Ins and Outs of Seller-Financed Homes

Veterans and active service members have some great mortgage options. But, sometimes the conventional mortgage route A) isn’t possible, or B) doesn’t make sense. Regardless of reason, buyers often purchase homes with seller financing. As such, we’ll use this article to explain the ins and outs of seller-financed homes.

Specifically, we’ll discuss the following:

•  An Overview of Seller-Financed Homes
•  Potential Advantages to Seller Financing
•  Buyer Considerations with Seller Financing
•  Owner Considerations with Seller Financing
•  Structuring a Seller-Financed Home Sale
•  Final Thoughts

An Overview of Seller-Financed Homes

Most buyers finance home purchases with traditional mortgages. In other words, if you want to buy a home, you apply with a local bank or other financial institution for a residential mortgage. For some people, this may be a government-backed loan (e.g. FHA or VA loan). Other buyers opt for a loan without government backing, known as a conventional mortgage. Regardless which route these buyers take, they share a theme: using a lender to finance a home.

However, what if you A) don’t qualify for a traditional mortgage, or B) have some reason for not wanting to work with a lender? Yes, you can buy a home with cash. But, most of us do not have enough money sitting around to purchase a home outright. Fortunately, a possible alternative exists: seller financing.

With a seller-financed home purchase, the seller – not a bank or other lender – finances the home purchase. In other words, the buyer and seller arrange for the financing directly – not with a third-party lender. While individual situations vary, all seller financing arrangements share the following traits:

Promissory Note

The seller and buyer agree to the financing terms in a legal document known as a promissory note. This document outlines the major loan terms, including interest rate, repayment schedule, and the consequences of buyer default (i.e. what happens if the purchaser stops paying back the loan).

No Transfer of Principal

With a traditional mortgage, the seller receives a lump sum of cash (i.e. the loan principal) at closing. Then, the buyer/borrower gradually pays this off with the lender over the life of the loan. With seller financing, the seller never receives a lump sum payment. Rather, he or she accepts an agreement from the buyer to repay that loan principal over time in accordance with the promissory note.

Potential Advantages to Seller Financing

We list the below as potential advantages, because every seller financing situation differs, meaning the below won’t apply to all deals.

Speed

Traditional mortgages need to go through an in-depth, formal underwriting process. In a nutshell, the lender analyzes the deal and the buyer’s finances with a fine-toothed comb, looking for any reasons not to approve the loan. This process typically results in a number of follow-up requests for information from lenders, which can significantly delay the closing process.

Conversely, a seller-financed sale avoids this entire process, as the buyer and seller represent the only two parties to the transaction.

Cost

Lenders broadly make money two ways with a mortgage. First, they charge an origination fee to actually issue the loan, which borrowers normally pay in cash at closing. Second, they collect interest payments over the life of the loan. Seller financing typically does not include an origination fee, meaning buyers can expect far lower closing costs in these sorts of home sales.

Access to Credit

Due to poor credit scores, many would-be buyers do not qualify for traditional mortgages. Fortunately, seller financing provides an alternative path to access credit. More precisely, if you can’t pay cash or get a traditional mortgage for a home, a seller-financed deal still lets you use credit to purchase a home.

No Lender Required Repairs

With traditional mortgages, the lender will require a home inspection. If this inspection uncovers major issues with a home, the lender will require repairs prior to approving the loan. The buyer and seller can negotiate who completes these repairs, but someone needs to in order to close the deal. This requirement does not exist with seller financing, meaning the closing process can occur A) more quickly, and B) for less money.

NOTE: Buyers using seller financing should still negotiate major repairs with a seller. You don’t want to buy a home and then pay out of pocket for a major repair (e.g. broken HVAC system, damaged roof, etc.). Bottom line, seller financing should not change the due diligence you put into inspecting a home.

Buyer Considerations with Seller Financing

Expect Terms Similar to Traditional Mortgages

While seller financing can provide you access to credit, don’t expect it to provide you terms better than the current market. Most sellers will structure loan terms and interest rates in a comparable fashion to a traditional lender. So, if you don’t qualify for a traditional mortgage, you can expect to pay a slightly higher interest rate on the seller financing. This higher rate accounts for your increased risk as a borrower with poor credit.

Most Sellers Won’t Provide Seller Financing

While this option does exist, most sellers will not consider seller financing for two reasons. First, most home sellers have no experience originating and administering loans. Second, many home sellers plan on using sale proceeds to purchase another home. As outlined above, seller-financed deals do not include a transfer of loan principal. This means that sellers cannot use the proceeds from one of these sales to immediately purchase another home.

For buyers seeking seller financing, this reality means you need to tailor your home search for deals offering this option. Real estate agents can help you narrow down available homes accordingly.

Confirm the Seller is Allowed to Provide Financing

If a seller still has a mortgage on the property, his or her lender may not allow a seller financing arrangement. Before signing a promissory note, have a real estate attorney confirm that either A) the seller owns the home outright, or B) the owner’s loan terms allow for a seller-financed sale.

Owner Considerations with Seller Financing

Selling a Promissory Note

Signing a 15-year seller financing agreement doesn’t mean you need to administer the financing for the full 15 years. Rather, you can sell the promissory note to an investor. Plenty of real estate investors specialize in this sort of private lending. These investors will purchase promissory notes from seller-financed deals, providing sellers a lump sum payment.

However, investors will purchase these notes at a discount, meaning you’ll receive less money than if you collected all of the note’s payments. On the other hand, you A) receive cash now, and B) avoid the headache of administering a seller financing arrangement.

Include Seller Financing in Your Marketing

As outlined above, most sellers refuse to provide seller financing. This means that, to buyers seeking this arrangement, you can set yourself apart as a seller by offering this option. With residential home sales, you simply need to have your listing agent include a note about seller financing in your home’s MLS information.

Seek Professional Help

Unless you’re already an expert, you should seek professional assistance prior to offering seller financing. In particular, you’ll want to confirm A) the tax implications of such an arrangement, and B) the best-practice procedures for administering this sort of financing.

Structuring a Seller-Financed Home Sale

If considering seller financing, the question remains: how should I structure a seller-financed sale? Realistically, every state – and often, municipality – will have different regulations on these sorts of deals. Consequently, both the seller and buyer should hire a real estate attorney to negotiate, draft, and review the sales contract and promissory note.

In addition to ensuring legal and regulatory compliance, real estate attorneys serve as your advocates in a deal. While most people act in general good faith, some home sellers or buyers may try to take advantage of you in this sort of home sale. By hiring an attorney, you have an experienced professional in your corner, someone to protect your interests.

Final Thoughts

Not all home buyers qualify for – or want to use – traditional financing. Some home sellers will offer seller financing as an alternative. While this can be a good financing arrangement, sellers and buyers should both review the above considerations before pursuing this option.

Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.