The Risks and Rewards of Seller Financing
Seller financing is becoming a more feasible option for both buyers and sellers these days as more people are willing to learn and do the work themselves when it comes to real estate transactions rather than rely on middlemen who ultimately cut into the net gains of both parties.
Granted, if you’re going to take on any role in a real estate deal that’s normally handled by a professional, you need to know your way around. But if you’re willing to do the work, there are rewards to be had.
This is true for seller financing, which is sometimes referred to as owner financing or an owner-carry installment sale. The meaning is pretty straightforward: owner financing, as opposed to conventional bank financing, is what propels the transaction. Whereas most buyers need a mortgage in order to afford a house and go to a lender to procure one, in an owner-financed deal the seller effectively becomes the bank.
Precisely how the seller finances the deal can vary, and there are two main types: purchase-money mortgages and vendor take-back mortgages. Before you as a seller decide to go this route, you need to understand the differences between the two.
A purchase-money mortgage is the more common of the two, and it’s closest to a traditional mortgage. The seller extends the borrowing terms and effectively takes payments on the home without lending the entire sum upfront as a bank would. It’s usually done in situations where the buyer can’t qualify for a mortgage through traditional lending channels, for whatever reason.
The fundamentals are fairly straightforward and resemble a traditional mortgage: the buyer provides the seller with a down payment and gives a financing instrument as evidence of the loan. The security instrument is typically recorded in public records, protecting both parties from future disputes, and the buyer continues to make payments over a predetermined amount of time until the balance is paid off.
A purchase-money mortgage can also be used in situations where the buyer assumes the seller’s mortgage. In this case, the difference between the balance on the assumed mortgage and the sales price of the property is made up with seller financing.
Whether the property has an existing mortgage is relevant only if the lender accelerates the loan upon sale due an alienation clause. If the seller has clear title, the buyer and seller agree on an interest rate, monthly payment and loan term. The buyer pays the seller for the seller’s equity on an installment basis. The buyer assuming the seller’s mortgage or the seller accelerating their loan are the riskier options here, and it’s generally more advisable for a seller to extend financing if they don’t have a mortgage and therefore wouldn’t necessarily need all the cash upfront to pay off their existing mortgage.
In most cases, these transactions don’t pass legal title to the buyer but they will give the buyer equitable title. The buyer makes payments to the seller for a set time period and after the final payment (or a refinance), the buyer receives the deed.
Slightly less common is what’s called a lease purchase agreement, in which the seller gives the buyer equitable title and effectively leases the property to the buyer. After fulfilling the lease purchase agreement, the buyer receives the title and credit for part or all of the rental payments toward the purchase price and then typically obtains a loan for paying the seller. This is obviously a slightly more complex arrangement, and both parties should fully understand the mechanics before considering it.
There’s a separate class of seller-financed deals called vendor take-back mortgages. In this arrangement, the seller offers to lend funds to the buyer to help facilitate the purchase of the property. Usually, this is basically a secondary lien on the property, and in most cases the buyer will have a primary source of funding other than the seller.
So vendor take-back mortgages are usually a tool to allow the faster sale of a property or allow the buyer to purchase a property valued above what they could ordinarily finance themselves, as opposed to an option for a buyer who can’t obtain a traditional mortgage. Because the take-back mortgage is usually offered at a rate below market value, it’s a more attractive deal for the buyer. This in turn can translate into a fast sale for the seller because another source of financing is being offered.
So what’s the point in even considering a deal like this? There are a few obvious benefits here, especially on the buyers’ side. There’s less bureaucratic intrusion into their finances, and they have the ability to purchase a home when they otherwise couldn’t or to buy at a higher price point with better terms that make the entire purchase more affordable. What’s in it for the seller, and isn’t there some considerable risk here?
There are some risks, but the benefits can be substantial on the seler’s side. For one, a seller can insist on and receive the highest price when offering flexible owner-financing terms. In many cases, the seller can receive more than the fair market value of the property by offering these flexible or non-intrusive terms. Most buyers will have an obvious interest in this for one reason or another, and in most cases are willing to pay a premium for non-qualifying financing.
Owner-financed sales tend to close much faster too. If you’ve ever bought or sold a home, you probably know very well that nothing holds up a sale quite like new lender financing. Since most standard real estate contracts contain a financing contingency, the seller may end up back at square one if their buyer doesn’t qualify, losing valuable time that could have spent on a sale that would actually close.
Owner-financed arrangements mitigate this risk, and save the seller a good chunk of time on the closing. It can also offer an incentive for buyers if the home isn’t particularly unique, or if it’s in an area that’s poised for growth but has yet to reach its full potential. For more traditional transactions, the seller is competing with all of the other houses for sale and may need to spend thousands of dollars in paint, new carpet and landscaping just getting the house ready for the market.
Plus, there are relatively few deals on offer like this, which increases the appeal of a home. Buyers are likely to assume that they won’t come across another similar opportunity anytime soon. The closing can be done within a matter of days, meaning there’s no appraisal, underwriting, or survey involved. In many cases it can save the seller thousands in real estate broker fees.
To be sure, there are a few risks here for sellers. The first is the most obvious: the buyer could default, and stop making payments, at any time. If this happens and they don’t just walk away, the seller could end up going through the foreclosure process. Piggybacking on this is the risk that the seller might end up having to pay for repairs and maintenance, depending on how well the buyer took care of the property.
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