What Is Seller Financing?
If you’re looking to buy a home but think you’ll have a hard time qualifying for a traditional mortgage, seller financing could be an option for you. In this article, we’ll go over what seller financing means, how it works, the different transaction structures and the pros and cons for both buyers and sellers. This will help you decide if seller financing is right for you.
What Does Seller Financing Mean?
Seller financing is a real estate transaction where the seller helps finance the purchase of their property with the buyer, sometimes financing the sale entirely. Some prefer a seller-financed mortgage because it sidesteps the need for a mortgage from a traditional lender.
Seller financing is also known as owner financing or, in some cases, a purchase money mortgage.
When you and the seller opt for owner financing, much of the structure associated with a traditional mortgage may still exist. You’re just making payments to the seller instead of to a bank or other mortgage lender. Depending on the structure of the agreement, you may still be responsible for a down payment associated with seller financing.
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How Does Seller Financing Work?
Seller financing works similarly to any mortgage transaction with the exception that the seller is extending you the financing rather than a bank or mortgage lender. Unlike a traditional mortgage closing, the only money the seller receives at closing is whatever amount was negotiated for a down payment, if any.
You and the current homeowner will work to negotiate the details of a mortgage promissory note that says you’ll pay them back for the loan. This document will specify the interest rate you pay on the loan as well as the repayment schedule.
With a traditional mortgage, in addition to the promissory note, there’s a separate document – the mortgage itself – that defines what the penalties are if the repayment terms are violated. When financed by a seller, the consequences of default may be laid out in the promissory note or in a separate document.
While this isn’t always the case, seller financing typically involves a shorter term than you would see on a traditional mortgage. The seller has an incentive to be paid for the house they just sold.
Additionally, some owner-financed loans include a balloon payment, meaning a lump sum is paid at some point during or at the end of the term. If you don’t have the money to make a balloon payment when it comes due, people with improved credit will refinance the cost into a traditional mortgage.
Types Of Seller Financing Agreements
There are several types of seller financing that may be used between you and the seller. We’ll touch on them here.
There are several types of seller-financed mortgage that may apply. The commonality here is that in many aspects, they function like traditional financing. Here’s a breakdown of what you might see:
Properties Owned Free And Clear
In the simplest scenario, the seller has completely paid off the home, and the seller and buyer work out the terms of a down payment, final purchase price (when the loan will be paid off) and interest rate. The seller pockets the entire amount of any repayments.
All-Inclusive Trust Deed (AITD)
In an AITD, the seller keeps paying an existing mortgage with the proceeds of repayments from the buyer, also known as a wraparound mortgage. In addition to making these payments, the seller pockets any amount over and above the cost of the mortgage as well as the down payment.
There are risks to this for both the buyer and seller. For the seller, it’s important to note that most mortgages contain a “due on sale clause.” This means that as soon as the property is sold, the mortgage lender could demand payment. If enforced, this clause could defeat the purpose of the wraparound mortgage if you were planning to use the proceeds from the repayment to make the mortgage payment. Additionally, buyers assume risk, because if the seller isn’t making the payment on the underlying mortgage, the mortgage lender can take the house back.
A seller can help finance the real estate transaction by working out a junior mortgage, also called a second mortgage, with you. For example, a seller could cover the cost of a down payment that you would pay back to them separately from the primary mortgage financing the property. It’s important to note that many traditional lenders don’t allow these types of arrangements.
Another type of seller financing involves rent-to-own agreements. In a rent-to-own agreement, you rent a property at above-market rates. In exchange, some of the money you pay toward rent is usually set aside for a rent credit, which can go toward your down payment and a traditional mortgage down the line.
The first type of rent-to-own arrangement is a lease-option agreement. Under a lease-option agreement, you have the right to purchase the property at the expiration of the lease agreement if you so choose. You’re under no obligation to do so.
The basic difference between a lease-option and a lease-purchase agreement is that, under a lease-purchase agreement, you’re required to buy the property at the end of the lease. There should be two concerns for the buyer here: First, you need to know that you really like the property, and that you could see yourself living there permanently.
Second, you’ll want to have your financing lined up in advance of the lease expiration, so you’ll need to get your credit in order and be ready when the time comes. Make sure you’re aware of any consequences regarding what happens if you choose not to move forward with the purchase at the end of the lease.
A land contract is just another term for a seller-financed mortgage, which we’ve mentioned above. It can either be a straight contract, where the property is owned free and clear, or it can have a wraparound component if there’s an existing mortgage already in place.
It’s important to note that with most land contracts, you don’t get the title right away. Rather, the seller holds the legal title to the property, which is given to you once the seller is fully paid off.
While you don’t get the legal title immediately, you do gain an equitable title. This means that with each payment you make to the seller, you gain financial equity in the property.
Pros And Cons Of Seller Financing In Real Estate
Owner financing has pros and cons for both the buyer and seller. Let’s take the time now to run through these.
Buyer Pros And Cons
For the buyer, here’s a list of advantages and disadvantages of seller financing:
- It allows people to get a mortgage who may not have qualified otherwise.
- The closing process may be quicker and cheaper.
- Down payment amounts are negotiable with seller financing in a way that they usually aren’t when it comes to traditional mortgages.
- It can buy you time to get your credit and broader financial picture in order before applying for a traditional loan.
- Because the seller is taking on risk, they typically charge a higher interest rate than what would be associated with a regular mortgage. For this reason, if you can qualify for a traditional mortgage, that’s going to be a better option.
- If there’s a balloon payment, you either have to have a plan for paying when it comes due or securing financing to make the payment.
- Although one of the pros for this is that people may be able to qualify for seller financing even if they have less-than-stellar credit, there’s nothing that stops the seller from running a credit check of their own.
- You likely won’t be afforded the same protection you could get with a traditional mortgage. Depending on the terms of your contract and local law, a seller may be able to evict you for even one late payment.
Seller Pros And Cons
If you’re a seller, financing someone’s home purchase has its own benefits and potential downfalls. Here they are:
- Sellers can sell their home fast and at a price of their choosing. You don’t have to wait for final approval, an appraisal, etc.
- Payments from the buyer can serve as an additional passive income stream.
- You can get a higher interest rate than you could with other investments.
- You’re taking on up to the entire investment risk by providing seller financing. You need to really consider the fact that the reason someone is asking for seller financing is that they likely can’t qualify for a traditional mortgage.
- If you currently have a mortgage, you’ll have to seek the approval of your lender to avoid the consequences of a due on sale clause.
- If the buyer defaults on the terms of the contract, it’s up to you to go through the eviction and/or foreclosure proceedings. Depending on where you live, this may be easier in some states than others.
- If a resident knows they are about to be evicted, they might start to let the house deteriorate. Factoring in house repair and renovation costs is important if you plan on taking a property back..
- By selling to someone with a traditional mortgage, you might have to wait longer to close the deal – but you’re getting your money in a lump-sum check rather than having to count on those payments to keep coming in every month. You’re leaving less to chance.
The Bottom Line: Seller Financing Can Be Helpful For Those Who Need It
One of the big pros of seller financing is that you can qualify if you have credit with some dings on it. On the other hand, you don’t get the same protections you’d get with a traditional mortgage. For a seller, you can get a higher interest rate than you can on many other investments, but you’re taking on the entire risk of the transaction.
If you can manage it, it’s always better to qualify for a traditional mortgage as they come with lower interest rates and are more buyer friendly. If you’re looking to buy a home or perhaps refinance out of your current seller financing, you can apply online.