Sellers who are financing the purchase of a home can use this calculator to help buyers figure out how much they will owe on the property at the end of the seller-financed period of the loan. Seller financing is common for buyers who either have problem credit or lack the savings needed to make a substantial down payment & need more flexible underwriting guidelines than are typically found on conforming mortgages. Said buyers can then shift from interest only payments, less than interest payments, a balloon loan or regular fixed-rate amortizing payments to a traditional mortgage at some point in the future.
Some mortgages like FHA loans may be fully assumable. Other loans may allow resale while some have an alienation clause which prevents the seller from reselling the property without paying off the note in full. Instruments are typically recorded in public records to protect both parties from disputes. PMM loans typically charge a higher rate of interest than rates offered by commercial banks.
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Seller Financed Mortgages
As the name implies, seller financed mortgages are when the buyer contracts their mortgage with the property owner directly. The property owner acts in place of a traditional lender, like a bank, and collects payments monthly while assuming the inherent risks of default.
While rare in the field of home mortgages, seller financing can be strategic for both parties when there is a clear understanding of the pros, cons, risks and potential benefits to expect.
How It Works
- A seller agrees to offer mortgage financing to qualified buyers, typically advertising this option in the listing.
- An APR is set, either with or without a down payment. It will vary by seller and offer. Expect the APR to be slightly higher than a traditional lender, to offset the seller’s risk. Expect an adjustable rate or fixed rate with a large balloon payment due on any agreement. Shorter term loans (7-10 years) are common. Down payments and specifics will vary.
- Legally binding paperwork is drawn up, usually using the services of a real estate attorney. It will include a promissory note (signed by both parties and detailing the specifics of the loan) and filing a mortgage (or deed of trust, depending where you live) with the public records authority.
- The buyer moves in and directly pays to the seller a monthly installment on the loan, assuming the responsibilities associated with ownership.
Loans of this kind are generally meant to be short-term, with a balloon payment due after five to seven years. The balloon payment is in place earlier to protect the seller’s investment. The thinking is, during these years the buyer will be able to refinance the loan with a more traditional lender and avoid making the large balloon payment.
A seller usually does not really want to hold a loan for 30 years like a bank. Seller financing is meant more as a short-term solution to help buyers, often with challenged credit, be able to get a home of their own while helping sellers earn more from a less intrusive sale. It allows both parties to simplify the process and can also be a lucrative financial proposition for the seller.
Advantages & Disadvantages
The Pros of Seller Financing
Losing the big bank influence over a property sale will speed things up considerably. There is much less paperwork for the federal government and state regulators will not be used. There can be less stringent credit inquiries and buyer qualification needed. Though agents and attorneys may be involved, their role will be diminished compared to with a traditional mortgage.
Terms and conditions of seller financing are determined by the people involved, not imposed by a third party or regulation.
All the factors above can make seller financing faster, cheaper, and less intrusive than a traditional mortgage for both sides of the deal.
For the seller, offering financing can make your property listing stand out. Since it is rare, this alone makes an extremely attractive selling point to certain buyers. Sellers can also earn more from this type of deal than they might from a traditional sale. Sellers certainly can earn more from monthly mortgage payments with interest than other investments of the same size typically earn over the same time period.
Sellers can lose the burdens of property and homeowner’s insurance, repairs and maintenance, some taxes and insurance. They can sell the property as-is, without doing costly repairs.
Sellers can even immediately sell-off the promissory note once it is signed (at a discount, to an outside broker) to receive more of a lump-sum payment for their property. If things go south with the buyer, the seller keeps the down payment and any payments made as well as the property, which can go back on the market for resale.
Buyers can use seller financing to overcome credit challenges. A damaged credit history is not often going to prevent a seller from signing the promissory note, but it will kill most bank loans. A buyer can often use seller financing to avoid a lump sum down payment to get into their home.
Buyers appreciate that seller financing usually requires less intrusive credit checks. The seller approves the creditworthiness of the applicant, not a bank or a federal guideline.
Buyers can take advantage of the short-term design of seller financing to have an equity-producing home while they build personal credit and work toward better financing terms on their property.
