Home sellers may encounter buyers who are anxious to purchase but who lack the financial means to do so via conventional mortgage financing. The sellers can either forego the sale or provide the buyer with a personal mortgage.
To sell a home without a mortgage and make the sale go through, you could in theory pay off the buyer’s entire initial mortgage. An alternative is to provide only a second mortgage, which is used to fill the funding gap between the buyer’s down payment and the amount they can borrow from a traditional lender.
Would you ever think about extending credit? So, what’s in it for you? As essential, how can you hedge your bets against financial setbacks? Be well-versed in the benefits and drawbacks of acting as the bank by lending money to a buyer before taking the plunge into offering seller financing.
Benefits of Providing Seller Financing
Even though very few sellers are put in the position of considering financing, it does happen. If there isn’t much interest in a seller’s property, it could be because the market is cold. For others, conventional mortgage lenders are hesitant to provide financing since their properties are one-of-a-kind and only desirable to a select group of buyers.
It’s also possible that the house needs work before it can qualify for a conventional loan because it doesn’t currently meet the standards for habitability.
There are situations when a buyer simply cannot get a conventional loan, but if you already have an excellent relationship with them, you may feel comfortable lending them the money.
Financing is a win-win situation for both the buyer and the seller.
The following are some benefits of seller financing that should be taken into consideration.
1. Draw & Convert More Customers
The most obvious benefit is the ability to finalize the sale of your house even if the buyer is rejected by traditional mortgage lenders.
In addition to saving a doomed sale, retailers can also potentially entice new customers. The phrase “Seller Financing Available” might serve as a powerful marketing bullet point in your property offering.
Offering seller financing can increase interest in your home and increase the likelihood that it will sell within 30 days.
Remember that not just consumers with poor credit scores may be interested in seller financing. Instead of trying to force themselves into the round hole of a lending program, many purchasers would rather negotiate a unique loan with the vendor.
2. Earn Consistent Income
Lenders, including banks, receive regular interest payments every month as compensation for their services.
Instead of receiving a lump sum, you’ll be receiving a steady stream of money. Selling your home in one fell swoop and putting the funds to work for you is a win-win. Better yet, it’s a return on investment that you get to set.
3. Interest Rate is Decided By You
The interest rate is entirely up to you because it is your loan. Interest rates of 8%, 10%, or even 12% on seller financing have been considered. Naturally, the buyer will try to haggle down the rate of interest. After all, the terms of seller financing are negotiable, just like almost everything else in life.
4. You May Obtain Payment from Up Front
Mortgage banks make a profit in ways other than interest. They also have a number of up-front charges.
The points or origination fee is the first of these costs. The costs of mortgage points quickly build up because each point represents 1% of the loan amount. Two points on a $250,000 mortgage, for instance, would amount to $5,000.
However, points aren’t all that lenders care about. Furthermore, they tack on a long list of set fees, frequently totaling more than $1,000. Processing costs, underwriting fees, document preparation fees, wire transfer fees, and everything else they can come up with to legitimately charge are all examples of these types of expenses.
You may even impose such charges when playing the role of a bank. Maintain honesty and openness on pricing, but know that you can charge the same or similar rates as your competition.
5. Simple Interest Amortization Front-Loads the Interest
Most loans, including mortgages, auto loans, and others, use a method known as “simple interest amortization” to determine interest payments throughout the life of the loan. It’s not easy, and it heavily benefits the lending institution.
In a nutshell, the loan’s interest is paid in full upfront, rather than spread out throughout the life of the loan.
The monthly payment on a home loan of $300,000 amortized over 30 years at 8% interest would be $2,201.29. Over the course of those 30 years, however, the proportion of principal to interest paid shifts drastically.
- Your initial monthly payment will be split with $2,000 going to interest and $201.29 going toward your principal balance.
- The final monthly payment splits into interest ($14.58) and principal ($2,186.72), respectively.
This is why your mortgage lender wants you to keep refinancing. The beginning of the loan period is when they earn the most money.
You, too, stand to gain substantially during the loan’s early years, when your interest rate is rather high. A loan can be set up so that the interest-only payments are made throughout the first few years of the loan’s term.
6. Time Limits Can Be Set
A 30-year mortgage loan is a burden that few sellers are willing to shoulder. Thus, they don’t. As an alternative, they may use a balloon mortgage to structure the debt. Although the loan’s monthly payment is determined as though it were amortized over 15 or 30 years, the loan itself must be repaid in full before the end of the allotted period.
To repay your loan, the purchaser must either sell the house before the deadline or secure a mortgage refinancing. Let’s pretend you sign a mortgage for $300,000 with a 30-year repayment term and a 3-year balloon payment.
