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What is Seller Financing?
Seller financing is a type of transaction where the seller helps in financing the buyer on their loan instead of a lender while purchasing the home. Instead of giving cash to buyer, seller may also give some credit towards the purchase or remove any down payment while doing a purchase. A contractual agreement is signed with all the terms outlined between the buyer and the seller. This may be seen more common in Land contracts than in residential transactions. Usually, the sellers have an agreement in comparatively shorter term than the traditional mortgage loan. It also protects the sellers to refrain from exposure of risks by extending credit for longer term than necessary. The seller usually holds the promissory note until all the agreed upon terms have been satisfied by the buyer. the financing is done either partially or fully. This is also called as Purchase money mortgage or Owner financing.
Common types of Agreements
All Inclusive mortgage
All inclusive mortgage is a type of transaction where the seller holds on to the promissory note until the mortgage is fully paid off. Until then, the buyer has to pay the monthly mortgage and interest to the seller along with the agreed upon down payment.
Lease with an option to buy
The buyer usually pays a fee called as the option fee which ensures that the buyer has the option to buy the property later. During the leasing period, the buyer agrees to lease the property for an agreed upon rental amount outlined in the agreement. At the end of the agreement period, the buyer may have an option to buy the property. Usually the option fee is not taken into account for the down payment or purchase price. But, a part of the rental amount may be taken into account towards down payment or the purchase price. This agreement gives an exclusive right to the buyer to buy the property during the option term. The seller cannot sell their property to anyone else until the option term expires. At the end of the option term, the buyer is not obligated to buy the property.
Lease purchase agreement
This works exactly same like the option to buy agreement except the buyer may be obligated to buy the property at the end of the option term. The buyer and seller usually agree to a purchase price that is slightly higher than the market price. Initially, the buyer pays a rent to the seller until the agreed upon term, then the buyer opts in for a traditional mortgage by refinancing and pays off the seller. Usually the buyer is responsible for all the expenses and maintenance of the property during the lease term and they are contractually obligated to buy the property at the end of the option term. The option fee is usually non-refundable.
Installment contract
Installment contract usually works in a same way as the traditional mortgage loan where the buyer makes a down payment on the property and pays the agreed upon mortgage and interest to the seller. Usually, the term of the loan is comparatively shorter than the traditional mortgage. For example, a contractual agreement is done between the buyer and seller for five years, where the buyer pays the agreed upon monthly mortgage and interest for five years, then a balloon payment is requested at the end of the term where the financial situation of the buyer is expected to be better. Then, the buyer applies for a refinance in a traditional mortgage and pays off the seller.
Assumable mortgage
Assumable mortgage is a type of transaction where the buyer assumes the current mortgage of the seller. Assumable mortgage helps the buyer to take over the seller's mortgage under the seller's current interest rate, terms, balance etc. This might be a good deal when the seller's current mortgage rate and terms are more attractive than the new mortgage rate and terms. This is especially beneficial if the seller's current mortgage interest is substantially lower than the current mortgage interest on the market.
Second Lien
In today's market, most lenders are reluctant to provide loan to not more than 80% of the value of the home. Instead of financing the whole mortgage, the seller may also help in financing the buyers partly. The seller may agree to carry the difference in the purchase price or the down payment amount. But assuming the Second lien has a risk as the seller assumes to have a lower priority in case the borrower defaults. In case of foreclosure, the seller's second lien is only paid after the first lien loan amount is paid fully.
Components of Seller financing agreement
Purchase price of the home -It is important to include the purchase price of the property as it might help in calculating the loan amount.
Down payment amount - The seller financing agreement should always include the amount of down payment the buyer is paying and may also include any Earnest money paid in the transaction.
Loan amount - The loan amount can be calculated by subtracting the down payment, earnest money paid by the buyer from the purchase price.
Interest rate - The interest rate is also mentioned in the agreement which may be slightly higher than the traditional mortgage interest.
Time for the total payment - The term of the loan and how the loan is amortized over the term are also added in the agreement.
Prepayment Provision - The prepayment provisions and terms and the conditions for making prepayment on the loan amount are indicated in the agreement.
Balloon payment - Some seller financing agreements are designed for 20 or 30 years and some may be as less as 5 years, where by the end of the agreement the buyers are expected to pay the loan amount fully.
Monthly payment and due date - The agreement may also include information such as monthly payment amount, number of monthly payments to be done, what are the due dates and what are considered as late payment.
Property tax and Insurance - The property tax and insurance payments are usually added on to the mortgage payments while doing an escrow, but in seller financing it is usually paid by the buyers directly to the companies, but the contract usually mentions who is responsible for the payments though.
Maintenance provisions - The maintenance expectations are usually outlined in the agreement, for example if the home has any special maintenance needs or if it's a historic home, then there may not be any changes or modifications made before getting written consent of the seller.
Pros for Sellers
This may give the sellers an opportunity to sell their home faster and for the price they expected.
This enables the seller to sell their homes in an 'as is' condition without waiting for the appraisal.
This works as a passive income stream in some scenarios like lease purchase or lease option as the mortgage interest rate is typically little higher than the standard mortgage interest.
In a buyer's market, this helps attract more buyers and helps sell their homes faster.
It may help produce significant capital gains tax savings over time for the sellers in a long run.
Cons for Sellers
Eviction situation might arise while selling the home under option to purchase agreement where the buyer might not be able to make the payments and refuse to leave the home. In that case, the process of eviction has to be carried out and it may take several weeks or even months,
It might also result in Foreclosure process where the buyer is not able to make payments while in the lease purchase agreement and the process might take several months or years to be completed.
Sellers might need to be aware of the credit history of the buyer as they are financing alternatively rather than doing it the traditional way.
The sellers have to make sure the maintenance expectations are added on to the agreement as the lack of maintenance by the buyers may result in the loss of value of the property especially the buyers who opt in on Option to purchase agreement where purchasing is not an obligation to the buyer.