If you are looking to buy a home but think you will have difficulty qualifying for a traditional mortgage, seller financing may be an option for you. In this article, we’ll go over what seller financing means, how it works, the different transaction structures, and the pros and cons for both buyers and sellers. This will help you decide if seller financing is right for you.
What is seller financing?
Seller financing is a real estate transaction in which the seller helps finance the purchase of their property with the buyer, sometimes financing the sale in its entirety. Some prefer a seller-financed mortgage because it avoids the need for a mortgage from a traditional lender.
Seller financing is also known as owner financing or, in some cases, a purchase money mortgage.
When you and the seller opt for owner financing, there may still be much of the structure associated with a traditional mortgage. You are just making payments to the seller rather than to a bank or other mortgage lender. Depending on the structure of the deal, you may still be responsible for a down payment associated with seller financing.
How does seller financing work?
Seller financing works similarly to any mortgage transaction, except that the seller provides the financing to you instead of a bank or mortgage lender. Unlike a traditional mortgage closing, the only money the seller receives at closing is the amount that was negotiated for the down payment, if applicable.
You and the current homeowner will work to negotiate the details of a mortgage promissory note that says you will repay the loan. This document will specify the interest rate you pay on the loan, as well as the repayment schedule.
With a traditional mortgage, in addition to the promissory note, there is a separate document, the mortgage itself, that defines what the penalties are if the repayment terms are violated. When seller-financed, the consequences of default may be set forth in the note or in a separate document.
While this is not always the case, seller financing generally involves a shorter term than you would see in a traditional mortgage. The seller has the incentive to get paid for the house they just sold.
In addition, some owner-financed loans include a balloon payment, which means you pay a lump sum at some point during or at the end of the term. If you don’t have the money to make a lump sum payment when it comes due, people with improved credit will refinance the cost into a traditional mortgage.
Types of seller financing arrangements
There are several types of seller financing that can be used between you and the seller. We will touch on them here.
Seller Financed Mortgage
There are several types of seller-financed mortgages that can be applied. The commonality here is that, in many ways, they work like traditional financing. Here’s a breakdown of what you might see:
Free and clearly owned properties.
In the simplest scenario, the seller has fully paid for the home, and the seller and buyer agree on the terms of the down payment, the final purchase price (when the loan will be paid off), and the interest rate. The seller pockets the full amount of the repayments.
All-Inclusive Trust Deed (AITD)
In an AITD, the seller continues to pay off an existing mortgage with the proceeds of the buyer’s payments, also known as a wraparound mortgage. In addition to making these payments, the seller pockets any amount above the cost of the mortgage, as well as the down payment.
This carries risks for both the buyer and the seller. For the seller, it is important to note that most mortgages contain a “due-on-sale clause”. This means that as soon as the property is sold, the mortgage lender could demand payment. If enforced, this clause could defeat the purpose of the comprehensive mortgage if you plan to use the proceeds from the redemption to make the mortgage payment. In addition, buyers assume the risk, because if the seller fails to make the underlying mortgage payment, the mortgage lender can repossess the home.
A seller may help finance the real estate transaction by working out a junior mortgage, also called a second mortgage, with you. For example, a seller might cover the cost of a down payment that you would pay him or her separately from the primary mortgage that finances the property. It is important to note that many traditional lenders do not allow this type of arrangement.
Lease Option Agreements
Another type of seller financing involves lease-purchase agreements. In a lease-purchase agreement, you rent a property at above-market rates. In return, some of the money you pay for rent is usually set aside for a rental credit, which can go toward your down payment and a traditional mortgage in the future.
The first type of rent-to-own agreement is a lease option agreement. Under a lease option agreement, you have the right to purchase the property at the expiration of the lease if you so desire. You are under no obligation to do so.
Lease-option agreement
The basic difference between a lease option and a lease-purchase agreement is that under a lease-purchase agreement, you must buy the property at the end of the lease. There should be two concerns for the buyer here: first, you need to know that you really like the property and could see yourself living there permanently.
Second, you will want to have your financing lined up before the lease expires, so get your credit in order and be ready when the time comes. Make sure you are aware of the consequences regarding what happens if you decide not to move forward with the purchase at the end of the lease.
Land Contracts
A land contract is just another term for a seller-financed mortgage, which we mentioned earlier. It can be a straightforward contract, where the property is owned free and clear, or it can have an integral component if there is already a mortgage in place.
It is important to note that with most land contracts, you do not get the title right away. Rather, the seller has legal title to the property, which is vested in you once the seller has paid in full.
While you do not get legal title immediately, you do get the equitable title. This means that with each payment you make to the seller, you get equity in the property.