The monthly payment would stay at $2,201.29, but the buyer would be required to pay off the remaining sum in full within three years of purchasing the home from you. All of your money is returned to you within three years, and you even get interested on it.
7. No Appraisal
Home appraisals are necessary for mortgage approval since lenders need to know how much a house is worth and its current condition.
If the appraised value of the property is less than the sales price in the contract, the lender may choose not to make the loan or may make the loan based on the appraised value rather than the sales price, prompting the borrower to either lower their offer or withdraw it altogether.
If the seller is providing finance, a valuation is unnecessary. Regardless of what an appraiser says, you know the home is in good shape and wants to get the highest potential sale price. The buyer can save money and everyone involved can save time by skipping the evaluation.
8. No Requirement for Habitability
A mortgage lender may request an appraisal to determine whether or not a property is habitable. Sellers must make necessary renovations to make a home habitable for conventional and FHA loans.
Otherwise, they’ll turn down the loan and the buyer will have to secure a separate loan to finance the necessary repairs and renovations (such as an FHA 203k loan).
Because of this, the value of homes in need of repair is being driven down, and it becomes more challenging to sell such properties. However, if you wish to avoid completing any renovations before selling your house, you can do so if you offer to fund the purchase yourself.
Seller financing is an attractive option for certain buyers, such as those who are handy and intend to make minor repairs to the property over time.
9. Tax Implications
The first $250,000 of capital gains from the sale of a principal house are free from federal income tax for individuals and $500,000 for married couples filing jointly.
However, capital gains tax is still due if your income is greater than the exemption amount or if you sell an investment property. Spreading out your gains over time with seller financing can help you pay less in capital gains tax.
For tax reasons, this type of transaction is treated like an installment sale and the proceeds can be reported over numerous years. Get in touch with your tax preparer or financial counselor to discuss the best way to organize your loan to maximize your deductions.
Drawbacks of Seller Financing
There are a number of dangers associated with accepting seller financing. While the possibility of the buyer/borrower defaulting is the biggest risk, it is not the only one.
Before agreeing to and negotiating seller financing, be sure you have a thorough understanding of each of these drawbacks. In one deal, you can be taking a chance with tens of thousands of dollars.
1. Work and Hassles to Arrange
House-hunting is a full-time job in and of itself. The work involved increases dramatically, however, if you’re also on the hook for the money.
Once the financing conditions have been negotiated in addition to the price and other terms of sale, a full loan application including the buyer’s details must be collected and carefully vetted.
To do so, you’ll need to gather relevant paperwork, such as tax returns, pay stubs, bank statements, and more, spanning multiple years. You need to get a buyer’s credit report and go through their payment history with a fine-tooth comb.
The new homeowner’s insurance policy, on which you must be listed as the mortgagee, must also be collected from the buyer. You must work with a title company that will do the title search and finalizes the settlement. Deed and transfer documentation are prepared, however, they will wait for your instructions as the lender.
It’s important to learn the ins and outs of the home closing process, as you’ll be acting in two capacities that of the seller and the lender. Finally, there is the official loan documentation.
To secure financing from a conventional lender, you may need to produce and sign hundreds of pages of documentation. Nobody expects you to go to the same lengths as they did in preparing the food, yet somebody does.
2. Potential Legal Fees
To draft legal documents like the note and commitment to paying, you should certainly engage an attorney unless you already have experience in the mortgage market. Legal costs must be covered.
Of course, you can charge the borrower for those costs. However, that reduces the amount you can request in advance for the loan. Simply finding an attorney to hire will need some effort on your behalf. Don’t forget this before continuing.
3. Work in Loan Servicing
The borrower’s signature does not release you from all of your obligations. The borrower must keep making timely monthly payments until the loan is repaid in full or the balloon payment date is reached. If they don’t pay on time, you need to remind them, charge them late fees, and monitor their account until they do.
Verify also that they are current on both property tax payments and homeowner’s insurance premiums. If they don’t, you’ll need to have a mechanism in place to pay the bills and charge them back and issue demand letters.
Mortgage interest payments must be reported on Form 1098 to the borrower annually. Mortgage maintenance is, in a word, a job. It’s not as simple as just cashing a cheque once a month.
4. Foreclosure
Foreclosure is your only legal option for recovering loan funds from a defaulting borrower. It takes more time and money than an ordinary eviction, and you’ll need an attorney. To get started, you’ll need to come up with the cash; later, you can add that expense to the borrower’s loan total as allowed by law.
And there’s no promise that you’ll ever be able to get that money back from the borrower who stopped making payments. The foreclosure process is unpleasant on all fronts and can drag on for a long time.
