What Is A Purchase-Money Mortgage And How Does It Work?
If your credit could be in better shape, applying for a mortgage may be difficult. If your debt-to-income ratio (DTI) is too high, it can be tough to qualify for a sufficient loan amount. You also may have to improve your credit score.
One alternative to a traditional mortgage in this situation is a purchase-money option. Although Rocket Mortgage® doesn’t offer purchase-money mortgages, we want to give you the knowledge you need to make an informed decision. In this post, we’ll go over what it is, how it works, the potential pitfalls and how you can work toward a better deal by qualifying for a traditional mortgage.
Purchase-Money Mortgage Definition
A purchase-money mortgage – also called seller or owner financing – is a mortgage issued to the buyer by the seller of a given property. This type of mortgage is typically part of real estate transactions where the buyer has had difficulty getting approved for a loan with more traditional lenders.
Types Of Purchase-Money Mortgages
Since a purchase-money mortgage is a type of seller financing, you have to come to an agreement with the seller and the exact specifications of that agreement will vary with each unique contract. However, there are a couple of types of purchase-money mortgage that have different terms, so you should know what you’re getting into.
One option is a straight land contract where you make a down payment upfront and agree with the seller on terms such as length of the mortgage and interest rate.
This is essentially a rent-to-own contract where you’ll have the option to purchase the home when the lease expires. Most lease-option agreements typically include additional money each month that goes toward the down payment of the home, sometimes referred to as rent credit, allowing you to contribute to the down payment while already living in the home. This option is useful if you can’t qualify for traditional financing or don’t have enough cash saved for a down payment.
A lease-purchase agreement is essentially the same as a lease-option agreement, except that you’re contractually obligated to buy the property at the end of the lease term.
How Purchase-Money Mortgages Work
When you’re getting seller financing through any kind of purchase-money mortgage, it’s usually because you have difficulty qualifying for financing elsewhere. Given that, the seller may ask for a higher down payment, a higher interest rate and more in closing costs.
The way the title works will depend on the type of purchase-money mortgage you agree to. If it’s a land contract, you don’t get the title right away, but it’s signed over once it’s either refinanced into a traditional mortgage or the final payment is made. If it’s a lease-purchase agreement, you get equitable title, but you have to buy at the end of the lease.
The legal form for how they’re established varies from state to state, so be sure to check local laws for the proper forms and consult an attorney if you have any questions.
What Happens To Existing Mortgages In Purchase-Money Mortgage Agreements?
If there’s an existing mortgage that won’t be paid off by you or the seller at or before closing of the purchase-money mortgage, it’s sometimes possible to assume the seller’s payment on the existing loan. There are two things you should be aware of when it comes to this.
First, when you assume the other person’s loan, you could end up making two payments at different interest rates. You’ll have the payment on the existing mortgage, but chances are good that the sale price is higher than the existing mortgage balance in many cases.
When this happens, you’ll have a separate agreement with the seller as far as term and interest rate for the difference between the purchase price and the existing mortgage balance.
The second thing to be aware of is that if you plan to officially assume the existing mortgage, you’ll need to qualify with the mortgage company, meaning you’ll need a decent credit history and to keep your DTI in a manageable range.
The problem here is that most people are looking for a purchase-money mortgage because they can’t qualify for a regular mortgage. The instance in which this might make the most sense is when you can make the payment, but don’t have a ton of money to put down and you work something out with the seller.
One option you might have is to make an agreement with the seller where they just keep making their mortgage payment. If a sufficient amount of time has passed, the seller can convert their mortgage to an investment property and keep their existing rate by working with their lender.
Purchase-Money Mortgage Example
As an example, let’s say that a potential buyer wants to purchase a home for $250,000. However, they’re not able to get approved for a traditional mortgage due to poor credit. They offer a down payment of $10,000 and ask the seller for a purchase-money mortgage for the remaining $240,000. The seller agrees, and the buyer pays the seller back in monthly installments at a higher interest rate than they might have been able to secure if they had gotten a typical home loan through a bank.
Benefits Of Purchase-Money Mortgages
A purchase-money mortgage has benefits for both the buyer and the seller. For buyers, a purchase-money mortgage can allow you to get a mortgage if you were unable to qualify for one through a traditional lender. The seller typically has less strict requirements than other lenders, making it easier to qualify.
For a seller, providing a purchase-money mortgage typically allows you to receive the full asking price, or in some cases over asking price, for the home. As a seller, you’ll also have additional monthly income from the payments the buyer makes to you.
Pitfalls Of Purchase-Money Mortgages
There are several potential hazards to purchase-money mortgages that you should be aware of:
- Higher sale price and higher monthly payments: One of the things you need to know about a purchase-money mortgage is that sellers are taking on increased risk by handling the financing, so they may expect a higher sale price and thus higher payments.
- Higher interest rate: If a seller can’t get a higher price for taking the risk, they may charge a higher interest rate than what you would get on a standard mortgage. In some cases, the price and interest rate might be higher.
- Increased risk of foreclosure: There’s an increased risk of foreclosure in a couple of ways. In a traditional mortgage, the lender won’t kick you out for missing one payment. Depending on the terms of your purchase-money mortgage, sellers could do this and you would be out any money invested.
