Seller financing is when a seller of residential real estate helps a buyer complete the sale transaction by lending the buyer part of the money for it; or even the entire sum (assuming the seller owns the home free and clear). In essence, the seller assumes the role of a banker.
As with a traditional mortgage loan, the property buyer makes a promise to pay, evidenced by a written promissory note, and the property itself serves as collateral for the loan. As collateral, the property can be sold if the buyer defaults on the loan agreement, through nonpayment or some other failure to meet the loan terms.
Below, we'll discuss:
- the reasons a home seller might want to offer this form of financing
- positive aspects of home financing for the seller
- challenging parts of home financing for the seller, and
- procedures for arranging seller financing.
Pros for the Home Seller Who Offers Financing
Although seller financing is relatively uncommon unless the local real estate market is cool or the house has no other viable offers, there are reasons a seller might want to offer, or at least be open to accepting, an arrangement in which they finance part or all of the real estate purchase. These include so as to:
- Attract more interested buyers. Not every buyer will want seller financing, but for those who need an extra leg up in buying a home, this offer will make it very attractive indeed.
- Set a higher sales price. A home seller who is offering financing to someone who might otherwise have had trouble qualifying might be in a position to command full list price or higher.
- Qualify for tax breaks. The seller might pay less in taxes on an installment sale, reporting only the income received in each calendar year.
- Receive monthly income. Payments from a buyer increase the seller's monthly cash flow, resulting in spendable income.
- Receive comparatively high return on investment. Owner financing can carry a higher rate of interest than a seller might receive in a money market account or other low-risk types of investments.
- Shorter listing term. Owner financing attracts a different set of buyers. If a property is not selling under conventional methods, offering owner financing is one way to stand out from the rest.
- Elimination of repair, decorating, and staging costs. The property could be sold 'as is," eliminating the need for costly repairs that conventional lenders would require, along with other customary steps to make the house look its best for sale.
- Saving on closing costs. Although the buyer normally pays most of the loan closing costs (for things like the loan origination fee and an appraisal), the fact that the buyer won't be on the hook for these leaves more money available for the rest of the transaction.
Owner financing attracts a different set of buyers. If a property is not selling under conventional methods, offering owner financing is one way to make your property stand out from the rest.
Cons for the Home Seller Who Offers Financing
Here are some downsides for sellers to consider before offering to, in essence, loan the buyer money with which to buy the home.
- Monthly or regular need to keep track of payments. A home seller could end up feeling like a debt collector if the buyer is disorganized or worse. Some home sellers hire third parties to handle the payment collection, but of course this also costs money.
- Possible need to foreclose. The buyer's financial situation could change for the worse. Or, the seller might not have gotten the buyer's full or accurate credit or employment picture initially. The seller would, upon the buyer's default, either need to negotiate a different arrangement or initiate the costly and often lengthy process of foreclosure. And if the property has declined markedly in value since the purchase, foreclosure could come with a huge financial hit for the home seller.
- Possible abandonment of the purchase. The seller could agree to a small down payment from the buyer to assist in the sale, only to have the buyer abandon the property because of the minimal investment that was at stake.
- Need to pay off existing mortgage in full. Before turning around and lending money to buy it, a seller will need to pay off the existing mortgage. (In a "normal" sale, the seller uses the proceeds of the sale to pay off the existing bank loan.)
- Need to spend time and effort to assess creditworthiness of buyer/borrower. You'll have to handle various tasks that a bank usually does, such as obtaining a credit report and financial information from the buyer and reviewing it for creditworthiness.
- Cost of attorney and other fees. In order to arrange this deal, you will probably need to hire an attorney, pay an escrow company, pay recording fees, and more.
- Tax obligation. Interest income on a mortgage loan is taxable along with other income.
By way of protection from such downsides, a seller should run a full credit check on the borrower, require homeowners' hazard insurance on the property, and include a due-on-sale clause (meaning that if the buyer resells the property, you'll be owed the entire balance of the loan amount immediately).
Process for Arranging Seller Financing of Real Property
If the seller is willing finance some or all of the purchase (to "take back" a mortgage on the house), the buyer will need to sign both a promissory note (promising to repay the loan) and either a mortgage or a deed of trust (allowing the seller to foreclose if the buyer fails to pay or otherwise defaults). (Learn about The Difference Between a Promissory Note and a Mortgage.)
In return, the seller will normally sign a deed transferring title (formal, documented ownership) of the property to the buyer. Because the buyer then holds the title, the buyer can sell the house or refinance, but must then either pay off the loan or keep making the agreed-upon payments to the seller.
A seller who finances the entire purchase would, however, keep title to the property for as long as it takes the buyer to pay off the loan. The contract between the buyer and seller is known by various names, including contract for deed, contract of sale, land sale contract, and installment sales contract.
How the loan is to be repaid and other loan terms are usually negotiated between buyer and seller. Without preset provisions such as you'd typically find in a mortgage from a traditional lender, a seller-financed loan can be as flexible as the parties involved would like. It's up to them to determine and agree on terms like interest rate, payment amount, late charge stipulations (if any), due dates, length of loan, down payment and so forth.
After the terms are worked out, a formal agreement as to the price, loan amount, interest rate, and terms should be signed by both buyer and seller. An escrow account should be opened with a title company. It would be wise to also hire a real estate attorney to handle the paperwork and provide competent legal advice with regard to the financing, disclosure, and repayment requirements that need to be met.