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How to Use Seller Financing to Buy a Home

How to Use Seller Financing to Buy a Home

Harry Jensen, Trusted Mortgage Expert with 45+ Years of Experience
, Trusted Mortgage Expert with 45+ Years of Experience
With seller financing, a borrower obtains a mortgage from a property's seller, instead of from a traditional lender such as a bank, to buy a home.  Seller financing is relatively rare but may be an attractive option for borrowers who find it challenging to obtain a mortgage from a traditional lender.  Additionally, in some cases the mortgage terms offered by sellers may more attractive than the terms offered by a bank plus your closing costs may be significantly lower.

The vase majority of home sellers simply want to sell their property and take the full proceeds from the sale and buy another home. Some property owners, however, prefer to take back a seller note, which means they are not getting the full sales price when the transaction closes.  A property seller may offer financing due to tax reasons or because they want the consistent monthly income stream provided by mortgage payments.  In some cases, the property may be unusual and traditional lenders may not be willing to offer a mortgage on it.  Just because a property owner offers seller financing does not mean the buyer is required to use it, although in rare cases that may be a conditional for selling the property.

Seller financing can be structured in several ways.  Usually the seller provides the only mortgage on the property, just like you receive from a bank.  In some cases the seller offers a second mortgage and you obtain the larger, first mortgage from a regular lender.  For example, if you want to buy a $100,000 you would obtain a $80,000 mortgage from a bank, a $10,000 second mortgage from the property seller and your down payment would comprise the remaining $10,000 of the purchase price.  A second mortgage may enable the buyer to pay a higher price for the home, receive better terms on the first mortgage or qualify for certain loan programs.  So in some ways, providing a second mortgage can benefit both the property buyer and seller.  

Because seller financing is so uncommon it is especially important for borrowers to carefully review the loan documents and mortgage terms.  It may be beneficial to hire a real estate attorney to review the mortgage note and make sure your interests are protected before agreeing to the mortgage.  There is usually more flexibility with seller financing so you should be prepared to negotiate to achieve the best loan terms possible.  In addition to focusing on the interest rate, make sure that you understand the loan program and any extra fees such as a prepayment penalty. Prepayment penalties are more common with seller financing because the seller usually does not want to be repaid within a short period of time.

Please note that the seller financing options we review below are not the same as a contract for deed, which confusingly is also sometimes referred to as seller financing.  With a contract for deed, the property ownership is not legally transferred until the buyer satisfies the terms of the contract, usually several years after the buyer has moved into the property, which creates significant disadvantages for the buyer.  A contract for deed is more similar to a rent-to-own and subject to a higher degree of fraud and predatory lending tactics.  For the seller financing we review below, property ownership and title are transferred to the buyer immediately at closing but the seller provides all or part of the financing to purchase the property instead of a lender. 

Below, we outline how to use seller financing to buy a home, keep points for borrowers to consider as well as the benefits to both property buyers and sellers.  When available, understood and used properly, seller financing is a valuable mortgage option for home buyers.   
1

How Seller Financing Works

When you use seller financing to buy a home you get a mortgage from the individual selling the property instead of from a traditional mortgage lender such as a bank. A mortgage from a property seller is also referred to as a seller note.  For example, if you are buying a $100,000 property and making a $25,000 down payment, the seller provides a $75,000 mortgage for you to purchase the property.

Additionally, in some cases the buyer obtains a first mortgage from a traditional lender and a second mortgage from the seller. Providing a seller second, also known as a purchase money second, piggyback loan or the seller taking back a second, enables the buyer to borrow more money and pay a higher price for the property. Please note that the lender for the first mortgage must approve any second mortgage including a seller second.

Seller financing is relatively uncommon because property sellers usually want to receive all of the proceeds immediately when they sell a home. They typically need the proceeds to pay off their existing mortgage and buy another home. With seller financing, the seller receives the down payment upfront when the home is sold and then receives the remainder of the proceeds over time as the buyer pays down the mortgage.  Property sellers offering seller financing typically make that known to prospective buyers during the home sale process as it may be a selling point. Borrowers can also ask a seller if they are willing to provide seller financing although sellers rarely do.

