Vendor Finance. Huonville: 8/16 Main St, Huonville 7109 DX 70754, Huonville PO Box 239, Huonville 7109 Ph:

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1 Vendor Finance Huonville: 8/16 Main St, Huonville 7109 DX 70754, Huonville PO Box 239, Huonville 7109 Ph: Hobart: Level 1, 18 Elizabeth St, Hobart 7000 DX 231, Hobart GPO Box 16, Hobart 7001 Ph: ABN Fax:

2 Contents Introduction... 3 What are the Advantages?... 3 Is it Risky?... 4 What are the risks for the vendor?... 4 What are the risks for the purchaser?... 4 How is the risk managed?... 6 Is a proper agreement the complete answer?... 6 What special terms are needed in a sale agreement involving vendor finance?... 7 What is the best way to document a Vendor Finance transaction? National Credit Code Special Law? Who is the registered owner of the property? Who holds the title deed? When does the agent earn their commission? What will it cost the vendor? What will it cost the purchaser? Would the purchaser get rental assistance? A rental under a lease with an option to buy may be entitled to rent assistance What if the property is damaged?

3 Introduction Sometime purchasers and vendors arrange sales with finance directly between them rather with banks. Purchasers pay off the purchase price by instalments to the vendor, rather than to the bank. Vendor Finance is finance offered by a seller (a Vendor) to finance the sale of goods, services or real estate to a buyer (a Purchaser). Most commonly, sellers offer terms to Purchasers to pay some now, some later. The some now is a deposit, the some later is an arrangement to pay the balance price of the price by instalments. What are the Advantages? Vendor Finance agreements suit some vendors because they allow them to find a purchaser who might otherwise not be able to borrow the money from the bank. This increases the market available and the prospects of sale. Sometimes the purchaser pays a slightly higher price because of the delayed payment. Some vendors are attracted to a return on their investment at rates much higher than if their money was invested with a Bank. Bricks and mortar secure an investment safely and if the vendor already owns the security establishment expenses of the investment are lower. Vendor Finance agreements sometimes postpone payment of the major purchase tax and may lower the purchaser s financing costs. This may free the purchaser s deposit to be applied more to the purchase price rather than to expenses. Vendor Finance agreements may allow purchasers who otherwise might not be able to borrow from the bank, to begin the process of securing their financial future through home ownership. Vendor Finance increases in popularity at those time of the economic cycle when bank lending becoming more restrictive and the banks less inclined to take risk. 3

4 Is it Risky? The parties need to assess their individual risks under the particular arrangement. Often there are good reasons why the bank will not take the risk of lending. The bare existence of risk is not reason itself to reject such a contract. There are risks whatever finance funds the transaction. The risk and benefits need to be weighed up and managed. The sale price, income return or winning a sale may justify the risk. What are the risks for the vendor? Will the purchaser; make the payments as agreed? look after the property? be able to pay the money as agreed? Will there be a capital gain on the sale, if so will the tax be payable on signing the contract and will the vendor then have the means to pay the tax on the capital gain even though funds are still outstanding on the contract? What are the risks for the purchaser? Like a bank loan: A purchaser who takes on more than he can manage could lose out badly. The property could be resold if the purchaser defaults. The purchaser could lose their investment. 4

5 The purchaser need to be sure the funds will be available particularly if there are instalments for a period followed by a payout of the balance in expectation of a bank loan at that stage. The purchaser could lose more than their investment. If the purchaser breaks the deal and the vendor calls off the contract, usually the vendor can resell the property and claim any loss on resale from the purchaser. That loss may be greater than the deposit paid. The purchaser could lose more than the deposit that is paid or should have been paid. The purchaser needs to check what happens to the deposit if there is default. Is it a windfall profit for the vendor? It is fair that the vendor is covered for his loss, but should some of the deposit be refunded to the purchaser? Usually the deposit in a Vendor Finance contract is paid to the vendor rather than held by an independent stakeholder. Depending on the deal, the purchaser may have occupation of the land but the vendor may still hold the title. The purchaser needs to be sure the title is secure. The purchaser needs to make sure the title will be transferred when the final payment is made or the deposit will be refunded as agreed if the sale falls through. If the vendor owes more than the value of the property to the bank the vendor may not be able to answer his obligation to the purchaser. 5

