Seller financing can be a useful tool in a tight credit market, when mortgage loans are hard to come by. This alternative type of loan allows home sellers to move a home faster and get a sizable return on their real estate investment. And buyers can benefit from the typically less stringent qualifying and down payment requirements, more flexible interest rates, and better loan terms. A home that seemed out of reach for the buyer might be possible after all.
Only a small fraction of sellers are willing to take on the role of financier—typically well under 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 inherent risks. Here, we'll discuss:
In seller financing, the property seller takes on the role of the lender. Instead of giving cash directly to the homebuyer, however, the seller extends enough credit for the purchase price of the home, minus any down payment. The buyer and seller sign a promissory note containing the loan terms. They record a mortgage (or "deed of trust," in some states) with the local public records authority. Then the buyer moves into the house and pays back the loan over time, 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 home will have gained enough in value or the buyers' financial situation will have improved enough to refinance with a traditional lender.
From the seller's standpoint, the short time period is also practical. Sellers can't count on having the same life expectancy as a mortgage lending institution, nor the patience to wait around for 30 years until the loan is paid off. In addition, sellers don't want to be exposed to the risks of extending credit longer than necessary.
A seller is in the best position to offer financing when the home is free and clear of a mortgage—that is, when the seller's own mortgage is paid off or can, at least, be paid off using the buyer's down payment. If the seller still has a sizable mortgage on the property, the seller's existing lender must agree to the transaction. In a tight credit market, risk-averse lenders are rarely willing to take on that extra risk.
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 potentially 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 it means a lower priority or place in line 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. Also, the bank might not agree to make a loan to someone carrying so much debt.
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, the buyer gets the deed.
Lease option. The seller leases the property to the buyer for a contracted term, like an ordinary rental—except that the seller also agrees, in return for an upfront fee, to sell the property to the buyer within some specified time in the future, at agreed-upon terms (possibly including price). 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.
Many real estate sellers are reluctant to underwrite a mortgage, fearing that the buyer will default (that is, not make the loan payments). But the seller can take steps to reduce this risk. A good professional can help the seller do the following:
Require a loan application. The property seller should insist that the buyer complete a detailed loan application form, and thoroughly verify all information the buyer provides there. 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 made 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 that the seller (lender) can foreclose if the buyer defaults. The home should be properly appraised at to confirm that its value is equal to or higher than the purchase price.
Require a down payment. Institutional lenders ask for down payments to give themselves a cushion against the risk of losing the investment. Making this payment also gives buyers a stake in the property and makes them less likely to walk away at the first sign of financial trouble. Sellers should try to 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.
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 BankRate and HSH—check for daily and weekly rates in the area of the property, not national rates. Be prepared to offer a competitive interest rate, low initial payments, and other concessions to lure homebuyers.
Because real estate sellers typically don't charge buyers points (each point is 1% of the loan amount), commissions, yield spread premiums, or other mortgage costs, they often can afford to give a buyer a better financing deal than a bank or traditional mortgage lending institution. They can also offer less stringent qualifying criteria and down payment allowances.
That doesn't mean the seller must or should bow to a homebuyer'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.
Both the homebuyer and seller will likely need an attorney or a real estate agent—perhaps both—or 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 might need a financial or tax expert to provide advice and assistance.
Going forward, to help ease the paperwork burden, sellers can hire a loan servicing company to help draw up the mortgage, mail statements to the buyers, collect payments, and otherwise administer the mortgage.
For a detailed discussion of the entire home selling process, including a variety of ways to get reluctant buyers excited about buying your home, see Selling Your House: Nolo's Essential Guide, by Ilona Bray.