My Friend’s Mortgage Application Was Denied – Four Alternatives For Moving Ahead

A good friend of mine had a rent-to-own agreement on the house she was living in, but her application for a mortgage was denied so she was unable to meet the purchase deadline.

A rent-to-own agreement is what it sounds like – it looks like a typical lease, except at a specified date, the tenant has the right to purchase the property for an already agreed upon price. For my friend, it was a chance to lock in the sales price while she saved up for the down payment and closing costs. For the seller, he got a buyer – the property had languished on the market until my friend came along.

Unfortunately for my friend, she had some previous financial judgments against her that tanked her mortgage chances. In recent years, she had made good with her outstanding debts, but the last judgment won’t disappear from her credit report for another 13-16 months.

Her mortgage broker suggested she try again at that time. However, the seller doesn’t want to wait another 13-16 months, so he has put the home back on the market. My friend can rent it while it shows, but if another buyer comes along, she’ll have to move and will lose the chance to purchase the house.

Rent-to-own can be costly if you don’t purchase the property

This is a big setback for my friend in terms of time and money. She has already spent 18 months renting the place and had made some fixes in anticipation of moving in.

In addition, she paid $4,000 for her option to buy, which she loses. She also paid a higher monthly rent with the understanding that the differential would be applied to the purchase price, and she loses that too. Finally, there is the uncertainty of when she will have to move, the cost of moving and the cost of setting up at another place.

For all these reasons, she’s keen to still purchase the property before another buyer comes along. However, she doesn’t have the cash to buy it without the mortgage. What are her options? We brainstormed four possibilities:

1 – Move out and start over

There are multiple signs that suggest it’s better to just move out and start over elsewhere.

• Since the seller really wants to sell, my friend can’t get more than a month-to-month lease in her current place, and as a single mom, she needs more stability than that.
• The house needs a lot of work, and the deal falling through might actually be a good thing because it allows her to walk away from a potential money pit.
• With the pandemic and its economic fallout, there might be better deals 13-16 months later when my friend will actually be able to buy.

However, my friend is clinging to this deal in a real-life example of the fallacy of sunk costs.

The fallacy of sunk costs is best explained by the adage, “throwing good money after bad.” Since my friend has already spent several thousand dollars, she’s attached to making the situation work, even though walking away might be the best thing to do.

Unfortunately, the money she already put down for the option to buy is gone – that’s the sunk cost – and to continue to pursue the house, rather than focusing on more feasible and possibly better options, is throwing good money after bad.

2 – Find someone who could buy the property before the deadline and sell it back to her

While my friend doesn’t have the cash to buy outright and can’t get a mortgage, she could find a family member or friend who could buy the property for her.

This Friends & Family buyer would buy the property, enter into a new rent-to-own agreement with my friend, and sell the property back to her once her credit is cleaned up.

In addition to helping out a friend, the buyer could make some money off the deal depending on the initial purchase price, rent collected and selling price on the new rent-to-own agreement. With interest rates so low, a friend with cash sitting in the bank at less than 1% may be perfectly willing to front the cash and collect rent, if that means a higher return.

On the flip side, mixing money and friendship is one way of losing both! There are multiple scenarios where a rent-to-own agreement with a friend can go wrong.

• What if your friend can’t get a mortgage at the purchase deadline? You might be stuck with a property you intended to sell quickly.
• What if your friend loses her job and can’t pay rent? You might have to evict a friend, or subsidize her rent.
• What if your friend wants to move instead of buying the property?

Before going into a financial transaction with a friend, play out all the scenarios. This will enable you to write a rent-to-own agreement that protects both of you.

3 – Have the seller finance the property

Instead of leaning on a friends & family loan for the mortgage, my friend could see if the seller would finance.

Seller financing is one way foreigners buy property in Costa Rica since the banks only lend to citizens. (We opted for a cash-out refinance to buy our first property in Costa Rica and used a solo 401k for our next two properties.) Seller financing is similar to taking a mortgage with a bank, except that the bank or lender in this case is the seller.

There are several reasons why a seller would be willing to finance the buyer.

• If the seller really wants to get the deal done and the buyer can’t get a mortgage, then the seller might hold the mortgage just to make the sale.
• If the seller doesn’t need cash from the sale to pay off a mortgage, then the seller may prefer a monthly stream of income instead of a lump sum.
• Finally, depending on the loan rate, the seller may see financing as a better return on their money than less than 1% on a savings account or the volatility of the stock market.

Of course, the downside is that the seller is relying on the buyer’s creditworthiness and ability to repay.

4 – Find a better property to buy

The first alternative I listed for my friend was to simply walk away from buying the rent-to-own house. This fourth alternative is also about walking away, but specifically to buy something better.

As we looked into the numbers for the original house – the purchase price, plus what it would cost to renovate – I pointed out to my friend that there were already renovated properties on the market for a comparable price. If she could pay more to start, she could move into an already renovated home and skip the hassle of renovating on her own.

Since my friend needs to wait 13-16 months anyway to clear her credit, she may benefit from further price reductions as the pandemic drags on. There may be even better deals when my friend is ready to buy. At the very least, if the market is depressed and the original house is still on the market, she might be able to negotiate a better price than what she would have paid today.

There are always alternatives

My friend was in despair when she first told me her story because she assumed she had to move out.

She briefly thought about a friends & family buyer, but assumed that wouldn’t work, even though a deal like that could be structured to work for both parties and to preserve the friendship. She didn’t think about seller financing or about going on the offensive and finding an even better deal. We only came up with these options when I asked her to come up with at least three new alternatives. Now that we have alternatives, she feels better and is in a stronger position to make a new deal with the seller, if she chooses that route.

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It is hard to get a mortgage right now – see CNBC, Fortune, or Realtor.com. If you are denied in your mortgage application, know that you have options.

Are there other alternatives you have tried?