6 How is the risk managed? Because of the extra complexity and the longer period of the relationship, a detailed agreement is vital. The longer the relationship the greater the risk: The greater the risk, the greater the need for care. Sometimes these contracts have extended settlement dates to enable a purchaser to increase their interest in the property sufficiently to borrow from the bank. If final settlement is to be postponed longer than this, say for many years, the risk is greater as the time is longer. A carefully negotiated and recorded agreement and a written document can manage the relationship to reduce the risk. Is a proper agreement the complete answer? The parties need to do more than carefully record their agreement. Both parties need to be aware that their rights under the contract may need to be enforced. This may require court proceedings. Court proceedings may mean costs, uncertainty and delay. If a party has no assets or no money, the other may not be able to enforce the protection given by the legal agreement. No matter how good the agreement or the enforcement rights, you cannot get blood out of a stone. If a purchaser is able to pay a substantial deposit, that deposit is a bond to protect the vendor and the risk is thus reduced. To manage the risk, structure the arrangements so that each party has sufficient monies invested in the property to secure their obligations. Often there are good reasons if a bank refuses to take the risk of lending. Without a sufficient deposit, the vendor has no bond to secure the risk of lending. 6

7 If the vendor owes the entire value of the property to the bank, the purchaser has no bond to secure the purchaser s interest in the property. What special terms are needed in a sale agreement involving vendor finance? The parties need to agree; the purchase price, how the purchase price is to be paid, what will be the deposit paid on signing, will the entire purchase price be paid by instalments, will there be balloon payment to complete the transaction, what household goods are to be included, the amount of the instalment payments, the frequency of the instalment payments, the makeup of the instalment payments, how much of the instalment is by way of capital to reduce the debt owing to the vendor, how much is by way of interest or rent, what part of the deposit is refundable to the purchaser if the transaction fails, when is any real estate commission is paid, who pay rates and land tax pending final payment, what happens to any commission paid to the agent if the contract does not proceed, the tax implications of the payments, 7

8 Can and when can the purchaser claim the First Home Owners Grant Does and when does the purchaser pay the major purchase tax- Stamp Duty When does title pass What security does the vendor have for outstanding payments How secure are the payments by the purchaser if title is yet to pass. The different needs of the parties determine how these variables are resolved. Some vendors prefer a higher purchase price so that the rent payments are lower so they pay less income tax. Some purchasers are happy with this to maximise their deposit for future borrowing. Other purchasers would prefer the lower stamp duty that goes with a lower price. Three Typical Types of Vendor Finance 1. Terms Finance: Where the whole of the price is paid by instalments. The Vendor funds the price by allowing it to be paid by instalments. The Purchaser takes possession once the Contract is entered into. Title (ie ownership) remains with the Vendor until the final instalment is paid (or the loan is refinanced). The Contract period may be long, say up to 25 or 30 years, but generally a Purchaser may pay it out as soon as they are able to refinance, which is often after 2 years. The Purchaser may pays interest at a rate of, say, between.5% and 3% above what the Vendor is paying on their loan. Usually, payment of the rates and land tax becomes the purchaser s responsibility from when they move in. 8

9 Typically the purchaser rather than the vendor is bound to maintain the property under these arrangements. Usually it is not in either party s interest for the purchaser to make structural changes or incur substantial expenditure on the property until after final payment. This form of Vendor Finance is documented by an Instalment Sales Contract, a standard Contract for Sale of real estate can be modified to provide for: - The price is payable by instalments, instead of a lump sum on completion. The instalments are payable regularly, and will include interest. - The time between the date the Contract is entered and is therefore legally binding (called the exchange of Contracts ) and completion of the Contract (also called settlement in Australia and closure in the USA) may be as long as 25 years rather than the 30 days found in a standard Contract. - The Purchaser takes possession of the property, and will be responsible for all expenses as from the exchange of Contracts. The Purchaser must reimburse the Vendor for all Council and Water rates, taxes and other outgoings, the insurance premium, and must carry out all repairs and maintenance from that time to keep the property in good condition. - The deposit paid by the Purchaser may be less than 10% and often include the First Home Owner s Grant. The deposit may itself be paid by instalments, and will be given direct to the Vendor, and not held by a deposit holder until completion. - The Vendor retains legal title until completion. The Purchaser does not have title to the property transferred into their name (and are therefore not the owner ) until the final instalment of the price is paid. 9

