away with it all the time, but these practices are loan fraud,
punishable by a nice vacation at Club Fed.
A Real-World, Common-Sense “Nothing Down” Deal
As you can see, there are smart and not-so-smart ways to
buy “nothing down”. The following is an example based on a real deal I
helped a student of mine put together:
Sandy is interested in purchasing a home to live in, but she doesn’t have
much cash. She just started her own business and cannot not qualify for a
conventional or FHA low-down payment loan. Sandy finds a seller with a nice
property, with very little equity, but a low-interest rate loan. Sandy
leases the property from the owner for three years for $1,200 per month,
with an option to buy at $162,000. The house is currently worth $179,000.
The seller agrees to the discounted price because he saves a real estate
commission and can wrap up the deal quickly.
The agreement provides that the seller give Sandy a 25% ($300) credit
towards the purchase price for each rent payment Sandy makes. Sandy also
puts up $1,200 as a security deposit, which will be credited towards the
purchase price when she exercises her option to purchase the property.
After 12 months, the property has appreciated in value to $189,000. Or, if
the property values do not increase, Sandy has made improvements to the
property that increased its value. In addition, Sandy’s “equity” has
increased because of the $300/month rent credit. Thus, after 12 months,
Sandy’s equity position is $31,800:
$162,000 original option price
less $ 3,600 rent credit
less $ 1,200 security deposit
------------------------------
$157,200 “strike price”
$189,000 market value
minus $157,200 strike price
---------------------
Equals $31,800 “equity”
Sandy exercises her option to purchase the property at the
“strike price” (original option price, less credits).
The Lease/Option “Refi”
In funding a loan to buy the property, most lenders would consider this
transaction a purchase, and base their LTV requirements on the option strike
price ($157,200), not the appraised value ($189,000). So, if Sandy were to
borrower 90% LTV, most lenders would have happy to give her .9 x $157,200,
which is $141,000 (which is actually about 75% loan-to-value). In
short, the lender is treating the exercise of a purchase option the same as
a home purchase, effectively "penalizing" the buyer.
A small number of lenders will treat Sandy's transaction
as a refinance, in which case the LTV is based on the appraised
value, not the option strike price. So, a 90% LTV refinance would allow a
lender to give Sharon .9 x $189,000 = $170,100, which would cover the strike
price ($157,200) and the loan costs (approx $4,000). In fact, Sandy would
have enough cash left over to buy new furniture. Or, Sandy could simply
borrow less, having a lower monthly payment. Either way, this is solid,
“nothing down” deal.
Note that a lease/option “refi” is not an ordinary transaction, so be
patient if you are looking for a lender that will fund in this manner; it
will take a lot of phone calls!
