Why vendor finance may be too risky to try

Often referred to as “seller finance”, vendor finance is an alternative way to achieve homeownership without taking out a mortgage with a traditional lender. Vendor finance also refers to ways in which you can start owning and repaying your home, even if you have poor credit or employment history or you can’t qualify for a traditional mortgage for any other reason.

Vendor finance provides the buyer with the opportunity to finance a property through an alternative means. Essentially, it helps borrowers who are not “finance ready” by allowing them to access finance and pursue homeownership with flexible terms.

How does vendor finance work?

The purchaser and vendor arrange the finance terms privately rather than through a bank, and the purchaser pays off the property’s purchase price via instalments to the vendor. Because this happens as a private arrangement rather than a transaction through a bank or lender, there are several risks you need to be aware of.

With vendor finance, the buyer usually pays a small deposit to the seller and makes repayments over time. These repayments may or may not include interest, but the purchase price or the payments are typically higher than a standard loan. For example, a traditional mortgage may come with an interest rate of 2.5%, but the vendor finance provider charges 4%. Or the property would generally sell for $500,000, but you agree to pay an inflated price of $550,000.

Depending on the individual agreement, you either have the option of paying the instalments until you repay in full, or you make the repayments until you’re in a position to qualify for a mainstream mortgage, in which case you refinance and pay off the balance in a lump-sum payment.

These agreements are typically established over a 30-year term, but the intention is to repay the contract once the purchaser is in a position to refinance the debt through a conventional mortgage. Generally, this occurs 2-5 years after moving into the property.

Because of the need to refinance, borrowers need to ensure that they can meet the repayments, save enough for a deposit and maintain a good credit rating to qualify for a mortgage during this period.

Should everything work according to plan, once you’ve made the last repayment, you assume ownership of the property. Unfortunately, however, such agreements often end with a buyer losing the funds they put toward their home.

Would vendor finance suit me?

There may be some situations in which vendor finance is a possible option, including:

• Lack of genuine savings: If you can’t save a large deposit, such as 20% of the purchase price, which is a requirement of many mortgages, then vendor finance may provide you with the time and flexibility to get your finances in order before refinancing with a bank.

• Poor credit file: It may be hard to qualify with a lender loan if you have a poor credit rating or little credit history. Vendor finance may be a suitable option in this case.

• Self-employed: If you run your own business but have poor cash flow and can’t demonstrate financial discipline or savings, vendor finance may be a solution.

Buyer beware!

Vendor finance carries some significant risks, many of which may far outweigh its potential benefits. Before entering into any agreement, you should consult a solicitor,

• Market risk. If the property depreciates over time, the bank may not want to lend you the money to refinance.
• Expensive. The purchase price and repayments usually are higher than the market value, which can make it harder for you to build up equity and qualify for a traditional mortgage when you need to refinance.
• Ownership. As your name isn’t included in the property title, your interest in the property is at risk. For example, if the vendor becomes bankrupt, others can make claims against the property. Therefore, you need to ensure there is a clause in the contract stating that the title is to be transferred to your name when you make the final payment so that you assume ownership of the property.
• Harsh penalties. As laws regulating vendor finance are incredibly murky, the buyer is often at the mercy of the seller. As a result, sellers can impose harsh penalties for missed payments, including the buyer forfeiting everything they’ve paid toward the property.

What are the different types of vendor finance?

There are three standard forms of private vendor finance, including:

• Terms finance: Terms finance is where the buyer repays the purchase price in instalments. The title remains with the vendor until they pay the final instalment or the borrower refinances the loan with a bank. The duration of the contract can be 25-30 years, but a purchaser typically pays it out as soon as they can refinance, usually within 2-5 years.
• Mortgage-back finance: A mortgage-back finance structure is where the vendor loan is used as deposit finance. The vendor and an external party fund the deposit, and the title transfers to the buyer immediately. The vendor funds the difference between the price and the external finance and takes security for payment through a second mortgage on the property.
• Lease option finance: The property is leased to the purchaser while they make payments under an option towards the deposit on the purchase of the property.

Do I have to put down a deposit?

It depends on the vendor and the agreement you enter into. It may be possible to purchase the property with no deposit, but you are generally required to hand over a deposit of around 2-5% of the property purchase price. However, this compares favourably to a 10-20% deposit required by most New Zealand lenders for a standard mortgage.

What are the costs involved?

The same fees and taxes are payable with vendor finance as they would be with a standard mortgage. However, the additional complexity means more legal work and higher costs than would usually be associated with a traditional mortgage.

• Legal fees. Legal charges for vendor finance could set you back around $850-$1600. These fees are for a legal professional to look over the agreement and ensure all the paperwork is correct so you can take ownership of the property.
• Repayments. You need to ensure that you have sufficient funds to meet the monthly repayments. If in doubt, talk to an accountant or financial advisor to ensure that you’re in the financial position to make the payments.

While vendor finance may seem like a potential solution for borrowers who have trouble saving a deposit or fall outside lenders’ criteria, the risks involved can far outweigh the potential benefits. Before entering into any agreement, you must seek the advice of a solicitor and make sure your interests are protected. However, considering the risks, vendor finance may have too many potential pitfalls to be worthwhile.

Frequently asked questions about vendor finance

• Is vendor finance legal?

  Yes. Purchasing a property where the seller provides finance is legal when conducted correctly. Private owners can generally sell their properties through vendor finance legally. However, businesses must either carry a real estate licence or a credit licence, depending on the type of transaction.

  Some argue that current legislation is not adequate to deal with the loopholes and risks associated with vendor finance. If you’re thinking of purchasing or selling property through vendor finance, you should seek a solicitor to run you through the process and legal considerations.

• Why would a seller engage in vendor finance?

  Many homeowners or investors may not immediately need the money tied up in their property and therefore don’t mind if you repay it over time.

  Like any transaction, the seller wants something in return for their flexibility. Therefore, you typically pay a slightly higher price for the property, around 3-7% of the value on the sale date, which is the premium you pay for alternative and flexible short-term finance.

• What if the property is damaged?

  The contract typically specifies that the purchaser is responsible for the costs associated with repairing damaged property. It’s a good idea to take out insurance as a precaution.

• Am I protected if my name isn't registered as the owner?

  Although you aren’t the legal owner, you have the option of having your name registered on the title. In addition, your solicitor can lodge legal documentation that prevents the vendor from selling the property without your approval.

• What happens if I make repayments late?

  If you don’t make your repayments on time, the vendor may also fail to meet the instalment on their mortgage, given that your payments most likely form their instalment amount. If this happens, the vendor’s mortgage provider may charge late fees or other penalties, and the vendor may pass this cost onto you.

  Suppose you’re experiencing financial hardship and you don’t think you can make your repayments. In that case, you should get in touch with the vendor as soon as possible to negotiate a new arrangement or set up a different repayment schedule.

• Is there a timeframe in which I need to refinance by?

  No. You should be able to refinance with a bank at any time. However, you should refinance and pay out the vendor when you have built up enough equity and good repayment history. If you refinance as quickly as possible, you’ll likely pay less interest to a lender than you would to the vendor.

• Who is responsible for covering repair and maintenance costs?

  As the buyer, you are responsible for looking after repairs and maintenance to the property.

• How about rates, taxes and insurance?

  You need to reimburse the vendor for council rates, water rates, insurance and taxes related to the upkeep of the property.

• Can I renovate the property?

  Usually, you can conduct cosmetic renovations to the property, such as painting or installing a new kitchen, without seeking the vendor’s permission. However, if you want to make major structural changes to the property, you need to first speak to the vendor (and the local council).