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Is seller financing right for your real estate situation?
You can buy or sell a home without using a bank — but there are risks for everyone involved.
Seller financing can open doors to both buyers and sellers. If a seller isn’t getting much interest in their home, offering a solution for buyers who can’t qualify for a traditional mortgage can help the home sell quickly. However, taxes and laws can get complicated, so make sure you get an attorney and tax professional.
What is seller financing?
Seller financing, also called owner financing, is a type of home financing where the homeowner becomes both the seller and the lender. There’s no bank or middle man, and the seller can choose if 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 needs to refinance with a traditional lender and pay the seller the remainder of the money owed.
To protect both parties, a lawyer generally draws up a promissory note for the buyer and seller to sign, and they’ll record a mortgage or deed of trust.
Benefits for the buyer
Owner financing is great for buyers who may have trouble in the traditional mortgage market.
- Down payment flexibility. Some sellers may be willing to accept a lower down payment than a bank would.
- Possible credit forgiveness. If you have a poor credit score or a lack of sufficient credit history, it may be hard to qualify for a loan with a lender. Seller financing may be a suitable option in this case.
- Fewer fees. Closing costs and fees may be less without a lender in the picture.
- Verification of employment. If you’re self-employed and have trouble proving your income to a lender, seller financing may require less of a paper trail.
Benefits for the seller
Kickstart the sale of your home by offering owner financing.
- Speed. The seller can often complete the process quickly without a bank and its detailed lending criteria slowing down the process.
- Additional income. When a seller finances the loan, the buyer’s mortgage payment acts as investment income.
- Retaining the title. If the entire purchase of the home is financed by the seller, he or she keeps the title and can take back possession of the home if needed.
- Sell as-is. If you’re offering seller financing, you may not have to make the costly repairs that some lenders require to get the house ready to go on the market.
Risks for the buyer
Seller financing carries some significant risks that may 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 need to foreclose on the home and take it back. This can be complicated and expensive. Then you need to start from scratch to sell the home.
- Repair costs. If the buyer damages the home and then stops making payments, repair costs can be pricey before you can resell.
- Taxes. Taking on the role of a lender can complicate your taxes. Keep all receipts and documents and consider hiring a tax professional.
5 types of seller financing
The most common forms of private seller financing include:
- All-inclusive mortgage. When the seller is responsible for the full home loan, they act like a regular lender. The loan generally has a balloon payment due after five years, so the buyer needs to pay the remaining balance or refinance with a different lender.
- Junior mortgage. The seller loans the buyer the money for a down payment with a traditional lender. The buyer pays back both the lender and the seller.
- Lease option. A seller leases a property to a potential buyer, under an option-to-buy agreement. Depending on the agreement, some or all of the lease payments are put toward a down payment.
- Land contract. The seller keeps the title to the home until they’re paid back in full. While the loan is being paid to the seller, the buyer usually has an equitable title, giving them temporary shared ownership.
- Assumable mortgage. Allows the buyer to take over — or assume — the seller’s current mortgage. The terms and rate often stay the same, though there are varying risks to discuss with the lender before going this route.
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Costs are higher than with a traditional mortgage
The additional complexity of owner financing 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 need to hire a lawyer.
- Taxes. Property taxes get complicated with seller financing, and likely requires 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 makes monthly payments on the loan.
- Foreclosure costs. If the buyer fails to make payments, the seller needs to foreclose on the home, repair any damage and relist it on the market for sale.
- Maintenance and repairs. The buyer is generally responsible for these costs, but if the buyer defaults and files for bankruptcy, the seller will have to pay.
4 steps to take before seller financing
There are several ways to mitigate risk when entering a seller financing scenario.
- Hire a real estate attorney. They can help draft an official agreement and make sure everyone is as protected as possible.
- Take an application. Running a credit check and looking into a potential buyer’s financial history can help you decide if they’re a qualified buyer.
- Collect a down payment. This can help reduce general risk and determines how serious the buyer is. Taking a down payment also makes it less likely that a buyer will walk away.
- Speak with a CPA. A tax professional can help you determine whether or not you’re leaving any tax benefits on the table.
While seller financing may seem like a potential solution for borrowers who have trouble saving a deposit or if credit falls outside lender 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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