10 - Default under the Contract will result in late payment charges. If the Contract is terminated, the deposit and all instalments paid are forfeited to and kept by the Vendor. - The Purchaser can pay out the balance price under the Contract before the due date for completion, but must pay all payments due to that date and an early completion charge. - The Vendor may need to provide a Credit Code Disclosure Statement and a Statement every six months to comply with the National Credit Code. 2. Mortgage Back Finance: The Vendor lends back part of the price under mortgage back finance, transferring the property and taking a mortgage back by return. The vendor loan may be used as deposit finance, where the deposit is funded by the Vendor with an external financier funds most of the price (and takes a first mortgage), and title passes to the purchaser immediately. The Vendor may thus only fund the shortfall between the price and the external finance and takes security for payment by way of a second mortgage over the property. Usually, payment of the rates and land tax becomes the purchaser s responsibility from when they move in. Nearly always the purchaser rather than the vendor is bound to maintain the property under these arrangements. Usually the vendor is not concerned if the purchaser to make structural changes or incur substantial expenditure on the property before final payment, as long the changes are an improvement. Mortgage back finance is documented by a standard Contract for Sale of real estate which has details of the loan agreement and the terms of the mortgage. The loan documentation may need to comply with the National 10

11 Credit Code, and include a Credit Code Disclosure Statement; 3. Lease Option Finance: The property is leased to a purchaser whilst payments are made under an option towards the deposit on the purchase of the property. Often useful where the Purchaser is required to build up a deposit. Whilst a tenancy exists under the Residential Tenancy Act the owner insures, pays of the rates and land tax and maintains. The Lease takes the form of a standard Residential Tenancy Agreement. The rental may be set a little higher than market rent, to cover rates and other outgoings. The Option records the right of the Purchaser to purchaser real estate (what is known as a call option) according to an attached Contract for Sale of Land. The Purchaser may pay an upfront option fee and ongoing option fee payments, which are generally credited to the deposit payable under the Contract that comes into existence if and when the option is exercised. Options (and the Lease which runs concurrently) typically run for between 2 and 5 years. In all three cases For the protection of both parties, the purchaser should make the usual precautionary enquiries before moving in. Usually once the purchaser takes possession they have no rights to complain about the property. What is the best way to document a Vendor Finance transaction? There is no single best type of finance. There is no single best way to document a Vendor Finance transaction. 11

12 Each method is a compromise. The most appropriate compromise depends on the circumstances. Some considerations are: Amount of deposit the Purchaser has available. o The higher the deposit the more likely an Instalment Sales Contract or Mortgage Back Finance will suit. o If the initial deposit is low a Lease/Option may be better. The availability of the First Home Owners Grant. o The Grant is generally payable in the early stage of the Instalment Sales Contract or Mortgage Back Finance, o It is not payable under a Lease / Option Contract until the option is exercised. Stamp Duty is payable by a Purchaser on the full contract Price: o Up front on Mortgage Back Finance, o Only on final settlement of the Instalment Sales Contract and the Lease / Option Contract. Income tax is payable according to the circumstances of the Vendor. o Generally payable according to the tax year of the date of contract for and Instalment Sales Contract or Mortgage Back Finance. o Lease/Option arrangements may defer capital gains tax. 12

13 National Credit Code The National Credit Code applies throughout Australia to regulate consumer lending where: the lender is in the business of providing credit a charge is made for providing the credit the debtor is a natural person or strata corporation, and the credit is provided: o for personal, domestic or household purposes, or o to purchase, renovate or improve residential property for investment purposes, or to refinance credit previously provided for this purpose. There has not been a definitive decision on whether the Code applies to vendor terms contracts. The definition of credit in section 4 of the Code, which defines credit to be the deferral of payment of a debt owed by one person (the debtor) to another (the creditor). This definition presupposes that there must be some earlier point in time at which the debtor would have been obliged to make payment and that the payment has been deferred. Thus, it has been argued that vendor terms contracts are not credit contracts, as no debt arises in any given instance until the instalment becomes due, and at that time there is no deferral of the obligation to pay. Vendors are commonly drafting their contracts on the basis that the Code does apply, just in case. Section 15 of the Code sets out a number of matters that must be included in a credit contract including: the annual percentage rate applicable to the contract; the method of calculating interest, for example, interest is calculated daily on the outstanding balance; 13