5. The Purchaser May File For Bankruptcy Against You
Allow us to assume that the borrower has stopped making payments, you have filed for foreclosure, and an auction date has been set eight months later. The borrower files for bankruptcy on the morning of the auction in an effort to halt the foreclosure process.
The auction is called off, and the borrower (who may or may not actually pay) negotiates a repayment plan with the bankruptcy court judge. If the bankruptcy plan payments are not made, the debtors might stay in the house rent-free while you go through the procedure again.
6. Loss Prospects
There is no assurance that the property will sell for enough to cover the loan balance at auction if foreclosure proceedings begin.
It’s possible you forked over $300,000 in loan money and spent another $20,000 on legal representation. At the foreclosure auction, the highest price might only be $220,000, leaving you short $100,000.
In that predicament, unfortunately, you have zero good choices. You have the option of taking the loss of $100,000 or purchasing the home outright.
If you choose the second option, you’ll have to spend extra time and money (months of legal proceedings and an eviction file) getting rid of the nonpaying buyer. And if you do decide to kick them out, you could be disappointed in what you find when you do.
7. Property Damage Risk
Don’t kid yourself into thinking that the defaulting borrower will clean up the property and leave it in pristine shape after you go through the hassle of foreclosing, having an auction, reclaiming the property, and filing for eviction.
The situation you’ll be walking into is a tragedy. They have probably not even kept up with basic maintenance on the property. Most evicted tenants, in my experience, leave behind a mountain of rubbish and filthy property.
Worst case, they do it on purpose to sabotage the property. I’ve seen tenants who are unhappy with their living situation do things like pour concrete down the drains, punch holes in every cupboard, and generally wreck the place.
8. Collection Risks & Pains
If you lose money in any of the examples above, you can seek a deficiency judgment against the borrower who went into default. The catch is that you have to go to court, win, and then collect on the verdict.
It’s not simple to collect. Collection accounts sell for a fraction of their true value because the vast majority are never collected.
To collect from a borrower who has defaulted on their loan, you might employ a collection agency to file a lien against their vehicle or salary garnishment against their paycheck.
However, the collection agency will likely take 40% to 50% of the total amount they recover for their fees.
It’s possible that you’ll get to witness at least part of the verdict, but it’s also possible that you won’t.
Possibilities for Self-Protection When Offering Seller Financing
There are a few ways to reduce the dangers of seller financing, so don’t worry too much. Take these into careful consideration as you wade into the unknown seas of seller financing, and if possible, try to speak with other sellers who have offered it to receive the benefit of their experience.
1. Only Provide a Second Mortgage
Lending the borrower a portion of the down payment is a viable alternative to providing them with the main mortgage loan, which might be hundreds of thousands of dollars.
Let’s say you find a buyer willing to pay $330,000 and have $30,000 available for a down payment. In exchange for a 10% down payment, you may provide the buyer with a $300,000 primary mortgage loan.
You can either allow them to borrow $270,000 from a conventional mortgage lender and then lend them an additional $30,000 to cover the difference between that amount and what the primary lender is willing to provide, or you can do neither of those things.
This tactic allows you to risk less of your own money on a loan while still having most of the purchase price available at closing. The second mortgage holder, however, acknowledges the lower lien status.
As a result, the first mortgagee will be paid in full before any money is distributed to you in the case of foreclosure.
2. Take Further Security
You can also safeguard yourself by making the buyer provide additional collateral. All sorts of things could be used as collateral. A lien could be placed on an asset such as a car or a house if the debtor possesses either.
There are two main upsides to this. To start, in the event of a default, you have options beyond just selling the house to recoup your losses. Second, the borrower is more aware of the consequences of defaulting because of the increased stakes.
3. Watch Borrowers Carefully
There is a good reason why mortgage companies are so meticulous when underwriting loans. Giving someone hundreds of thousands of dollars and saying, Pay me back, pretty please, is the actual meaning of lending.
Don’t extend credit to someone who doesn’t have a lengthy record of paying back loans. Allow them to borrow from another source if they have poor credit or a credit report with warning signs. Pay just as close attention to borrowers who have little in the way of credit history.
Accepting a cosigner with good credit to help a borrower with weak credit or no credit is the sole possible exception. You may, for instance, accept the parental cosigner of a new college grad with poor credit but a desire to buy.
You could also request a lien on the cosigner’s property as additional collateral. Debt-to-income ratios should be calculated after a thorough examination of the borrower’s earnings.
The front-end ratio measures how much of one’s monthly income must go into paying for a home’s up-front costs, such as the mortgage’s principal and interest payments, as well as taxes, insurance, and any mandatory fees charged by a condo or homeowners association.
