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Why seller financing may be too risky to try
You can buy a home without using a bank — but it's risky for everyone involved.
What is seller financing?
Seller financing is a type of home financing where the seller of a home is also the lender. There’s no bank or middle man, and the seller can choose whether or not they’re willing to take on the risk based on the buyer’s income and credit history.
How does seller financing work?
The buyer pays the seller a down payment, and then continues to make payments at an agreed-upon interest rate to the seller. In most cases, the loan is amortized over 30 years, but has a balloon payment for the remainder of the loan amount due in five years. When the balloon payment is due, the buyer will need to refinance with a traditional lender and pay the seller the remainder of the money owed.
In order to protect both parties, a lawyer will generally draw up a promissory note for the buyer and seller to sign, and they’ll record a mortgage or deed of trust.
Why would someone choose seller financing?
Seller financing is generally used when a buyer can’t qualify for a traditional home loan because of:
- Lack of savings. Some sellers may be willing to accept a lower down payment than you’d be able to use for a loan with a bank.
- A poor credit file. If you have a poor credit score or a lack of sufficient credit history, it may be hard to qualify for loan with a lender. Seller financing may be a suitable option in this case.
- Self-employment. If you have trouble proving your income to a lender, seller financing may be a solution.
Risks for the buyer
Seller financing carries some significant risks, many of which may far outweigh its potential benefits.
- Market risk. If the property depreciates over time, the bank may not want to lend you the money to refinance. If you can’t refinance, you could lose the home.
- High interest rate. Sellers can set their own interest rate, and it may be much higher than what you’d get with a traditional lender.
- Harsh penalties. As laws regulating seller financing are extremely murky, the buyer is often at the mercy of the seller. This means sellers can impose harsh penalties for missed payments.
Risks for the seller
Seller financing can also be risky for the seller.
- Defaulting on the home. If the buyer stops making payments, you’ll need to foreclose on the home and take it back. This can be a complicated and expensive process, and then you’ll need to start from scratch to sell the home.
- Repair costs. If the buyer damages the home and then stops making payments, you’ll likely have to foot the bill for repair costs before you can resell.
- Taxes. Operating as a lender can make your taxes much more complicated, and you’ll need to keep all receipts and documents and hire a tax professional.
How to reduce risks
To help prevent problems down the line, both the buyer and the seller should have their own lawyer. Lawyers can help draft an official agreement and make sure everyone is as protected as possible.
It’s also a good idea for sellers to require a loan application from any potential buyers and run a credit check before approving a buyer. Requiring a down payment can also help reduce risks because it ensures you’ll get at least some money if the buyer stops making payments.
What are the different types of seller financing?
There are three common forms of private seller financing, including:
- All-inclusive mortgage. This is when the seller is responsible for the full home loan. They act like a regular lender, though the loan will generally have a balloon payment due in about five years, by which time the buyer needs to refinance with a different lender.
- Junior mortgage. A junior mortgage is when the seller loans the buyer the money for a down payment with a traditional lender. The buyer then has to pay back both their main lender and the seller.
- Lease option. In this scenario, the property is leased to the buyer under an agreement that they’ll have the option to buy the home at an agreed-upon price and time in the future. Depending on the agreement, some or all of their lease payments may be used towards a down payment.
- Land contract. In this option, the seller keeps the title to the home until they’re paid back in full, at which point they’ll sign over full ownership of the home to the buyer. While the loan is being paid to the seller, the buyer will usually have an equitable title, which gives them temporary shared ownership.
What are the costs involved?
The additional complexity means more legal work and higher costs than would normally be associated with a traditional mortgage product.
- Legal fees. Both the buyer and the seller will need to hire a lawyer.
- Taxes. Property taxes can get complicated with seller financing, and will likely require a tax professional. The seller may also have to pay capital gains taxes on any interest money they make.
- Closing costs. Closing costs can include running a credit check, hiring a loan servicer, having the home appraised and inspected and all of the other closing costs you’d see with a traditional loan.
- Monthly payments. The buyer will need to make monthly payments on the loan.
- Foreclosure costs. If the buyer doesn’t continue to make payments, the seller will need to foreclose on the home, repair any damage and relist it on the market for sale.
While seller financing may seem like a potential solution for borrowers who have trouble saving a deposit or fall outside lenders’ criteria, it can be risky for both the buyer and the seller. Before entering into any agreement, it’s crucial to talk to a lawyer and make sure your interests are protected.
If you’d rather not take on the risk of seller financing, compare mortgage lenders to find one that fits your needs.
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