Seller Financing Risks
Perhaps the main reason seller financing is not more popular is because it is a risky proposition compared to traditional options – for both the buyer and the seller. While setting your own terms has liberating freedoms, it also has inherent risks. Especially if something goes wrong.
The seller risks the buyer’s default and the buyer has a balloon payment that will be quite a challenge if better financing is not arranged. A default would land both parties in a long and costly court arbitration to resolve the compounding issues.
For the seller, additional drawbacks include the need to create all your own paperwork, the need to collect and report on loan payments, all without existing infrastructure. Add the fact the buyer could severely damage the property and default, leaving you with a court case and repairs.
Sellers do not always receive a down payment, as they would in a traditional transaction. With no down payment a buyer can stop paying and the seller would be forced to make it a legal matter immediately, to protect their own investment. Things could get very ugly without a course of action clearly outlined.
For the buyer, there is a risk of assuming debt tied to the home that they do not see – meaning a creditor could have a lien on the house and be able to evict the buyer. The buyer could have a bad turn of luck, and then be obligated for the big balloon payment in five years or so. The property could also fall in value before the balloon payment is due, making it a loss.
The buyer is almost definitely going to pay a higher APR to get seller financing. And an unscrupulous seller may not make his own mortgage payments – so after a down payment and months of paying in, a buyer could lose everything to a bank who is actually holding the mortgage.
In hot markets where buyers are eager, there is less chance of seller financing to occur because it is not really needed. Many qualified buyers make the inherent risks of financing less attractive to a seller. In softer or cold markets, the incentive to look beyond traditional options makes seller financing more prevalent.
Sellers should only be considering this type of financing if their home is free and clear of a mortgage, or if the buyer’s down payment will cover the balance. For example, if you owed $175,000 on a $300,000 home, your mortgage holder will not likely allow you to offer any kind of seller financing. But if you owed only $10,000 on the same property, you could require $10K as a down payment from the buyer and be able to self-finance the remainder of the sale.
Since the deal will be structured in terms set by the signing parties, you can work in some protections to help the financing go more smoothly. Some ideas to consider:
- Down Payments: though these can be flexible, they should be a part of the deal. A down payment shows a seller the buyer is serious about the deal, and buyers will open more opportunities if they are willing to pay a minimum 10% down payment. The down payment protects the seller in case of default, so it can be used to assuage hesitations.
- Seasoned Assistance: Have a real estate lawyer draw-up all documents and advise on what is needed. It is not unusual to employ real estate agents for advice on closing as well. Just because you do not need them in the process does not mean they cannot offer you extremely valuable guidance in doing it the right way. Consult a CPA about tax implications.
- Know the Credit Score: Buyers and sellers both should be aware of the buyer’s credit score. Though it is not necessary for a seller to run a credit check, it is not wise to enter a mortgage financing arrangement without doing so. Buyers can check with a mortgage company for preapproval, thereby arming themselves with the knowledge of what they could get at a lender.
- References: Buyers will need references and sellers will need to diligently check each one. Since this deal is not governed by traditional covenants, a lot could depend on how other people vouch for the dependability and character of the buyer.
- Secure the Loan with the Home: If the buyer defaults, the seller receives back the property and all fees/payments made to-date. Have the home appraised to ensure its value matches or is greater than the financed loan amount.
They May Be Rare, but May Be Right
Though seller financing makes up only a sliver of the real estate deals every year, they can certainly work out well for everyone involved. Part of the reason that they are not common, are the misconceptions and the lack of knowledge surrounding them.
There are different types of financing to consider as well, including all-inclusive mortgages, assumable mortgages, junior (or second) mortgages, land contracts and lease options. Which vehicles are available to each situation will depend on the specifics – encouraging you to research all your potential options before deciding.
For short term financing, sellers can open increased possibility for themselves to earn more, and for their buyer to find a home of their own with flexible terms. It can electrify a stagnant marketplace and cut out the middleman. A clear case of buyer (and seller) beware, but seller financing executed well can certainly be a great fit for all involved.