2

Benefits of Seller Financing to Borrowers

The main borrower benefit to seller financing is that it may allow you to obtain a mortgage at better terms than you could from a traditional lender.   If a borrower has a challenging credit profile or is self-employed they may not be able to get a mortgage from a traditional lender and if they do they will likely pay a higher interest rate.  A seller may apply more flexible borrower qualification requirements than a lender which benefits credit-challenged borrowers. In some cases, seller financing may be the only way for certain borrowers to buy a home. In other cases the seller may offer very attractive terms such as a low mortgage rate, which benefits all borrowers.

Additionally, the seller may have a strong preference for seller financing due to financial considerations and may even require the property buyer to use seller financing. In these situations using seller financing may be the only way for you to buy the home you want.

3

Benefits of Seller Financing to Sellers

Property sellers usually provide financing because it offers them an attractive investment return. The interest rate the borrower pays on the mortgage provides the seller a return that may higher than other investment opportunities. For example, a seller could generate a 5.0% return on a $100,000 mortgage as compared to putting $100,000 money in the bank and receiving a much lower return on investment. The downside for the seller is that the mortgage is not liquid, which means that the seller cannot immediately access the $100,000 if they need that money for some reason, whereas money in the bank or another liquid investment product is accessible.

Seller financing may also enable the seller to realize a higher property sales price. For example, if a seller applies more flexible borrower qualification guidelines than a traditional lender, the buyer may be able to afford a higher mortgage amount and in turn pay a higher price for the property.

Providing a seller second, or a second mortgage in addition to the buyer's first mortgage, may also enable the seller to achieve a higher sales price. For example, a lender may qualify a buyer for a certain first mortgage amount which limits the price the buyer can pay for the property.  Providing a seller second enables the buyer to pay a higher price than he or she could with a first mortgage only.

Finally, the seller may realize tax benefits by offering seller financing instead of receiving 100% of the proceeds when the property is sold.

4

Important Seller Financing Terms

Although a mortgage obtained through seller financing may have slightly different terms than a regular mortgage, it works the same way.  The borrower pays interest based on a negotiated rate but instead of making your monthly mortgage payment to a lender you make your payment to the seller.  The seller usually has a target interest rate (investment return) they want to generate but borrowers may be able to negotiate a lower interest rate depending on their credit and financial profiles.

As with a traditional mortgage, the seller reviews the buyer’s credit and borrower qualification profile including credit score, monthly income and debt and employment history to make sure you can afford the mortgage and repay the loan. Sellers are typically clear about what type of mortgage they are willing to offer and most seller financing mortgages are 30 or 15 year fixed rate mortgages.

Prepayment penalties are more common with seller financing than with regular mortgages because the seller wants the investment return for a fixed period of time.  A prepayment penalty is a fee paid by the borrower is a mortgage is repaid in full within a specified period of time.  For example, a seller may request a prepayment penalty if the mortgage is repaid in full within five years.  Some sellers may also require the buyer to make a higher down payment than the 20% typically required for a mortgage from a traditional lender.  As a way to protect their mortgage (investment), some sellers include a clause that allows them to inspect the property annually.

5

Seller Financing Tips

The borrower and property seller hire a title company, escrow company or real estate attorney to draft the mortgage note between the two parties. The mortgage note outlines key terms of the loan such as interest rate, program and length of the loan and prepayment penalty, if applicable.  Borrowers should review all loan documents carefully, especially the mortgage note, to make sure they understand the terms and conditions for the mortgage. 

It is also important that the company or attorney you hire makes sure that both the property title transfer and mortgage note are properly filed with your county recorder office.  This provides a legal record for the property purchase and mortgage which can be helpful in the event of a dispute in the future.

You should also strongly consider hiring their own representation, such as a real estate attorney, to review all documents and represent your interests in the transaction. If structured properly, seller financing can be a win-win outcome for both the property seller and buyer.

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Sources

Seller Financing: https://www.consumerfinance.gov/ask-cfpb/what-is-147seller-financing148-en-111/

About the author

Harry Jensen, Mortgage Expert

Harry is the co-founder of FREEandCLEAR. He is a mortgage expert with over 45 years of industry experience. Over his career, Harry has closed thousands of loans for satisfied borrowers and now offers his advice and insights on FREEandCLEAR. More about Harry

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