- Losing the house through no fault of your own: If you choose to pay the seller on a monthly basis, while they make their mortgage payment on the existing mortgage, you’re taking a risk yourself that they’ll make those payments to the mortgage company. If they don’t make the payments, they lose the house and you get kicked out.
Alternatives To Purchase-Money Loans
If you would prefer not to deal with the downsides associated with a purchase-money mortgage, there are a couple of alternatives you can consider.
Hard Money Loans
A hard money loan is a loan from a private investor. These types of loans typically have shorter terms and much higher interest rates than what is typical with other loan types, but they can be a good option if you need a couple of years to fix your credit before taking out a traditional loan.
If you don’t want to take the risk of using a purchase-money or hard-money loan, there are several other types of mortgages that you can consider. These include:
Each of these types of loans have slightly different rules and requirements for the buyer, so be sure to do your research to determine which option is best for your situation.
How To Qualify With Traditional Lenders
Given the downsides of a purchase-money mortgage, getting a loan through a traditional lender can be attractive. However, if you’ve been having trouble qualifying, there are steps you need to be taking to get there.
Because traditional mortgage lending will offer you better terms, it makes sense to make every effort to get one rather than having to go the purchase-money route. Here are the things lenders consider and how you can improve your chances for approval.
Build A Strong Credit History
Maybe you can’t get a mortgage because you're new or relatively new to credit. Maybe you’ve had several blemishes in the past and are working on a rebuild from the ground up. Whatever the case, building a strong credit history will better your chances of qualifying.
The question then becomes how you do that. The good news is it isn’t anything complex. Here are some steps you can take to build your credit:
- Start small: If you’ve never had credit, you may have to work with your bank to get either a secured credit card backed by your own personal funds or a credit-building personal loan paid back in installments. After that, you can work your way up to regular credit cards as well as car loans, working up to a mortgage.
- Pay on time: A sizable portion of your credit score is based upon making on-time payments. Late payments and collections or charge-offs can hurt your score.
- Don’t use more than you need: You want to have some use of credit and debt so that you can prove to future creditors and lenders that you can handle it responsibly. However, your credit usage should never exceed more than 30% and you want to keep DTI in check.
- Mix it up: Creditors and lenders want you to be able to show a mix of the different types of credit. Revolving debts are those where the balances change monthly – think credit cards. Installment loans involve a fixed balance paid off over time like personal and car loans.
Work On Improving Your Credit Score
If you follow the above steps, you’ve got a good start in improving your credit score. Beyond that, there are a couple of steps you can take if it still needs improvement.
- Pay debts down or off: This goes back to measurements of debt and credit usage. If it’s impossible to get a handle on current debts, you can try to work out something with creditors. Agreeing on a payment still isn’t the best for your score, but it’s better than nothing.
- Monitor your credit: It’s a good idea to monitor your credit on a regular basis, both for the purposes of checking on your progress and fixing any errors you might find that could be dragging your score down.
Although you’ll have more options if you have a really good credit score, there are traditional loan alternatives that won’t take you forever to build up to. You can get FHA loans with a credit score of it as low as 580 and with a 3.5% down payment. If your median FICO® Score is 620 or higher, you can have a higher DTI, which may add to your budget.
VA loans are available to qualifying servicemembers, veterans and surviving spouses. You don’t need a down payment. The VA doesn’t have a minimum FICO® Score requirement, but lenders set their own policies. At Rocket Mortgage®, we require a minimum median score of 580.
Improve Your DTI
Paying down debts is incredibly important in terms of your DTI. DTI is a key metric for lenders doing all types of loans because the lower it is, the more capacity you have to take on monthly payments for additional obligations.
DTI is simply a ratio expressed as a percentage which compares your existing revolving and installment debt payments to your pretax monthly income.
A key thing to remember here is that to be approved for most possible mortgage options, it’s a good idea to keep your DTI at or below 43%. However, FHA and VA loans allow you to be approved with slightly higher debt loads, depending on your credit score. Feel free to speak with one of our Home Loan Experts about these options.
Build Up Your Savings
It’s vital to pay special attention to your savings when trying to qualify for a mortgage. For starters, there’s the down payment. If you don’t qualify for a VA loan, the most you would potentially be required to put down is 5% of the purchase price on a conventional loan.
Beyond that, you’ll also need savings for reserves. Reserves are a number of mortgage payments that you could afford given the loss of income or other emergency causing a financial hardship. How much you will need in reserves depends on the type of loan you’re getting, but a good starting point is 2 months’ worth of payments.
The Bottom Line
A purchase-money mortgage is an agreement with the seller on terms for financing that the seller provides. They are typically used if you have trouble qualifying for a traditional mortgage.
While it’s an option if your credit could be better, they can also come with higher interest rates as well as a higher selling price and payment. They also come with an increased risk of foreclosure – in some cases, even if you’ve been making your payments.
You can get better terms with a traditional mortgage. In order to qualify, there are steps you can take to build your credit history and improve your score. It also helps to pay down debt and build up your savings over time.
For more on mortgages and home buying, check out the Rocket Mortgage Learning Center. If you feel you’re ready from a credit standpoint, we would love to help you go over traditional mortgage options. You can apply online or give us a call at (888) 452-0335.