The Ins and Outs of Seller-Financed Real Estate Deals

Seller financing is an agreement in real estate where the seller handles the mortgage process rather than a financial institution. Rather than obtaining a mortgage from a traditional bank, the buyer enters into a mortgage transaction with the seller.

In most residential real estate deals, the seller finds a willing buyer with the required income, employment history, and credit score to qualify for a mortgage. A lending institution such as a bank or a credit union then finances that mortgage for the buyer. If traditional financing is unavailable, the buyer and seller may still want to proceed privately with the sale. In that case, seller financing is one of their available options.

How Does Seller Financing Work?

A bank isn’t involved in a seller-financed sale; the buyer and seller make the arrangements themselves. They draw up a promissory note setting out the interest rate, the schedule of payments from buyer to seller, and the consequences should the buyer default on those obligations. Unlike a sale involving a mortgage, there is no transfer of the principal from buyer to seller. Instead, the agreement is that the buyer will repay that sum over time.

This alternative to traditional financing can be useful in certain situations or in places where mortgages are hard to get. In such tight conditions, seller financing provides buyers with access to an alternative form of credit.

The seller's financing typically runs only for a fairly short term, such as five years. At the end of that period, a balloon payment is due. The expectation is usually that the initial seller-financed purchase will improve the buyer's creditworthiness and allow them to accumulate equity in the home. Once that happens, they can then refinance their payment to the seller with a traditional lender.

Seller financing is sometimes called owner financing.

Advantages of Seller Financing

With only two main players involved, seller-financed sales can be quicker and cheaper than selling a home the customary way. There is no waiting for the bank loan officer, underwriter, and legal department.

This also means that closing costs are generally lower for a seller-financed sale, making the overall sale less expensive for the buyer. Without a bank participating, the transaction avoids the cost of mortgage or discount points, as well as origination fees and a host of other charges that lenders routinely extract during the financing process.

Sellers, in turn, can usually sell faster and without having to make costly repairs that lenders typically require. Also, because the seller is financing the sale, the property may command a higher sale price.

What Buyers Should Know About Seller Financing

For all the potential pluses of seller financing, transactions that use it come with risks and realities for both parties. Here's what buyers should consider before they finalize a seller-financed deal.

Don't Expect Better Terms Than With a Mortgage

As the terms of a seller-financed deal are hammered out, flexibility frequently meets reality. The seller digests their financial needs and risks, including the possibility the buyer will default on the loan, with the prospect of a potentially expensive and messy eviction process.

The upshot can be sobering for the buyer. It's possible, for example, that you’ll secure a more favorable interest rate than banks are offering. But it's also possible that you’ll pay more, as the seller is less able to take on risk than a traditional lender.

You May Need to Sell Yourself to the Seller

It's smart to be transparent and straightforward about the reasons you didn’t qualify for a traditional mortgage. Some of that information may emerge anyway when the seller checks your credit history and other background data. This will include your employment, assets, financial claims, and references.

But make sure, too, that you point out any restrictions on your ability to borrow that may not surface during the seller's due diligence. A potential buyer who has solid credit and a sizable down payment on hand may have recently started a new business, and so be unable to qualify for a loan for up to two years.

Be Prepared to Propose Seller Financing

Homeowners who offer seller financing often openly announce that fact in the hope of attracting buyers who don’t qualify for mortgages. If you don’t see a mention of seller financing, though, it doesn’t hurt to inquire. However, instead of asking if owner financing is an option, you might want to present a specific proposal. You could say, for example, "My offer is full price with 20% down, seller financing for $350,000 at 6%, amortized over 30 years with a five-year balloon loan. If I don't refinance in two to three years, I will increase the rate to 7% in years four and five."

Confirm the Seller Is Free to Finance the Sale

Seller financing is simplest when the seller owns the property outright; a mortgage held on the property introduces extra complications. Paying for a title search on the property will confirm that it’s accurately described in the deed and is free from a mortgage or tax liens.

According to Jason Burkholder, a Realtor with Weichert Realtors in Lancaster, Pennsylvania, "Most mortgages have a 'due on sale' clause that prohibits the seller from selling the home without paying off the mortgage. So if a seller does owner financing and the mortgage company finds out, it will consider the home 'sold' and demand immediate payment of the debt in full, which allows the lender to foreclose."

What Sellers Should Know About Seller Financing

Keep these tips and realities in mind if you're considering financing the sale of a home.

You Don't Need to Finance the Sale for a Long Time

As the seller, you can, at any point, sell the promissory note to an investor or lender, to whom the buyer then sends the payments. This can happen the same day as the closing, so the seller could get cash immediately.

In other words, sellers don't need to have the cash, nor do they have to become lenders. Be aware, however, that you will likely have to accept less than the full value of the note in order to sell it, thus reducing your return on the property. Promissory notes on properties typically sell for 65% to 90% of their face value, according to Amerinote Xchange, a company that specializes in secondary-market funding.

Make Seller Financing Part of Your Pitch to Sell the Property

Because seller financing is relatively rare, promote the fact that you’re offering it, starting with the property listing. Adding the words "seller financing available" to the text will alert potential buyers and their agents that the option is on the table.

When potential buyers view your home, provide more detail about the financing arrangements. Prepare an information sheet that describes the terms of the financing.

Seek Out Tax Advice and Consider Loan-Servicing Help

Because seller-financed deals can pose tax complications, engage a financial planner or tax expert as part of your team for the sale. Also, unless you’re experienced and comfortable as a lender, consider hiring a loan-servicing company to collect monthly payments, issue statements, and carry out the other chores involved with managing a loan.

How to Structure a Seller Financing Deal

Both parties in a seller-financed deal should hire a real estate attorney or real estate agent to write and review the sales contract and promissory note, along with related tasks. Try to find professionals who are experienced with seller-financed home transactions. If possible, find professionals who have experience where you live; some relevant regulations (such as those that govern balloon payments) vary by jurisdiction.

Professionals can also help the buyer and seller decide on the particular agreement that best suits them and the circumstances of the sale. If it isn't a seller-financed deal, real estate investor and Realtor Don Tepper points out that "there are actually dozens of other ways to buy" other than a traditional mortgage arrangement. These arrangements, Tepper notes, include lease-option, lease-purchase, land-contract, contract-for-deed, equity-sharing, and wrap mortgages. "Most buyers and most real estate agents don't know how any of these work," he says.

The Bottom Line

Seller financing is an alternative to a traditional mortgage in which the seller finances the purchase, rather than a bank or other lender selling a mortgage to the buyer. It can be a helpful option in a challenging real estate market. However, the arrangement triggers some special risks for buyers and sellers, and it's wise to engage professional help to mitigate those and keep the process running smoothly.