A credit report and telecredit check
A review of a buyer’s creditworthiness requires accurate credit history information on the buyer. Credit history obtained from reporting agencies includes consumer credit reports and telecredit checks.
The telecredit check reviews the buyer’s check writing history and informs the agent if the buyer has written bad checks in the past.
A consumer credit report contains information about a consumer’s creditworthiness or credit score (FICO) standing supplied by a consumer credit reporting agency. The credit application form can require the buyer to cover the cost of the credit report.
A credit report does not assure the future performance of the buyer to repay the note, nor does the report demonstrate the buyer’s ability to pay.
Properly reviewed, a credit report helps to establish the buyer’s past performance paying money obligations as agreed. Money obligations include amounts owed on loans or financing agreements, on judgments or tax liens or for late penalty charges on retail and bank credit accounts.
The credit report is used by agents to establish an individual’s eligibility for:
- credit to be used for personal, family or household purposes;
- employment purposes; or
- rental of a dwelling unit. [CC §1785.3(c)]
When the carryback transaction involves a carryback note of $150,000 or more, a consumer credit report will also contain information not otherwise available in a credit report, regarding:
- bankruptcies predating the report by more than ten years;
- civil suits and judgments predating the report by more than seven years;
- paid tax liens or accounts predating the report by more than seven years; and
- records of criminal activity predating the report by more than seven years. [15 United States Code 1681c(b)]
Carryback sellers seeking credit information must identify themselves to the reporting agency, state their purpose for seeking the information and certify the information will be used for no other purpose than stated. [CC §1785.14]
A listing agent seeking information on a buyer will be refused a credit report unless the buyer signs a release form for the information, a provision typically included in credit application forms. [See first tuesday Forms 203 and 302]
The release requirement is waived if the listing agent or his broker is a member of a credit reporting agency’s credit association. Credit reports are provided at a preset cost-per-request by the agency to the agent or broker member for a one-time membership fee and a minimum monthly billing.
Membership in a credit association requires applicants (agents or brokers) to have their own creditworthiness reviewed by the agency.
The credit reporting agency will provide the necessary notice to the buyer being investigated.
Although necessary for completing a credit clearance, a credit report does not contain information on the buyer’s capacity to pay, called net worth, or his likelihood to commit a crime.
Financial statements for income and worth
Two financial aspects of a buyer’s ability to perform on the carryback note must be investigated by the seller and his listing agent:
- the ability of the property’s income to cover the expenses and carry the debt service if it is income-producing; and
- the ability of the buyer to personally service any negative cash flow resulting from the debt burden or lack of rental income or the buyer’s use of property.
To investigate the ability of income property to carry its debt service, the property’s income and expenses are analyzed using the Annual Property Operating Data Sheet (APOD). [See first tuesday Form 352 and the first tuesday Income Property Brokerage (IPB) analysis program]
If the property’s income is unable to support its operating expenses and debt service, then the seller must look for other abilities of the buyer to carry the negative cash flow brought on by payment of the carryback note.
The buyer’s personal capacity to pay is investigated by a review of the financial statements delivered by the buyer itemizing his income/expenses (profit and loss statement) and net worth (balance sheet).
The buyer’s income includes:
- his base salary;
- overtime;
- bonuses;
- commissions;
- interest earned;
- dividends; and
- rental income.
Income from alimony, child support or other separate maintenance income such as social security and military benefits does not have to be reported on the financial statement if the buyer does not want the income to be considered as available for repayment of the property’s debt.
Personal expenses by a buyer are broken down into housing expenses and all other expenses.
The buyer’s monthly housing expenses include real estate loan payments, rent, property taxes, association charges, homeowner’s/tenant’s insurance premiums and utilities.
When housing expenses are added to all other expenses, such as alimony, child support, income taxes and other installment payments such as credit cards, automobiles, etc., the buyer’s total expenses are determined. [See first tuesday Form 203]
The buyer may be self-employed, or involved in a business, rental or investment activity which provides the buyer with his primary source of income used to establish his creditworthiness. For a self-employed buyer, financial statements such as an operating statement and balance sheet on each business, rental or investment activity are needed to determine any profit or loss and the buyer’s net worth, together with tax returns for the preceding two years, for confirmation of the financial statements. [See first tuesday Forms 207 and 207-1]
Assets of the buyer include cash balances in checking, savings and other accounts receivable. Also included is the current market value of stocks, bonds, personal property, businesses and real estate owned by the buyer. Finally, the current values of vested interests in retirement funds and insurance policies are included.
The buyer’s liabilities include the balance owed and monthly payments on credit cards, open credit lines, alimony and child support. Also, loans secured by assets must be listed as part of the buyer’s liabilities. A buyer’s net worth is the total value of his assets minus his total debt obligations. Net worth is the bottom line shown on the financial statement identified as the balance sheet. [See first tuesday Form 207-1]
Evaluating credit information
Once a listing agent has obtained a buyer’s credit application and financial statements, the data must be evaluated by the agent and seller of the real estate.
When evaluating the information provided on the forms filled out by a buyer, the listing agent and seller must not conduct themselves in a manner which would discriminate against the buyer based on their race, color, religion, sex, sexual orientation, marital status, national origin, ancestry, familial status, source of income or disability of that person. [Calif. Government Code §12955]
The buyer’s representations of employment, cash deposits and loans with existing lenders should be verified by requesting confirmation, as would be done by any mortgage lender or mortgage loan broker originating a loan. [See first tuesday Form 208 through 215-1]
Formulas for determining a buyer’s ability to pay for any negative cash flow generated by the purchase of the real estate are structured as costs of ownership-to-income ratios, referred to as a debt-to-income (DTI) ratio. [See first tuesday Form 230]
For example, the Department of Housing and Urban Development (HUD) and Federal Housing Administration (FHA) ratio of homeownership expenses and debt to gross income is set at no more than 31%. The ratio of total ownership debts and all other installment debt to gross income is set at no more than 38%.
Institutional lenders generally set the ratio of home loan payment to gross income at around 30%, and the ratio of total installments on all debt to gross income at around 40%. However, when applying ratios as guidelines to determine a buyer’s creditworthiness, each buyer needs to be treated individually. A buyer who does not meet the DTI ratio is not necessarily an increased credit risk.
Also, the seller may apply an arbitrary ratio or formula for the buyer’s installment payment burden, such as a three-to-one income-to-note/rent payment ratio, as the only basis of determining the buyer’s creditworthiness, as long as the ratio is uniformly applied to all transactions. [Harris v. Capital Growth Investors XIV (1991) 52 C3d 1142]
Income-to-debt ratios assume all non-conforming individuals are unable to pay installments on their debts based on arbitrary mathematical formulas.
Qualifying ratios cause the more complete credit reviews of a prospective buyer to be sacrificed for a quick and easy test of their financial ability. By the use of mathematical qualifying ratios, some buyers qualify who are not actually good credit risks, and some disqualified buyers are actually good credit risks.
Also, requiring employment to be a qualification for prospective buyers unfairly discriminates against people who receive income from investments, annuities, retirement pay, family support or private subsidies.
Thus, the carryback seller reviews all credit information supplied by the buyer and looks for a reason why the buyer does or does not qualify as a good credit risk for the amount of debt and the payments to be made.
Only after all credit information has been reviewed and creditworthiness has not been established can the seller reasonably cancel the carryback transaction – or renegotiate it – due to the buyer’s lack of credit.
For a discussion on the tax benefits of carrying paper for the seller and the flexible sale terms available to the buyer, see Part I of this article series.