14 the amount of repayments or method of calculating the amount; the number of repayments and the total amount of repayments; details of all credit fees and charges; and the frequency with which statements of account are to be provided (unless the annual percentage rate is fixed for the term of the contract). Special Law? By contrast to all other Australian states, the ACT and Tasmania have no legislation dealing specifically with vendor terms contracts. Who is the registered owner of the property? The agreement can provide for the title of the property to pass immediately to the purchaser and a mortgage back to the vendor, or more usually, the vendor remains the owner of the property until the last payment is made. It is probably neater for the registered ownership is passed to the purchaser and the rates of the vendor be recorded merely as a loan in the form of a mortgage. This however means that the transfer costs need to be better up front and there are some extra costs to record the mortgage and its release. Who holds the title deed? If the title is not transferred to the purchaser, the purchaser should lodge a caveat to record against the deeds at the land registry the interest of the purchaser in the property. Where the purchaser is paying significant instalments to the vendor without a transfer of title to the purchaser, an independent stakeholder should hold the title if there is no mortgage. 14

15 If the vendor has mortgaged the property, the purchaser need to know the extent of the bank debt and the bank should acknowledge the rights of the purchaser. When does the agent earn their commission? This is a matter for agreement between the vendor and the agent. Some vendors agree that the finding of the purchaser and the signing of the contract performs the work and the agent is then entitled to a full commission. On other occasions the risk of the matter not proceeding is shared by the agent s commission also being payable by instalments and subject to the matter proceeding. What will it cost the vendor? Circumstances may vary the cost and the fees will be time based. The vendor s lawyer s fee is likely to be approximately $ to $ for the work for the vendor s lawyer s work on the initial stage of review and drafting the agreements, checking the purchaser and the property is in order for the purchaser to take possession of the property and begin payments. The vendor s lawyer s fees at the end of the contract when the final payment is made to the vendor are likely to be $ to $1000. This is an estimate only and because settlement may be delayed for many years, it is not possible to give a firm quotation. If there is a bank involved the usual bank fee will apply. It is usually simplest if everyone pay their own lawyer and the sale price reflects the cost of financing but some parties negotiate for the purchaser to pay the vendor s cost to install vendor finance. What will it cost the purchaser? The same basic fees and taxes are payable by the purchaser when the contracts are installed, whether or not the payment timetable is extended. 15

16 The extra complexity means extra legal work and extra cost. It is necessary for some of the searches to be done twice, once as the contract is signed and repeated when the contract is completed. Circumstances may vary the cost and the fees will be time based. The purchaser s lawyer s fee is likely to cost about $ to $1400 for the work for the purchaser s lawyer s work on the initial stage of checking the agreement and property is in order for the purchaser to take possession of the property and begin payments. The taxes on the initial searches are likely to be approximately $ depending on what searches are required. It is best for the purchaser to register a claim against the vendor s title and there is tax to do so of just under $200. The major tax on purchase is the stamp duty. The duty payable varies according to the value of the property on a sliding scale, the percentage increasing with the price. The rate is about 3 or 4 per cent. Duty, and the Land Registry transfer tax of just under $200, is payable on registration on ownership, or within three months of the date of transfer of ownership. o If the purchaser has an option to buy rather than gives a commitment to buy this tax is postponed until within three months of the date of the exercise of the option. If there is to be bank lending, the cost of establishing that bank lending of course only needs to be paid when it is installed. If bank lending is deferred so to are the costs. The lawyer s costs at the end of the contract when the final payment is made to the vendor are likely to be about $ to $1000. This is an estimate only and because settlement may be delayed for many years, it is not possible to give a firm quotation. This estimate is based on today s procedures and values, which will of course change over time. 16

17 Would the purchaser get rental assistance? Rent assistance is not likely to be available for payments made under contracts for purchase by Instalment Sales Contract or Mortgage back finance. Centrelink regard these contracts as being essentially one of purchase and for that reason will not provide rent assistance for payments made by the purchaser. A rental under a lease with an option to buy may be entitled to rent assistance. What if the property is damaged? The contracts usually have the purchaser bearing the risk of damage to the property. The purchaser should take out insurance. The wise vendor would not rely on the purchaser and the insurance of the purchaser. Wise vendors would have their own insurance cover or at least proof the purchaser has insured noting the outstanding interest of the vendor. Both parties have an interest until final payment. Both parties should insure to protect themselves. This booklet is not a complete statement of the law. It does not deal comprehensively with your particular situation. This booklet is to provide general information to supplement our specific advice to you. Do not act in reliance on this booklet without our specific advice. We are responsible only if you give us specific instructions and for the specific advice we give. This booklet has been updated as at the 10 April It does not reflect changes to the law after that date. You need to take specific advice on the possibility or effect of any such changes. 17