If you’re having trouble qualifying for a traditional mortgage loan, you have other options. One solution could be financing a loan through the home’s seller, where you can negotiate an agreement to pay the money that ordinarily would go to the bank.
Although this type of financing can be quicker than the traditional mortgage process, there are important steps sellers and buyers should take to ensure their interests are protected.
What Is Seller Financing?
Seller financing, sometimes called owner financing, is when the seller takes on the role of lender, working directly with the buyer to finance the purchase of the home. Requirements for how this works are different across the country, as each state is in charge of regulating these transactions.
A typical seller-financed arrangement is known as a land contract, also called contract for deed. In this type of deal, the seller controls the legal title (in other words, still owns the property), but the buyer gains a financial interest in the property, known as equitable title, by making regular payments. The buyer pays the seller instead of a bank or credit union, and earns the legal title once all terms of the loan are met.
Land contracts are typically much shorter than a 15- or 30-year mortgage. The agreements are often for five years or less, says Erica Crohn Minchella, a real estate attorney in Skokie, Illinois. At the end of the land contract, a balloon payment is typically due to pay off the balance of the loan. For the land contract, the buyer and seller will have to negotiate the terms of a promissory note, which will include sale price, down payment and interest rate, like a typical home purchase contract.
“A well-crafted contract for deed will allow payments made each month to go toward some principal,” Minchella says. The buyer could then take advantage of the equity earned and try to get a lender to agree to a refinance arrangement to buy the home outright.
In some contracts, the buyers could have an option to sell the property after they fix it up, Minchella says. “The beauty of these transactions is that you can craft them any way you want,” she adds. “There is a lot of flexibility.”
Land contract agreements are often made between family members or friends, says Bryan Zuetel, a real estate attorney, broker and investor in Orange County, California.
It’s best if the seller financing a home owns it free and clear, or has a “minimal loan that could be paid off by the buyers putting a down payment on the property,” Zuetel says. “It’s not applicable to properties with minimal equity or properties where the seller is looking to cash out of the real estate market and be done.”
When Is Seller Financing Best?
Here are a couple of examples of how seller-financed arrangements could work for both parties:
Mutual desire to save time and money. Buyers and sellers who know each other very well – such as parents and children – might want to cut out the extensive documentation and costs of a typical mortgage and just handle it on their own. Although a high degree of trust and care is needed in these situations, both sellers and buyers could enjoy a quicker closing process, low closing costs and no ongoing fees or charges from lenders.
Urgent need for repairs. A seller who doesn’t want to make repairs to a home that would help it pass a Federal Housing Administration or Veterans Affairs pre-financing inspection might look for a buyer who will make the repairs. This could happen in an estate sale if a home wasn’t kept up before the homeowner died, and the children who inherited the house know it needs a lot of repairs before it goes on the market.
“A seller who can’t do that now has a solution,” Minchella says. The buyer could make the repairs and have a better chance at getting a mortgage or selling and pocketing the increased value of the home.
The Pros and Cons of Seller Financing for Sellers
Save money. Sellers who make arrangements to provide financing – especially with buyers they know – should save on costs associated with listing and selling a home, as well as on fees. They can get a continuing stream of income through principal and interest payments, Zuetel says. And they’re able to spread out some of the financial gain they earn from the sale of the home – depending on how the payments are structured – which can defer or minimize capital gains taxes.
Attract more buyers. In a buyer’s market, offering seller financing might allow a seller to stand out among the competition by attracting buyers who will have trouble securing a loan.
Possible foreclosure. If the buyer stops making payments and won’t leave the property, you might need to start the foreclosure process, which could take months or even years. “You don’t want to be in a situation where you’re not able to get payment under contract of deed for two years while you’re foreclosing,” Minchella says.
Loss of value. The buyer might not keep up the property and could let it get rundown before the end of the contract, Minchella says. If this happens, “then you’re taking it back in worse shape than you sold it in,” she adds. “You want to make sure the people you’re selling it to feel invested in the property” and have the financial ability, and the interest, in making it their own.
The Pros and Cons of Seller Financing for Buyers
Easier financing. If you can’t get approved for a mortgage – maybe because of your credit record or your lack of money for a down payment – then owner financing might be the best option. If you save money and improve your credit score enough to get a mortgage in a couple of years, you might be able to get a refinancing arrangement from a lender and buy the home outright. “There are some real advantages for buyers in that scenario,” Minchella says.
Faster and less expensive closing. The closing process with a conventional lender involves a large stack of documents and several fees and requirements. With an owner-financed purchase, the underwriting and paperwork is substantially less, Zuetel says.
Potentially higher costs. A seller is in a position of strength when you can’t get a mortgage and might insist that you pay an above-market price on the house and charge a high interest rate.
Payment deadline. The contract might require a balloon payment at the end, which will likely force you to get a mortgage.
Take These Steps Before Opting for Seller Financing
Here are a few steps buyers and sellers should take before entering into an owner-financed property arrangement:
Hire an attorney. At least one real estate attorney ought to be part of the transaction, possibly one each for the buyer and seller. The attorney will prepare necessary documents, obtain proper signatures and disclosures, have documents recorded correctly, and “make sure both sides are informed of their rights and obligations under this legal arrangement,” Zuetel says.
Specify payments. Either the buyer or seller will need to pay property taxes, and one of the parties will need to hold an insurance policy on the home. All of that and more needs to be spelled out in the contract, as well as the consequences if the buyer skips payments.
“Don’t allow missed payments to stack up from the buyer regardless of what the excuse is,” Zuetel says. “Exercise your rights earlier rather than later.”
Get to know the other party. Buyers will need to make sure the mortgage is paid off and that there are no liens on the property, as either could delay or prevent an eventual final sale to the buyer. Sellers will need to be assured that buyers will make mortgage payments as required and keep up the home. Minchella recommends confirming the buyer is employed and doing a credit check.
Even if they know each other, each party needs to understand the seriousness of the deal.
“It’s not as if it’s some kind of easygoing handshake arrangement,” Zuetel says. “If it’s done correctly, it is a legal arrangement, and the buyers could be foreclosed on by an individual seller just like a bank could.”