What Are the Risks of Buying a Home With Seller Financing?

Among the many options for financing a home purchase is borrowing the money from the seller. Not all real estate sellers are willing to do this, but some will, particularly if the home is hard to sell and the seller is ready to take the risk of a buyer who is perhaps having trouble qualifying for traditional financing.

Although seller financing might sound appealing, and appear simpler than traditional financing, you should assess the risks to determine whether they outweigh the benefits. Below are some issues to consider, including:

• the possibility that the seller will take advantage of your situation, and
• how to deal with those risks by adding protective language and terms to the purchase contract.

Risk of Unfavorable Loan Terms From the Property Seller

You and the home seller will need to agree on the principal amount of the loan, the interest rate for repayments, and the length of time the loan will last. Sellers who are extending their own financing (also called "taking back a mortgage") often charge a higher interest rate than institutional lenders, because of the increased level of risk that the buyer will default (fail to pay, or otherwise violate the mortgage terms).

The seller is also likely to prefer a shorter time frame for repayment than a traditional lender would require. The seller might, for example, specify a 10% interest rate, a 5-year term (during which time you'd pay no more than for the same loan on a 30-year mortgage), and then a balloon payment of the remaining balance at the end of the 5 years. (At that point, you would likely want or need to refinance with another lender.)

See how this would play out in the below comparison between a 30-year loan and a five-year loan for the same amount with a balloon payment at the end:

Another option some sellers offer is interest-only payments. That makes your monthly payment low, but comes with a risk that you'll get in too deep financially. The main concern is that interest continues to accrue on the principal amount owed so that, despite making all the payments, you are not making a dent in your underlying obligation. Expect a short loan term and a balloon payment at the end, as well.

Dealing With Risks Via Language in the Purchase Contract

Consider how the seller financing will or should affect the language in the purchase contract. Here are some key issues to pay attention to.

Contingencies That Must Be Dealt With Before Closing the Sale

Make sure that the transaction is contingent on the seller actually providing financing in the amount, at the interest rate, and according to the other terms that the two of you agreed upon. Otherwise, the seller could change the basic terms and you would still be stuck buying the property.

Furthermore, take the financing into account as you address, within the contract, which party will be responsible for which closing costs.

Loan Qualification Requirements

Is there anything you need to do, or financial information you need to provide, for the seller to approve the loan? Is the loan contingent on a credit check or bank or job references? Probably so, to protect the seller's interests.

To protect your interests, however, the contract should be written to make these conditions clear and fair. That way, if the seller cannot or does not loan you the money, you can cancel the contract.

Who Pays What Portion of Property Taxes and Insurance

You should also discuss, and incorporate into the purchase contract, how the property taxes and the homeowners' insurance are to be paid. With a traditional lender, a portion of the annual taxes and insurance are often added to each monthly mortgage payment.

With private lenders, however, borrowers usually pay the taxes directly to the government and the insurance directly to the insurance company. That's fine, assuming you know about and are ready to take on this responsibility.

Confirming the Seller's Valid Title to and Ownership of the Property

Make sure your seller has the ability to lend you the money. Even though the seller might have agreed to do so, you need assurance that the seller has enough money to pay off an existing mortgage or other encumbrance before finalizing the transfer. In most cases, the loan documents between the seller and the seller's lender will prohibit the seller from selling the property without paying off the mortgage.

Even though the seller might not require a title search (from a title company or attorney), ordering one will give you information about whether your seller can really give you a mortgage. The title commitment will tell you whether there are any mortgages, liens, or other encumbrances on the property that must be paid off before the seller can transfer it. The commitment will serve as independent confirmation as to whether the seller can, in fact, finance your purchase.

Seller's Right to Sell Your Promissory Note

If you are dealing directly with your seller, you have a level of comfort with each other that encourages you to work together. However, financial considerations or family pressure could one day make the seller decide to cash out and transfer the note to a third party.

You would then need to make new arrangements to pay your mortgage. The third party might be stricter about late payments and have different payment instructions than your seller. In order to make sure that payment is received in time, for example, you might have to mail it in advance, or else face late charges.

To avoid problems with a third party, address these issues in the original loan documents. For example, you could include a grace period and/or the opportunity to cure defaults, as well as language that allows you to pay electronically. Such requirements would flow down to the buyer of the note. Another option would be to include a right of first refusal that allows you to refinance at any time with no penalties.

Legal Review of Loan Documents

Review the loan documents or have an attorney review them before you sign, to make sure that all the terms you agreed upon are there and are correct. You want to avoid the type of situation where, to use a real-life example, the buyer learned after many years that his note was amortized over 50 years, not 30 years, so that at the end of the 30-year term, he still owed a large balloon payment.