Creditworthiness in carryback transactions can be a moving target. This article helps real estate professionals determine whether a client is a suitable candidate for a carryback financing transaction.

Broker’s agency duty

The duty owed a carryback seller by their agent to disclose the buyer’s credit status includes:

  • correctly representing the buyer’s ability to pay the obligations undertaken by entering into a carryback note;
  • disclosing relevant information about the prospective buyer’s identity, occupation, employment, income, and credit data as known to the broker and their agent;
  • disclosing the buyer’s existing and future loan obligations, including payment history and any pending bankruptcy known to the broker and their agent; and
  • affirmative advice on any need to conduct a credit investigation.

Also, written disclosures itemizing the buyer’s credit information are mandated on all sales involving one-to-four unit residential properties when the seller carries back a portion of the sales price.

All disclosures need to be made in good faith by the buyers, brokers and agents to meet the objective of the credit investigation. [See RPI Forms 302, 207 and 207-1]

To properly determine the buyer’s ability to repay the debt, the seller’s agent needs to obtain and provide the seller with documentation of the buyer’s income, credit and assets. This includes copies of the buyer’s:

  • Internal Revenue Service (IRS) tax returns;
  • IRS Form W-2s;
  • federal, state, or local government agency benefits and entitlements; and
  • relevant asset information, such as funds held in accounts with financial institutions, equity ownership interests, or rental property.

With this information, the seller makes an informed decision to either proceed with the carryback transaction or cancel it under a further-approval contingency in the purchase agreement. [See RPI Form 158 §8.5]

Any real estate agent who misrepresents a buyer’s credit information or makes false statements to the carryback seller about the buyer’s ability to repay the carryback mortgage is not only liable for money damages, but faces suspension or revocation of their license for committing fraud.

The need for credit checks

The right to obtain credit information also applies to private parties such as carryback sellers. A carryback seller reviews the creditworthiness of the buyer for the same reason a landlord obtains reliable credit information on prospective tenants — to determine if they are willing and able to pay as agreed. Accurate credit information on the buyer is critical for the seller to analyze the risk of default that exists when extending credit to the buyer.

In addition, the seller needs to assure themselves the buyer will maintain the property unimpaired under the carryback trust deed and not commit waste. Thus, if the buyer does not meet all these qualification standards, the seller may justifiably cancel the transaction under the contingency.

The buyer needs to have the financial ability and credit history to pay both the senior mortgage and the seller’s carryback mortgage before the seller approves and closes the sale. Any default by the buyer on the senior mortgage jeopardizes the seller’s security interest in the property under their second mortgage.

The seller’s agent checks the buyer’s creditworthiness and ability to perform by:

  • analyzing the buyer’s application for credit, along with credit reports and a criminal background check [See RPI Forms 203 and 302];
  • reviewing the buyer’s operating statement (profit and loss statement) and a balance sheet (net worth statement), and confirming their bank balances [See RPI Forms 207 and 207-1];
  • contacting the buyer’s creditors (landlords, mortgage holders) and document their experiences with the buyer’s payment history; and
  • inspecting properties owned by the buyer to determine the level of care and maintenance the properties receive under the buyer’s ownership and management.

All carryback sellers face the risk a buyer will default, no matter how wealthy, conscientious and qualified the buyer appears to be.

On any default in payments on a carryback mortgage, the seller’s sole source of recovery is the mortgaged property, unless the mortgage is subordinated to a construction loan or additionally secured by property other than the property sold (as it then becomes recourse debt).

Even an existing mortgage holder has a right to obtain credit information from the buyer on a change of ownership. The mortgage holder, like a carryback seller, needs to make an informed decision as to whether the risk of default in the payments or care and management of the property will increase under the new ownership, called impairment.

The creditworthiness contingency

A seller’s agent has the duty to obtain credit information from a buyer and disclose any material facts known or readily available to them about the buyer which might affect the seller’s decision to carry back a mortgage on a sale.

Also, for the seller’s agent to properly disclose the separate financial, tax and risk-of-loss aspects to a seller, a carryback disclosure statement needs to be attached to any purchase agreement which calls for a carryback mortgage.

The carryback disclosure statement is mandated on the sale of a one-to-four unit residential property. However, a prudent seller’s agent will also include a disclosure statement in carryback transactions on all types of property. [See RPI Form 300]

Both the carryback disclosure statement and the purchase agreement include a credit approval provision known as a further-approval contingency. The credit approval provision calls for the buyer to hand the seller a completed credit application. [See RPI Form 302]

A prudent buyer’s agent preparing a purchase agreement calling for seller financing will have their buyer fill out a credit application prior to commencement of negotiations and attach it to the buyer’s offer as an addendum. Early disclosure helps the seller determine the buyer’s sincerity and good-faith willingness to cooperate in the credit analysis process.

A review of the buyer’s financial statements and the verification of earnings and funds by the seller’s agent are completed during the contingency period. [See RPI Forms 208 through 213]

Cancellation on disapproval

The credit provision also allows the carryback seller to terminate the purchase agreement by a written Notice of Cancellation if they disapprove of the buyer’s creditworthiness. [See RPI Form 150 §10.5]

However, the credit contingency does not give the carryback seller the unrestricted right to withdraw from a binding and otherwise enforceable purchase agreement without good cause.

Consider a carryback seller who enters into a purchase agreement containing a credit approval contingency provision giving them the right to cancel the transaction based on the buyer’s lack of creditworthiness.

