When it comes to financing residential real estate, most transactions follow a well-worn process. The seller finds a willing buyer with the required income, employment history and credit score to qualify for a mortgage, and a lending institution puts up the money to finance the deal.
But what if traditional financing is unavailable, and buyer and seller still want to proceed privately with the sale? Enter what’s known as seller financing. As the term implies, the person who’s selling the house finances the purchase, rather than the bank providing a mortgage to the buyer.
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What's Favorable About Seller Financing
This alternative to traditional financing is a useful option at times when mortgages are hard to get. In such tight conditions, seller financing allows buyers access to an alternative form of credit. Sellers, in turn, can tap a population of buyers who don’t necessarily qualify for a traditional mortgage. And because the seller is financing the sale, the property may command a higher sale price.
A bank isn’t directly involved in a seller-financed sale; buyer and seller make the arrangements themselves. They draw up a promissory note setting out the interest rate, schedule of payments from buyer to seller, and the consequences should the buyer default on those obligations. Unlike a sale involving a mortgage, then, there is no transfer of the principal from buyer to seller, but merely an agreement on repaying that sum over time.
With only two main players involved, owner financing can be quicker and cheaper than selling a home in the customary way. Willie Kathryn Suggs, a Harlem-based broker, says that when the seller finances the sale "the deal closes faster, as there is no waiting for the bank loan officer, underwriter and legal department to clear the file." Suggs also notes that "buyers love [seller financing] because they can get in the home for less money.”
Closing costs are indeed lower for a seller-financed sale. Without a bank participating, the transaction avoids the cost of mortgage or discount points, as well as origination fees and a host of other charges that lenders routinely level during the financing process. There’s also greater flexibility, at least ostensibly, about the loan provisions, from the required down payment to the interest rate to the term of the agreement.
The seller's financing typically runs only for a fairly short term, such as five years, with a balloon payment coming due at the end of that period. The theory—or the hope, at least—is that the buyer will eventually refinance that payment with a traditional lender, armed with improved credit-worthiness and having accumulated some equity in the home.
What Buyers Need to Know
For all the potential pluses to seller financing, transactions that use it come with risks and realities for both parties. Here's what buyers should consider before they finalize a seller-financed deal.
Don't expect better terms than with a mortgage. As the terms of a seller-financed deal are hammered out, flexibility frequently meets reality. The seller digests their financial needs and risks, including the possibility the buyer will default on the loan, with the prospect of a potentially expensive and messy eviction process.
The upshot can be sobering for the buyer. For example, it’s possible you’ll secure a more favorable interest rate than banks are offering, but it's more likely you’ll pay more, perhaps several additional percentage points above the prevailing rate. And you'll probably have to provide a down payment that's comparable in size to those of a typical mortgage—that is, 10% or more of the property’s value.
You may need to sell yourself to the seller. It's smart to be transparent and straightforward about the reasons you didn’t qualify for a traditional mortgage. Some of that information may emerge anyway when the seller checks your credit history and other background data, including your employment, assets, financial claims, and references.
But make sure, too, that you point out any restrictions on your ability to borrow that may not surface during the seller's due diligence. Todd Huettner, a mortgage broker and the president of Denver-based Huettner Capital, points out that even a potential buyer who has good credit and a hefty down payment on hand may have recently started a new business, and so be unable to qualify for a loan for up to two years.
Be prepared to propose seller financing. Homeowners who offer seller financing often openly announce that fact, in the hope of attracting buyers who don’t qualify for mortgages. If you don’t see a mention of seller financing, though, it doesn’t hurt to ask about it, says mortgage broker Todd Huettner.
When you do, he says, propose the option as explicitly as you can. Rather than asking if owner financing is an option, Huettner recommends that buyers present a specific proposal. “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.'"
Confirm the seller is free to finance the sale. Seller financing is simplest when the seller owns the property outright; a mortgage held on the property introduces extra complications. Paying for a title search on the property will confirm that it’s accurately described in the deed, and is free from a mortgage or tax liens.
According to Jason Burkholder, a broker, sales manager and real estate agent with Weichert, Realtors in Lancaster County, Pa., "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."
What Sellers Need to Know
Keep these tips and realities in mind if you're considering financing the sale of a home.
You needn’t necessarily finance the sale for long. As the seller, you can, at any point, sell the promissory note to an investor or lender, to whom the buyer then sends the payments. 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. Be aware, however, that you will likely have to accept less than the full value of the note in order to sell it, thus reducing your return on the property.
Make seller financing part of your pitch to sell the property. Since seller financing is relatively rare, promote the fact that you’re offering it, starting with the property listing. Adding the words "seller financing available" to the text will alert potential buyers and their agents that the option is on the table.
When potential buyers view your home, provide more detail about the financing arrangements. Prepare an information sheet that describes the terms of the financing, along a general explanation of what seller financing is, since many buyers will be unfamiliar with it.
Seek out tax advice, and consider loan-servicing help, too.
Since seller-financed deals can pose tax complications, engage a financial planner or tax expert as part of your team for the sale. Also, unless you’re experienced and comfortable as a lender, consider hiring a loan-servicing company to collect monthly payments, issue statements and carry out the other chores involved with managing a loan.
The Bottom Line
As unusual and unfamiliar it is to most people, seller financing can be a helpful option in challenging real-estate markets. However, the arrangement triggers some special risks for buyer and seller, and it's wise to engage professional help to mitigate those and allow the process to run smoothly.
Both parties should hire an attorney or real estate agent to write and review the sales contract and promissory note, along with related tasks. Try to find professionals who are experienced with seller-financed home transactions—and experienced where you live, if possible, since some relevant regulations (such as those that govern balloon payments) do vary by jurisdiction.
Professionals can also help buyer and seller decide on the particular agreement that best suits them and the circumstances of the sale. If it isn’t a seller-financed deal, real estate investor Don Tepper of Long & Foster Real Estate points out that "there are actually dozens of other ways to buy” other than a traditional mortgage arrangement.
These arrangements, Tepper points out, include lease-option, lease-purchase, land contract, contract for deed, equity sharing, and wrap mortgages. "Most buyers, and most real estate agents, don't know how any of these work," he says.