Some sellers offer the option of a seller-financed deal to home shoppers. Seller financing can be very attractive when a hopeful buyer can’t obtain a loan approval. After 2020, we could see an uptick in such situations, as a good number of sellers and buyers try to restore their pandemic-battered finances and seek alternative ways to borrow. Indeed, seller financing has long helped make homebuying a more flexible prospect for self-employed people and others who might not fit the profile preferred by loan underwriters. Bonus: no private mortgage insurance (PMI).
How Does a Seller-Financed Mortgage Work?
In a seller-financed deal, the buyer and seller sign a promissory note which contains the loan’s terms and conditions. They record the loan, and the buyer begins to repay the seller. Owner financing and documentation can be done through a mortgage or security instrument.
Under a security deed, the lender can automatically take, sell, or foreclose the property in the case of a borrower default. If there is an owner carry deal, the seller is financing a mortgage. The parties can negotiate their terms, including the payment schedule. Unlike banks, though, sellers are mere mortals who’d rather not wait 30 years to be paid back. So, consider an owner-financed loan that comes with a 30-year amortization schedule, but also a balloon payment to be paid in five years. This gives the new owner time to get onto stronger financial ground, able to refinance the home with a mainstream mortgage company.
From the start, the buyer is not jumping through the underwriter’s hoops, so the parties can get to the closing table faster, on their terms. The buyer avoids loan origination and underwriting fees, while the seller now has a monthly income stream rather than one chunky, taxable sale. If the home has risen in value, this helps the seller avoid paying a large sum on capital gains taxes all at once.
What About a Home With an Existing Mortgage?
The buyer must be sure a title company confirms clear title. Does the seller’s home have an existing mortgage lien? If so, an owner-financed mortgage could be barred.
But the seller can offer a wrap-around loan if there is no due-on-sale clause in the home’s existing mortgage. By wrapping around the prior mortgage, this new loan considers the unpaid balance and rate on the existing mortgage, then augments the loan money to meet the full cost of the home purchase.
To profit, a seller must receive a higher interest rate than the one on the existing mortgage. So, wrap-around loans can be pricey. Yet deploying a second mortgage could enable the buyer to handle an otherwise unreachable purchase price.
What Are the Leading Types of Seller Financing?
Well-known types of seller financing include:
- All-inclusive mortgage. This is called an all-inclusive deed of trust in some states. The seller finances the full price of the home, minus the down payment.
- Junior mortgage. Sellers might offer a loan to cover whatever amount a mortgage company won’t. Wrap-around loans are junior loans. Senior loans get priority in the event of foreclosure.
- Contract for deed. Also known as an installment sale agreement, or land contract. The buyer gets equitable title and moves in. But the seller stays on the deed and retains legal title with full property rights until the loan is repaid. In a default scenario, the seller can take the house back. A quitclaim deed, readied in advance, can ensure the defaulting borrower gives up any claim on the property. Consult state law for more detail about what is and is not allowed where your home is. States deem these deals high-risk, and under some state laws the buyer won’t be reimbursed for home improvements. The recommended seller financing route is the use of a promissory note, mortgage, and warranty deed. To learn more about the risks with a contract for deed, read this first!
- Lease agreement or rent to own. The seller asks for an upfront fee, to sell the property later, with the rental payments partly or wholly directed into the home purchase.
What Terms Does a Seller Financing Contract Contain?
While the terms can be created to meet the parties’ needs, the loan contract must meet your state’s requirements. There are helpful templates available: the home’s current mortgage loan documents, and other legal seller financing contracts recorded in your state. Have a real estate agent or attorney review the documents.
Loan agreements must describe the property and the effective sale date, and spell out the price of the home, citing the appraisal. State the upfront payment amounts and the remaining balance. An amortization schedule should specify payment amounts of principal and interest, balloon payment provisions, insurance, taxes and applicable fees.
State which party will get property tax deductions, and set forth the terms of the escrow account.
What else is essential to include?
- State that the buyer must maintain the condition and value of the property for the duration of the contract.
- Detail the buyer’s responsibilities such as repairs, landscaping, local taxes, and association dues.
- Outline the appliance replacement responsibilities and limitations the buyer will have. Spell out what appliances and fixtures are included in the loan and must be left alone pending repayment.
- Include loan servicer information, if applicable.
- Detail the default process and consequences, adhering to your state law. Cite the state provisions and rights in the language that applies in the state where the property is.
Speaking of state-based rules, do follow yours for the proper signature and notarization procedures.
Consider the Risks, and a Few Tips to Manage Them
For every reward in real estate, there is usually a cost. A seller-financed deal is no exception to the rule. What are the possible drawbacks?
- For buyers, the interest rates can be pricier than the standard mortgage rates. This is especially so if the seller is leveraging the new loan to cover and exceed an existing mortgage rate.
- For sellers, the big concern is having to cope with a possible buyer default. In a worst-case scenario, this would lead to eviction and foreclosure proceedings.
In 2014, the Dodd-Frank Act went into effect to prevent careless lending practices and to lower the risk of buyer default. But the Act does not apply to seller-financed deals between ordinary owners and buyers who aren’t typically financing multiple homes at a time.
So, how do the parties control their own risk?
For one thing, tapping professionals to assist in the transaction can make the deal more like an arm’s-length transaction and put curbs on the risks. There are other best practices, too. For example:
- Even if the parties prepare their own deed, they can have a professional draft the promissory note and contract for sale.
- Be sure that buyers planning to live in the property have the ability to repay. Have the buyer go through the formalities of a vetted loan application form and credit check.
- Be sure the sale agreement is contingent on the seller’s approval of the loan application.
- Get at least 10% down, so the buyer’s invested in the loan, and secure the loan with the property to allow for foreclose in a worst-case scenario.
- Sellers can hire a professional loan servicing company in their local area to create and administer the mortgage.
And a Final Note on Saving Resources
An underrated benefit of the seller-financed home sale is its overall frugality. In uncertain times, it can be difficult to renovate a home for a competitive real estate market. Owner-financed sales are typically no-frills affairs, with both buyer and seller satisfied to transfer a property as-is.
With seller financing, both parties can conserve rather than spend on unnecessary upgrades and services. For two sides committed to the deal, a great deal of time, money, and material resources can be spared — making the best use of all three.
Documents, documents, documents! Check your state law. Transactions typically need:
Local property tax statements. The seller should give the buyer a copy of the most recent statement, and any homestead exemption information.
Homeowners’ association information: This includes rules, bylaws, fees, any litigation pending, and contact information.
Surveys and inspections: Obtain a copy of the most recent property survey and inspection reports and documentation of major appliance repairs, upgrades, and warranties for the buyer.
Warranty deed: Review the legal disclosures you are responsible for providing: airport noise, flood or earthquake hazards, pollution. File the new warranty deed with the county recorder along with the Tax Affidavit and Preliminary Change of Ownership Report.
Photo credit: Amy Hirschi, via Unsplash
Please note: This article is offered as general information for the Deeds.com readership, not case-specific advice. We encourage readers to consult their real estate and legal professionals, as well as government guidance on real estate transactions.