Are you a potential homebuyer having trouble securing financing? Are you a home owner who wants to sell but is having trouble finding a buyer?
As a buyer, getting a mortgage can be difficult if your financial situation doesn't fit into neat little boxes - a predictable salary that can be documented with paycheck stubs and W-2 forms, a stable employment history with no interruptions and a gleaming credit score. And as a seller, closing a deal on your home can be difficult if borrowers are having trouble getting approved for loans. Wouldn't it be great if you could take out the middle man and find another way to complete the transaction?
In this article we'll focus on a little-known option - seller financing - that can help you buy or sell a house.
Tutorial: Mortgage Basics
How Does Seller Financing Work?
Seller financing is just what it sounds like: instead of the buyer getting a loan from the bank, the person selling the house lends the buyer the money for the purchase.
The buyer and seller execute a promissory note providing an interest rate, repayment schedule and consequences of default. The buyer sends his monthly mortgage payments to the seller, who gets to earn interest on the loan, perhaps at a higher rate than he could get elsewhere. If the seller chooses to sell the loan (more on that later), the buyer will send the monthly mortgage payments to the investor who purchases the loan. (For more on this subject, see Promissory Notes: Not Your Average IOU.)
Seller financing arrangements are often for a short term, such as five years, with a balloon payment due at the end. The idea is that the buyer will be able to refinance before then. Of course, arrangements like this can seriously backfire if you're not careful.
Seller financing tends to be more common in markets where mortgages are hard to come by. There are two reasons for this:
- If mortgages are easy to get, but an interested buyer can't get one, the seller will be highly suspect of the buyer's ability to pay. Hence, when loans are generally difficult to obtain, it's more likely that there might be well-qualified buyers out there who are having trouble securing traditional financing.
- When credit is tight, selling becomes more difficult, so home sellers are more likely to consider unconventional options.
Why Is Seller Financing Uncommon?
If you're a seller, your first objection to this arrangement might be, "But I don't have the money to lend to a buyer!" Your second objection might be, "I don't want to become a lender. It's too risky." Another reason why seller financing is not that common is because most sellers need the full proceeds from the sale of their home to purchase their next home.
But according to Robin Daniels, a real estate investor and landlord in central Florida, "many sellers are afraid of selling with owner financing, but do not know that the note they hold is something that can be sold to someone else. This could happen the same day as closing so the seller gets cash right away." In other words, sellers don't need to have the cash, nor do they have to become lenders.
The other reason seller financing is uncommon is that people aren't familiar with it.
Real estate investor Don Tepper of Solutions 3D LLC says, "There are actually dozens of other ways to buy: lease-option, lease-purchase, land contract, contract for deed, equity sharing, wrap mortgages - and the list goes on and on. Most buyers, and most real estate agents, don't know how any of these work." (To learn more about lease options, lease purchases and other options, read Rent To Own, Own To Rent and Rent-To-Own Real Estate Full of Pitfalls.)
Why Would a Seller Offer Financing?
A home seller might be willing to offer financing for a number of reasons:
- to minimize carrying costs while waiting to find the perfect buyer and get a deal done quickly
- to distinguish the property from other listings and get it sold faster, especially in a down market
- to increase the possibility of garnering the home's full asking price
- to get a down payment to buy another property
- to pay down debt
- to ditch the monthly expense associated with owning the house
In other words, seller financing doesn't just benefit buyers who don't qualify for (or don't want) traditional financing. It also benefits sellers, especially those who are particularly motivated to sell their homes.
Advantages for Buyers
Seller financing has many advantages for buyers:
1. The closing process can be faster.
Prudent buyers and lenders will always use the closing period to perform their due diligence. But with seller financing, the closing process can be faster. Willie Kathryn Suggs, the principal broker and owner of the Harlem-based real estate brokerage that carries her name, says that with seller financing, "The deal closes faster as there is no waiting for the bank loan officer, underwriter and legal department to clear the file - a process that in New York easily stretches to two or three months for a row house and longer for a co-op."
2. Closing costs are lower.
Suggs also notes, "Buyers love [seller financing] because they can get in the home for less money. They do not have to pay the bank fees and appraisal costs."
3. The down payment amount can be extremely flexible.
Instead of having to meet a bank or government-mandated minimum, the down payment amount can be whatever the seller and buyer agree to. This does not necessarily mean that the seller will accept a down payment that is lower than what the buyer would be required to pay elsewhere, but it's always a possibility. (You might want to check out 4 Alternatives To A Traditional Mortgage.)
Disadvantages for Buyers
There are also a few potential problems to consider when investigating the option of using seller financing:
1. Buyers should expect to pay a higher interest rate than they would to a bank.
Buyers will have to pay an interest rate that makes the seller want to lend them money over investing their money elsewhere.
2. Buyers will still have to prove that they are worthy borrowers.
It's one thing if a buyer and seller just want to remove the bank from the equation. However, if a buyer doesn't qualify for a traditional mortgage, there might be a good reason for that -and a seller may not want to become that person's lender, either.
3. Buyers need to make sure the seller owns the house free and clear or that the seller's lender agrees to the seller financing transaction.
According to Jason Burkholder, broker/sales manager and real estate agent with Weichert, Realtors - Engle & Hambright, "most mortgages have a 'due on sale' clause that prohibits the seller from selling the home without paying off the mortgage. So if a seller does owner financing and the mortgage company finds out, it will consider the home 'sold' and demand immediate payment of the debt in full, which allows the lender to foreclose."
4. The original seller might sell the promissory note.
It's not really a big deal if this happens, but it means that the person the buyer thinks he will be making his payments to can change. The same thing happens all the time with traditional mortgages.
Making It Happen
If seller financing appeals to you as a home seller or buyer, how do you make it happen?
- Add It to the Listing
As a seller, you can offer seller financing in your listing. Simply adding three words to your listing - "seller financing available" - will alert potential buyers and their agents of the unique option you are offering.
- Make the Information Available
When potential buyers view your home, you can leave out an information sheet describing in detail the terms of the seller financing you are offering. It might also be a good idea to describe what seller financing is, since many buyers will be unfamiliar with it.
- Ask the Seller to Offer It
Buyers who are looking for seller financing could try just asking for it. Todd Huettner, a mortgage broker and the president of Denver-based Huettner Capital, says, "The secret to getting owner financing done is to present it correctly. Rather than asking if owner financing is an option, buyers should present a specific option. For example, ‘My offer is full price with 20% down, seller financing for $350,000 at 6%, amortized over 30 years with a five-year balloon. If I don't refinance in two to three years, I will increase the rate to 7% in years four and five.'"
- Create a Comfortable Situation
Huettner further advises that buyers paint a picture to make the seller comfortable with offering financing. The seller will want to know why a buyer couldn't qualify for a mortgage elsewhere, but is still credit-worthy. For example, Huettner says that a potential buyer might have good credit and a good down payment, but may have just started a new business and cannot qualify for a loan for two years. Likewise, sellers must paint a picture to make the buyer comfortable with the arrangement. They should thoroughly explain to the buyer what seller financing is, how it works and why the buyer should consider it.
Because seller financing is uncommon, the buyer and seller would be wise to each consult financial and legal experts who understand how it works before entering into such a transaction. These experts should look out for their clients' best interests and guide them through the process.
There's more than one way to buy or sell a house. Just because your financial situation is a little more complex than traditional lenders prefer doesn't mean you can't buy. And just because banks aren't approving borrowers easily doesn't mean you can't sell your house quickly - and for what it's worth. Seller financing might be just the solution you've been looking for. (If you are still on the fence about whether to purchase a property, check out To Rent Or Buy? The Financial Issues.)