Seller Financing in Home Sales
by
Broderick Perkins
Seller financing -- when the seller gives the buyer a mortgage -- can help both home buyers and sellers.
Seller financing -- when the seller of a home takes on the role of lender in a home sale -- can help both sellers and buyers in a tight credit market.
With seller financing, sellers may move a home faster in a slow market and get a sizable return on the investment. And buyers may benefit from less stringent qualifying and down payment requirements, more flexible rates, and better loan terms on a home that otherwise might be out of reach.
There's a greater chance of finding sellers willing to take on the role of financier in a slow market, but they still represent only a small fraction of all sellers -- less than 10%. That's because the deal is not without legal, financial, and logistical hurdles. But by taking the right precautions and getting professional help, sellers can reduce the risks inherent in seller financing.
How Does Seller Financing Work?
In seller financing, the seller takes on the role of the lender. Instead of giving cash to the buyer, the seller extends enough credit to the buyer for the purchase price of the home, minus any down payment. The buyer and seller sign a promissory note (which contains the terms of the loan), they record a mortgage (or "deed of trust" in some states) with the local public records authority, and then the buyer pays back the loan, typically with interest.
These loans are often short term -- for example, amortized over 30 years but with a balloon payment due in five years. The theory is that within a few years the buyer will have gained enough appreciation to refinance, interest rates will be more favorable, or other conditions will emerge to allow the buyer to get institutional financing. From the seller's standpoint, the short time period is also pragmatic -- sellers don't have the life expectancy of a mortgage lending institution. In addition, sellers don't want to be exposed to the risks of extending credit longer than necessary.
A seller has the best chance of getting a seller financing deal when the home is free-and-clear of a mortgage -- that is, when the seller's own mortgage is paid off. If the seller still has a mortgage on the property, the seller's existing lender must agree to the transaction, and in a tight credit market, risk-averse lenders may not be willing to take on that extra risk.
Types of Seller Financing Arrangements
Here's a quick look at some of the most common types of seller financing.
All inclusive mortgage. In an all-inclusive mortgage or all-inclusive trust deed (AITD), the seller carries the promissory note and mortgage for the entire balance of the home price, less any down payment.
Junior mortgage. In today's market, lenders are reluctant to finance more than 80% of a home’s value. Sellers can extend credit to buyers to make up the difference: The seller can carry a second or "junior" mortgage for the balance of the purchase price, less any down payment. In this case, the seller immediately gets the proceeds from the first mortgage from the buyer's first mortgage lender. However, the seller’s risk in carrying a second mortgage is that he or she accepts a lower priority should the borrower default. In a foreclosure or repossession, the seller's second, or junior, mortgage is paid only after the first mortgage lender is paid off and only if there are sufficient proceeds from the sale.
Land contract. Land contracts don't pass title to the buyer, but give the buyer "equitable title," a temporarily shared ownership. The buyer makes payments to the seller and after the final payment or payoff, the buyer gets the deed.
Lease purchase or lease option. The seller gives the buyer equitable title and leases the property to the buyer for a contracted term. When the buyer fulfills the lease purchase agreement, the buyer receives title and typically obtains a loan to pay the seller. Some or all of the rental payments can be credited against the purchase price. Numerous variations exist on lease options.
Assumable mortgage. Assumable mortgages allow the buyer to take the seller's place on the existing mortgage. Some FHA and VA loans, as well as conventional adjustable mortgage rate (ARM) loans are assumable -- with the bank's approval.
Getting Professional Help
Both the buyer and seller will likely need an attorney or a real estate agent -- perhaps both -- or some other qualified professional experienced in seller financing and home transactions to write up the contract for the sale of the property, the promissory note, and any other necessary paperwork.
In addition, reporting and paying taxes on a seller-financed deal can be complicated. The seller may need a financial or tax expert to provide advice and assistance.
Tips to Reduce the Seller’s Risk
Many sellers are reluctant to underwrite a mortgage because they fear that the buyer will default (that is, not make the loan payments). But the seller can take steps to reduce the risk of default. A good professional can help the seller do the following:
Get a loan application. The seller should obtain a loan application from the buyer and thoroughly verify all the information. That includes running a credit check and vetting employment, assets, financial claims, references, and other background information and documentation.
Allow for seller approval of the buyer’s finances. The written sales contract -- which specifies the terms of the deal along with the loan amount, interest rate, and term -- should be contingent upon the seller’s approval of the buyer's financial situation.
Have the loan secured by the home. The loan should be secured by the property so the seller (lender) can foreclose if the buyer defaults. The home should be properly appraised at a value equal to or higher than the purchase price.
Get a down payment. Institutional lenders ask for down payments to give themselves a cushion against the risk of losing the investment. It also gives the buyer a stake in the property and makes them less likely to walk away at the first sign of financial trouble. Sellers should do likewise and collect at least 10% of the purchase price. Otherwise, in a soft and falling market, foreclosure could leave the seller with a home that can't be sold to cover all the costs.
Negotiating the Loan
As with a conventional mortgage, seller financing is negotiable. To come up with an interest rate, compare current rates that are not specific to individual lenders. Use services like www.BankRate.com and www.HSH.com -- check for daily and weekly rates in the area of the property, not national rates. The seller should also consider getting professional help in order to set the interest rate. Be prepared to offer a competitive rate, low initial payments, and other concessions to lure buyers.
Because sellers typically don't charge buyers points (each point is 1% of the loan amount), commissions, yield spread premiums, and other mortgage costs, they often can afford to give a buyer a better financing deal than the bank. They can also offer less stringent qualifying criteria and down payment allowances.
That doesn't mean the seller must or should bow to a buyer's every whim. The seller also has a right to decent return. A favorable mortgage that comes with few costs and lower monthly payments should translate into a fair market value for the home.
Hiring a Loan Servicing Company
To help ease the paperwork burden, sellers can hire a loan servicing company to help draw up the mortgage, mail statements, collect payments, and otherwise administer the mortgage.
Another option is using a company like www.VirginMoneyUS.com (formerly Circle Lending), which specializes in facilitating loans between private parties. It will prepare the loan documentation, record the mortgage, develop the payment schedule, set up automatic payments, and provide year-end reporting, credit reporting services, and collection procedures, along with a whole host of other related services.
For a detailed discussion of the entire home selling process in California, get For Sale by Owner in California, by California real estate broker George Devine (Nolo).
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