As a point of comparison, the maximum front-end ratio permitted by conventional mortgage lenders is 28%. The whole amount of debt owed, not only mortgage payments, is factored into the back-end ratio. This applies to mortgages, car loans, credit card bills, and any other reoccurring monthly bills you may have.
Most conventional mortgage loans cap the loan-to-value ratio at 36%. A buyer who offers more than that probably can’t afford your home.
4. Demand Payment for Your Trouble
Lenders of mortgages will charge you points and fees. You should do the same if you’re the lender. You’ll have more to do to get the necessary documents for the loan. Additionally, you should charge the borrower for the fees you’ll incur in hiring an attorney to represent your interests.
You should check that you are getting paid not only for your time and money but also for the risk you are taking. You should only take out a loan if you can expect to earn more than you put into it.
5. Place a Balloon
This mortgage note is not something you want to still be holding onto in 2030. Or to compel your successors after your death to settle this indebtedness on your behalf. Place the mortgage balloon payment date between three and five years from now.
You will receive most of your principal when the buyer refinances or sells, with interest accruing throughout the meantime. Plus, if the loan period is shorter, there is less time for the buyer to run into financial difficulties and default on payments.
6. Have your Mortgagee’s Information on the Insurance
Mortgagee information is typically included on an insurance policy’s declarations page or “dec page”. If there is property damage and an insurance claim is filed, the mortgagee will be notified and will have certain rights and safeguards.
Before agreeing to a settlement, be sure you have read the insurance policy thoroughly. Insist that your borrower provide you with proof of current insurance coverage annually, and outline the repercussions for failing to do so in your loan documents.
7. Employ a Loan Servicing Business
It’s possible that you have a wide range of skills and expertise. Nevertheless, mortgage loan servicing is probably not one of them. There is the option of hiring a third-party firm to handle the servicing of your loans.
If you want to escrow funds for insurance and taxes, they will give you a monthly statement, a late notice if you’re behind, a 1098 form, and an escrow statement at the end of the year. In the event of a borrower default, a foreclosure lawyer can be retained to conduct the necessary legal actions.
Both LoanCare and Note Servicing Center are examples of loan servicing organizations that will take on seller-financing notes.
8. Provide Lease-to-Own Options Instead
Comparatively, the time and money required to foreclose on a home are much more than those required to evict a tenant.
Seller financing entails selling a property to a buyer while keeping the mortgage note in your own possession. The buyer under a lease-option agreement is technically a tenant who has the right to purchase the property from the owner at some point in the future.
Over the next year or so, they can concentrate on enhancing their credit score while you collect rent. They can buy from you whenever they’re prepared, using a standard mortgage and paying you in full upfront.
If worse comes to worst and they fail to pay, you may always evict them and find other tenants or potential buyers.
9. Look into Wrap Mortgages
Even if you sell the house with seller financing, you may be able to maintain paying the mortgage you already have in place. Wrap mortgages, also known as wraparound mortgages, are more complex and can involve a number of legal nuances. But if done correctly, they can benefit you and the customer equally.
Let’s pretend you took out a $250,000 mortgage at a 3.5% interest rate for 30 years. You list the house for $330,000 and are willing to finance $30,000 at 6% interest. The buyer makes a $30,000 down payment to you.
In a normal situation, $250,000 would be used to settle your mortgage. When you sell your home, your mortgage loan is typical “due on sale,” meaning you have to pay it off in full. The due-on-sale clause may be avoided and the loan continued in specific states and situations.
Even if the borrower is paying you $1,798.65 monthly, you continue to pay your mortgage payment of $1,122.61. When they refinance in a few years, they’ll cover the remaining sum on your old mortgage and the new one.
There is always the chance that the borrower won’t make their payments. After that, you’ll still have to make the property’s regular mortgage payment while you wait out the foreclosure process and, maybe, recoup some of your money.
Bottom Line
There are dangers associated with offering seller finance. However, in some cases, like with houses that are particularly difficult to sell, those dangers may be justified.
It is up to you alone to determine a comfortable risk-reward ratio and to negotiate loan conditions accordingly. Seller financing may be the only option for properties that are particularly rare or otherwise hard to finance.
When evaluating the returns, keep in mind that your annual percentage rate (APR) will be far higher than the interest rate charged.
When you structure the loan as a balloon mortgage, you can charge higher origination fees up front and reap the benefits of simple interest amortization, which puts more of each monthly payment toward interest in the early years of the loan.
Please exercise utmost caution and thoroughly vet any potential debtors. It should raise serious red flags if the borrower is unable to obtain a standard mortgage. With seller financing, the seller is putting up tens of thousands of dollars at risk on a single deal, so it’s important to proceed carefully.