During the contingency period and before the seller approves the buyer’s credit, the seller changes their mind about selling the real estate. They decide to cancel the transaction by using the credit contingency as a “back door provision” in an attempt to escape enforcement of the purchase agreement. The seller has no grounds for disapproving the buyer’s credit since they have received no derogatory information about the buyer’s creditworthiness or ability to perform on the purchase agreement or the carryback note.

The seller has to have good reason to disapprove the buyer’s credit and cancel the transaction. Any reason to cancel the transaction needs to relate to the unacceptable status of the buyer’s creditworthiness under the credit contingency provision. Without good reason, the seller who cancels has breached the purchase agreement in bad faith.

The consumer credit report

A review of a buyer’s creditworthiness requires credit history on the buyer from a consumer credit report.

A consumer credit report contains information about a buyer’s credit standing supplied by consumer credit reporting agencies. The credit application form may require the buyer to cover the cost of the credit report. [See RPI Form 202]

A credit report does not assure future performance by the buyer to repay the mortgage, nor does the report demonstrate the buyer’s ability to pay.

Properly reviewed, a credit report helps to establish the buyer’s past performance in repaying money obligations. Money obligations include amounts owed on:

  • loans or financing agreements;
  • judgments or tax liens; or
  • retail and bank credit accounts.

The credit report is used to establish an individual’s eligibility for:

  • credit for personal, family or household purposes;
  • employment; or
  • rental of a dwelling unit.

When the sales transaction involves a mortgage of $150,000 or more, whether originated by a lender or carryback seller, 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, and records of arrest predating the report by more than seven years;
  • paid tax liens predating the report by more than seven years;
  • accounts placed for collection or charged to profit and loss predating the report by more than seven years; and
  • records of criminal activity predating the report by more than seven years.

Income and net worth

For income-producing property, two additional financial aspects of a buyer’s ability to perform on the carryback mortgage need to be investigated by all principals and agents involved:

  • the ability of the property’s income to cover the expenses and carry the debt service; and
  • the ability of the buyer to personally service any negative cash flow resulting from the debt burden, lack of rental income or the owner’s use of the property, called implicit rent.

To investigate the property’s ability to carry its debt service, the property’s income and expenses are analyzed by using the Annual Property Operating Data Sheet (APOD). [See RPI Form 352]

If the property’s income is unable to support its operating expenses and debt service, the seller and their agent need to look for other abilities of the buyer to carry the negative cash flow caused by the debt.

The buyer’s personal capacity to pay is investigated by a review of financial statements delivered by the buyer itemizing their income, expenses and net worth.

The buyer’s income includes their:

  • base salary, overtime and bonuses;
  • commissions;
  • interest earned;
  • dividends; and
  • rental income.

Income which does not have to be reported on financial statements, if the buyer does not want it to be considered as available for repayment of the debt, includes:

  • alimony
  • child support; or
  • other separate maintenance income such as social security or military benefits.

Buyer’s expenses

The buyer’s personal expenses are classified as:

  • housing expenses; or
  • all other expenses.

The buyer’s monthly housing expenses include:

  • mortgage payments;
  • rent;
  • property taxes, including Mello-Roos and special assessment bonds;
  • homeowners’ association (HOA) charges;
  • hazard, liability and renter’s insurance premiums; and
  • utilities

The buyer’s total expenses are determined by adding housing expenses to all other expenses, such as:

  • other installment payments, such as credit cards and auto loans; and
  • alimony and child support. [See RPI Form 203]

Conversely, the buyer may be self-employed, or involved in a business, rental or investment activity which provides the buyer with their primary source of income.

For a self-employed buyer, financial statements, including profit and loss statements and balance sheets on each business, rental or investment activity, are needed to determine their income and net worth. Financial statements coupled with the previous two years’ tax returns confirm the information on the financial statements. [See RPI Forms 209-2 and 209-3]

Assets minus liabilities equal net worth

When determining the buyer’s net worth, the buyer’s assets and liabilities are analyzed on a financial statement.

The buyer’s assets include:

  • cash balances in checking, savings and other accounts receivable;
  • the current market value of stocks, bonds, personal property, businesses and real estate owned by the buyer; and
  • the current values of vested interests in retirement funds such as 401Ks and IRAs and insurance policies.

The buyer’s liabilities include the balance owed and monthly payments on:

  • credit cards;
  • open lines of credit;
  • alimony and child support; and
  • loans secured by the buyer’s assets.

A buyer’s net worth is the total value of their assets minus their total debt obligations or liabilities. Net worth is the bottom line shown on the financial statement entitled the balance sheet.

Evaluating credit information

Once a seller’s agent has obtained a buyer’s credit application and financial statements, the data needs to be evaluated by the seller and their agent.

When evaluating the financial and credit information received by the buyer, the seller’s agent and seller are not to conduct themselves in a manner which discriminates against the buyer based on their:

  • race, color, religion, national origin, or ancestry;
  • sex, gender, gender identity, gender expression, or sexual orientation;
  • marital status or familial status;
  • source of income; or
  • disability or genetic information.

The buyer’s representations of employment, cash deposits and loans with existing lenders need to be verified, as is documented by any mortgage lender. [See RPI Forms 210 through 215-1]

Formulas for determining a buyer’s ability to pay for any negative cash flow generated by the purchase of the property are structured as expense-toincome ratios. [See RPI Form 230]

The carryback seller needs to consider all credit information supplied by the buyer and look for a reason why the buyer qualifies as a good credit risk.

Only after all credit information has been reviewed — and creditworthiness has not been established — may the seller reasonably cancel the carryback transaction due to the buyer’s lack of credit.