What Is Seller Financing?
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How Does Seller Financing Work?
Seller financing (also called owner financing) works when a seller finances some or all of the property’s purchase price for a buyer. This usually involves extending enough credit to cover the price of the property, which the buyer must repay in installments, as specified in the loan documentation.
In cases where the buyer is unwilling or unable to obtain financing through conventional means, seller financing may be the only alternative financing option to close the sale.
By contrast, most residential real estate transactions involve the buyer securing a mortgage through a third-party lender, and the lender provides the funding to complete the purchase.
However, like a regular mortgage, the buyer signs a note promising to repay the loan in regular installments. The note is a binding contract specifying the purchase price, the interest rate, the monthly payment, penalties for default, and any other conditions.
Most of the time, seller financing is intended to be a short-term financing solution. The idea behind seller financing is to give the buyer time to qualify for traditional financing, either by improving their credit score or increasing their income while also building equity in the property.
Seller financing usually becomes more popular when credit markets are tight or the housing market takes a downturn. When credit is tight, seller financing opens the pool of potential buyers. Also, when the market is depressed, sellers can command a higher price when they offer to finance the purchase.
Seller Financing Options
Seller financing is not a one-size-fits-all arrangement. Depending on the property, existing mortgages, and the seller’s risk tolerance, seller financing can take several different forms:
- Free and clear. This is the most straightforward type of seller financing. When the seller owns the property outright, the buyer pays the seller a down payment and monthly loan payments in accordance with the negotiated promissory note.
- Rent-to-own/lease with option to buy. This agreement gives the buyer the option, but not the obligation, to purchase the property at the end of a predetermined lease period. Because the buyer has an easy out, the seller typically asks for a non-refundable deposit to hedge the risk of taking the property off the market for an extended period.
- Second lien. If there is an existing mortgage on the property, the seller can extend a second mortgage to cover their equity in the property. The buyer pays two payments each month: one to the primary lender and one to the seller. This is particularly risky for the seller since they are on the hook for both mortgages.
- Wraparound mortgage. If there is an existing mortgage on the property but the seller has significant equity, a wraparound mortgage is a less risky option than seller financing in the second lien position.
Say Joe has a $70,000 mortgage at 5% on a property worth $150,000. He sells it to Julie for $20,000 down with a wraparound mortgage for $130,000 at 7.5%. Joe continues to pay his mortgage and earns extra interest income.
This arrangement carries risks for both the buyer and the seller, however. The buyer should insist on an escrow company to ensure the primary mortgage is paid each month. The seller also risks triggering the due-on-sale clause in the primary mortgage if the lender discovers the wraparound.
Pros and Cons of Seller Financing
Seller financing offers advantages and disadvantages for both the buyer and the seller. Here are a few things to keep in mind before considering seller financing for a real estate deal.
Advantages of Seller Financing for Buyers:
- Seller financing may enable buyers to own property who otherwise might not qualify for a mortgage.
- There is no minimum down payment requirements, unlike government-insured mortgage programs.
- Closing costs are generally lower because there are no bank fees or mandatory appraisal and inspection fees.
Advantages of Seller Financing for Sellers:
- Seller financing has a quick closing process.
- Sellers can sell a property as-is without making repairs that might otherwise be required.
- Taxes may be lower with seller financing since the seller only reports the payments received each calendar year.
- Sellers can charge a premium above market price in exchange for providing seller financing and charge higher interest rates.
- Seller financing provides a steady monthly income stream.
- The seller retains title to the property until the note is paid in full and gets to keep the down payment (plus any money paid against the loan) if the buyer defaults.
- Sellers can sell the note to a real estate investor and get a lump-sum cash payout.
Disadvantages of Seller Financing for Buyers:
- The purchase price and loan interest rate will almost always be higher than market rates.
- Seller financing is not automatically approved; the seller may run a credit check and ask for other financial information.
- Most seller financing includes a balloon payment. If the seller cannot qualify for a traditional mortgage when the payment is due, they lose their down payment, monthly loan payments, and any improvements they might have made to the property.
- Without the mandatory disclosures and inspections most lenders require, buyers could face costly and unexpected repairs.
Disadvantages of Seller Financing for Sellers:
- If the buyer defaults, foreclosure is costly and time-consuming. In addition, the property may need repair before relisting it if the buyer has damaged it or failed to maintain it.
- There is a risk of buyer abandonment, especially if the down payment and monthly payments are low.
- Unless the seller owns the property free and clear, they need to pay off the existing mortgage should the lender call the loan for violating the “due on sale” clause.
- The Dodd-Frank banking reforms may limit the seller’s ability to offer seller financing without using a mortgage loan originator.
Seller Financing Best Practices
Sellers take on significant risk by offering seller financing, but sellers can take steps to mitigate them. It is usually a good idea to work with a real estate lawyer to review and finalize the contracts.
Other things sellers should keep in mind:
- Most real estate experts recommend that potential buyers complete a detailed loan application and provide records to prove the financial situation. Sellers should also request a credit report before making a lending decision. The contract should be contingent on financial approval by the seller.
- The seller should make sure the note is secured by the home so they can foreclose if the buyer does not make payments as agreed.
- Sellers should collect a reasonable down payment of at least 10%, for example, to cover the potential costs of default and discourage abandonment of the property. Data shows that the average down payment in seller-financed loans was 19%. Research by the Department of Housing and Urban Development also demonstrates that higher down payments reduced delinquency and default rates on seller-financed properties.
Dodd-Frank and Seller Financing
Seller financing typically creates two legal documents: the note and the security instrument, which could be a mortgage or deed of trust. Before the Dodd-Frank reforms of 2014, the seller, their attorney, or a title company could draft these documents.
Now, however, a licensed mortgage loan originator must create these documents in any sale in which the buyer plans to live in the property. If the seller is not licensed, they must hire a third-party loan originator to underwrite the loan unless the following exceptions apply:
- The seller owns the property to be financed and did not build it themselves or act as the contractor.
- The seller only finances one property in any calendar year.
- An estate or trust is the seller, which finances fewer than three properties in 12 months.
The Dodd-Frank Act restrictions on seller financing do not apply to investment rental properties, commercial properties, vacant land, or sales to corporations, trusts, or partnerships.
With seller financing, the borrower buys the property directly from the owner without going through a bank or financial institution. Seller financing is not a loan because the seller does not give the buyer any money; it is an installment sales agreement.
There are pros and cons for both the buyer and seller with seller financing. Buyers usually pay a higher sales price and interest rate, while sellers run the risk of abandonment if the down payment is too low. However, seller financing is a way for two parties to make a real estate deal when the buyer is unwilling or unable to secure traditional financing.
- InvestingAnswers. (2020.) 5 Owner Financing Options for Home Buyers. Retrieved from https://investinganswers.com/articles/5-seller-financing-options-home-buyers
- Brumer, L. (2019.) A Guide to Owner Financing. Millionacres – Motley Fool. Retrieved from https://www.fool.com/millionacres/real-estate-financing/articles/guide-owner-financing/
- Barnes, Walker, Goethe, Perron, & Shea, PLLC. (2015.) Seller-Financing Restrictions Under The Dodd-Frank Act. Retrieved from https://barneswalker.com/seller-financing-restrictions-under-the-dodd-frank-act/