Qualifying for a mortgage isn’t easy. Some lenders have strict requirements and weed out applicants with poor credit or too much debt. A possible alternative for those determined to buy a house is something called “seller financing.” This process, as its name implies, means the home’s owner will finance the purchase for the buyer. But whether this is a good idea is something you’ll need to consider carefully.
How Seller Financing Works
Seller financing is when a prospective homebuyer has part of his or her home purchase financed by the homeowner selling the house. In turn, the seller becomes the homebuyer’s lender and gets to set his or her own loan terms. This is typically viewed as a secondary option outside of normal home buying routes, such as paying cash or taking out a mortgage.
Let’s say you’re only eligible for a small mortgage loan. If you want to try seller financing, you can attempt to convince the owners to finance the remaining purchase amount for you. Other times, sellers can afford to lend buyers enough money to cover the cost of a whole home. Either way, the buyer is responsible for paying back whatever he or she borrows on a monthly basis, with interest.
Under this kind of arrangement, a seller will usually require that a homebuyer sign a promissory note with all of the details regarding the loan. This will include the schedule for making payments, the interest rate and all other terms.
The Benefits of Seller Financing
Benefits for Buyers
Owner financing can be beneficial to buyers in many ways. From the buyer’s perspective, seller financing can be an attractive alternative to getting a standard mortgage loan. The typical 20% down payment is tough for some to scrape together, so owners willing to accept less can be helpful. Also, by avoiding banks and other lenders, homebuyers might also pay fewer fees and less in closing costs.
Poor credit can make it hard to receive approval for a mortgage. By bypassing banks, credit unions and other home loan lenders, you also avoid their stringent approval requirements. So if you’ve struggled with payments in the past, owner financing might be worth looking into.
Benefits for Sellers
A seller who agrees to finance a home purchase can benefit from using the loan as an additional source of income. It’s essentially the same thing as investing in real estate, only slightly more personal. In addition, you can sell the promissory note for the loan to an investor for a lump sum payment.
If the seller finances the entire home purchase, he or she can retain the property’s title until the buyer pays off the loan. Regardless of the circumstances, the seller can reclaim the home if the buyer fails to keep up with the bills.
One of the pressures of selling a home is renovating and preparing for the market. But with seller financing, you’re more likely to be able to sell the home as-is. When all’s said and done, this allows you to pocket more of money from the sale.
If the seller finances part or all of a home purchase, the sale can be completed in a short amount of time. That can be advantageous to both owners who want to sell their homes quickly and buyers who don’t want to wait for a traditional lender to approve them for a conventional loan.
The Drawbacks of Seller Financing
Drawbacks for Buyers
Seller financing is usually the last mortgage option for homebuyers. Because sellers know this, they may try to jack up the interest rate to take advantage. So while you’ll probably still end up with a home, the deal you receive might be unremarkable.
What’s worse is that a buyer could get stuck making a balloon payment at the end of the mortgage term. Sellers typically don’t give their buyers 15 or 30 years to pay off their loans. Loan terms are usually fairly short and a seller can ask a buyer to make a large lump sum payment at the end of the loan period, and then apply for a conventional home loan. If you can’t afford to cover the cost of a balloon payment, seller financing might not be right for you.
Homebuyers might pay less up front, but over time, they could end up overpaying. This happens particularly if the owner financing comes with a high interest rate. Much like a traditional lender, a seller might decide to conduct a thorough review of the buyer’s credit history and financial background before lending a single dime. As a result, a low credit score could still prompt a seller to charge a higher interest rate.
Drawbacks for Sellers
Despite the advantages of seller financing, it can be risky for owners. For one, if the buyer defaults on the loan, the seller might have to face foreclosure. Because mortgages often come with clauses that require payment by a certain time, missing that date could be catastrophic. Should you end up in control of your property again for another reason, though, you may need to make repairs before putting it back out on the market.
Some sellers may be forced to utilize outside mortgage services. This is because the Dodd-Frank Wall Street Reform and Consumer Protection Act instituted new rules that requires some homeowners to integrate loan originators into the seller financing process. Whether this applies to you or not is largely dependent on how much real estate you finance annually.
Owner financing can provide a seller with a steady stream of income and make buyers’ path to homeownership much easier. But the arrangement has its downsides as well. If you decide to take on a loan from a seller or loan out money to a buyer, it’s a good idea to find a real estate attorney who can ensure that the seller financing agreement covers all your legal bases.
Tips for Homebuying
- There are many charges and fees that come into play when you’re buying a new home. One of the fees to look out for the most are closing costs. To get an idea as to what you can expect to pay to cover these fees, stop by SmartAsset’s closing costs calculator.
- Have more financial questions? SmartAsset can help. So many people reached out to us looking for tax and long-term financial planning help, we started our own matching service to help you find a financial advisor. The SmartAsset advisor matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to up to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
Photo credit: ©iStock.com/mihailomilovanovic, ©iStock.com/BartekSzewczyk, ©iStock.com/julief514