How Does Seller Financing Work?

Competition in the current housing market is stiff. Low supply and high demand are just two factors complicating the home search for many prospective buyers. Not only that, but qualifying for a traditional loan can be difficult. One option outside the norm is seller financing. With seller financing, the owner of the home offers the buyer a loan. Thus, you can avoid the pitfalls and challenges of the traditional mortgage experience. Seller financing offers several benefits, such as lower closing costs. But they come with their own challenges as well. Here’s how this lending process works and whether it’s right for you.

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What Is Seller Financing?

Seller financing is an alternative way for a buyer to purchase their home. Essentially, the seller becomes the lender and extends credit to the buyer so that they can cover the purchase price of the home (excluding the down payment). So, you effectively cut out the middleman – i.e., a traditional lender. The seller oversees the debt instead.

Also sometimes called a purchase-money mortgage, seller financing is sometimes attractive to those who struggle to qualify for a conventional loan. They may have a poor credit rating, for example. But a seller can be more flexible than a bank, particularly when it comes to the down payment.

When you enter a seller financing agreement, the seller acts as the lender. So you, the buyer, purchase a home from the seller with no involvement from a bank, credit union or other traditional lenders. The seller only extends credit to the buyer, though, not cash. Once they do, the buyer makes regular installment payments to the seller. They do this until they completely pay off the balance owed.

Although this agreement doesn’t involve lending institutions, the buyer and seller often use other professional help. Many times, they rely on attorneys and real estate agents to facilitate the purchase. Professionals in these fields also take the lead in generating the terms of the agreement. However, the buyer and seller may negotiate factors such as the loan’s length or interest rate.

Seller financing generally functions in two ways.

One, the buyer receives the house title after pledging to pay the seller’s offered loan. The buyer can then refinance or sell the property but continue to make payments to the seller per their agreement.

Or, two, the seller keeps the house title until the buyer fully repays the loan. Only after do they receive the title.

In either case, the seller often requires the buyer to complete an application, go through a credit check and offer a down payment. The seller may also demand certain requirements, such as an appraisal of the home. Or, they may insist on retaining the right to foreclose the property if the buyer defaults.

If both parties agree, they must sign a promissory note that contains that loan’s terms. Then they file a mortgage (or deed of trust in some states) with the local public records authorities.

Type of Seller Financing

Seller financing comes in a couple of forms. Here are the most common examples:

All-inclusive mortgage – With an all-inclusive trust deed (AITD), the seller pays their existing mortgage using payments from the buyer. The seller also pockets any amount exceeding the cost of the mortgage and the down payment.
Assumable mortgage – An assumable mortgage is one way for buyers to purchase a home at a lower interest rate. In this scenario, the buyer takes on the responsibility (or assumes) of the seller’s current mortgage, allowing them to buy the property.
Junior mortgage – A seller can help a buyer purchase a property by taking on a junior, or second, mortgage. For instance, the seller may cover the down payment’s cost, which the buyer repays separately from their primary mortgage.
Land contract – With a land contract, the seller finances a property for the buyer. The buyer repays the seller under the land contract’s terms in exchange. During this, the buyer gets equitable title, so they can build up equity. The buyer only gets the deed once they pay the purchase price in full.
Lease purchase – Sometimes referred to as a rent-to-own contract, this is a contract between a renter and their landlord. It acts as an agreement between the two parties that gives the renter exclusive buying rights. The renter just has to pay an option fee at a certain purchase price to the seller first.

Pros of Seller Financing

Like any form of financing, seller financing comes with its own pros and cons. The exact balance depends on the specific agreement made between seller and buyer. However, in many scenarios, this form of financing promises more lenient approval requirements and lower costs.

For example, a lackluster credit score may stop you from getting a traditional mortgage. But it’s possible to obtain seller financing even with a less-than-ideal score. You may not even need to go through a credit check, either, depending on the seller.

Seller financing also omits a real estate agent’s commission, often 6%. That’s serious money: On a property worth $300,000 that’s $18,000.

Not only that, but buying a home comes with a laundry list of expenses that seller financing can lower. Let’s say you can’t afford a large down payment. Your contract with a seller may not require a minimum down payment at all. As a result, you may not have to pay the cost of private mortgage insurance, either. Closing costs are also usually lower in this situation compared to a traditional mortgage.

Cons of Seller Financing

Despite the benefits mentioned above, seller financing can be risky. And that’s because it all comes down to the agreement the seller offers. While you can find some sellers who accept small down payments, others will not. They may want a hefty one, up to 20%, to financially protect themselves. They may charge a high-interest rate for the same reason – even higher than a traditional lender would.

You may run into a seller who refuses to negotiate on the home price, too. They may even avoid a property appraisal. So, you pay more in the end than you would otherwise. This is just one example of how sellers have the upper hand. And that is a consistent risk with seller financing.

Buyers generally have less protection in these agreements. That’s because the seller doesn’t have to operate under the same state and federal regulation as a traditional lender. If a buyer goes without legal representation, they may also face a contract that increases their risk.

The terms of the agreement may favor the seller, such as a short repayment period. If you agree to that too quickly, you may have to pay off your loan within five years. That’s a drastic difference compared to traditional loan terms. You may even need to refinance the loan if you cannot repay it by the end of the loan term.

Is Seller Financing Right for Me?

Today’s housing market is highly competitive. So, you may find the home of your dreams, but it’s out of your price range. Or, perhaps, you struggle with qualifying for a traditional mortgage loan. Either way, seller financing can open up the opportunity of homeownership to you. And you would have potentially advantageous terms, too, such as a low-interest rate, low minimum down payment and fewer closing costs.

But there are risks to seller financing. Contracts can include unfavorable terms, like a higher interest rate or a too-short repayment period.

If you struggle with meeting the criteria for a conventional loan, consider all your options. Seller financing isn’t the only router. There are other loan types that come with relatively lenient requirements. If applicable, consider researching FHA loans, USDA loans and VA loans as well before you choose.

The Bottom Line

While it can be hard to find a perfect loan, you shouldn’t rush into any lending agreement. Seller financing may be right for some buyers. But it heavily depends on the seller and the terms they offer. Before you explore this option, consider hiring an attorney. They can ensure that your rights as a buyer are upheld. Or, they can help you walk away if negotiation is impossible. Remember to explore all your options before you choose, though. There are other loans out there that come with lower credit requirements which may make more sense for you.

Tips for Home Buying

Selling a home is a major financial move, and it should be coordinated with your investment, tax and retirement planning. That’s where a financial advisor can offer valuable insight and guidance. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Make sure you crunch the numbers before you start looking. SmartAsset offers a free mortgage calculator that can help you estimate how much house you can afford.