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Many people wish to become homeowners, but not everyone can meet the strict lending requirements for a mortgage. To get around this, one option might be to borrow the money from the seller through a process called seller financing. Such an agreement can be highly beneficial for both parties as it gives the buyer the funds they need to complete a purchase while also helping the seller shift what may have been a difficult home to sell.
However, like almost everything in real estate, seller financing agreements have pros and cons that must be carefully considered beforehand. They won’t work for every buyer; even when they do, risks still need to be mitigated.
What is Seller Financing?What is Seller Financing?
Also known as owner financing, seller financing is when the seller takes on the role of a mortgage lender in helping a buyer complete a home purchase. However, unlike a traditional bank loan, the seller does not provide money to the buyer. Instead, they provide a line of credit to cover the buyer’s shortfall in the purchase price. The buyer must then make regular payments (with interest) until the full amount is paid off. Until then, the seller will usually retain the home’s title.
Selling financing is attractive to buyers because they won’t be subjected to the same level of financial scrutiny that a traditional lender might use. That said, most sellers will still run a credit check on the buyer and may turn down the offer if they perceive the buyer as a credit risk. Sellers can also benefit from seller financing as it means they can sell a home as-is without needing any costly repairs that a traditional lender might require. In addition, sellers may also be able to command a higher selling price and attract more prospective buyers that otherwise couldn’t afford the price they’re asking for.
The Terms of a Seller Financing AgreementThe Terms of a Seller Financing Agreement
The terms of a seller financing agreement are typically outlined in a promissory note, a document signed by the buyer that is given to the seller on closing day. Before then, both the buyer and the seller will negotiate on the exact terms of the agreement, such as the principal amount of the loan, the interest rate, the repayment schedule, and the consequences of a default. Given that the seller is taking on a significant risk in agreeing to a seller financing agreement, buyers should expect stringent terms with very little leeway.
For example, interest rates for a seller financing agreement are often significantly higher, as much as 10 percent. Buyers should also expect a short timeframe for repayment, usually five or ten years, with low monthly payments and a final balloon payment due after the loan term is up. At this point, most buyers choose to refinance the loan through a traditional lender, their finances now (ideally) being in a much stronger position than they were before. As for the consequences of a default, the buyer should expect to lose the home along with all the equity they’ve put into it.
Seller Financing Considerations for BuyersSeller Financing Considerations for Buyers
For all their benefits, seller financing agreements come with significant risks for both parties. To ensure you can mitigate these risks, buyers should consider the following before finalizing a seller-financed deal:
Valid Title and OwnershipValid Title and Ownership
Seller financing should only ever be entered when the seller owns the property outright or has enough savings to pay off the existing mortgage before the deal is closed. That’s because most mortgage lenders will include a due-on-sale clause that prohibits the borrower from selling the property without first paying off the mortgage. Any failure to pay will result in the lender considering the loan in default, resulting in foreclosure. Therefore, buyers should order a title search of the property to confirm the seller’s ownership and ensure that the home is free of any mortgage or tax liens.
Taxes and InsuranceTaxes and Insurance
A traditional mortgage usually adds taxes and insurance to the monthly mortgage payment. However, with a seller financing agreement, the buyer and seller will need to discuss how these payments will be handled. In most cases, the buyer will pay their property taxes directly to the government and their insurance directly to the insurance company.
Seller’s Right to Sell the Promissory NoteSeller’s Right to Sell the Promissory Note
Sellers typically retain the right to sell the promissory note to a third-party investor or lender at any time, even on closing day. If that happens, then the buyer will need to make new arrangements for how repayments will be made. This can be problematic for the buyer as the third party may be stricter about late payments or how payments are to be processed.
To forestall this, buyers should address these issues in the promissory note before signing on the dotted line. For instance, you can include provisions for a grace period in the event of late payments and the right to make all payments electronically. These clauses will apply to anyone who purchases the promissory note and should also include a right of first refusal that allows the buyer to refinance the loan whenever they wish with no penalties.
Legal Due DiligenceLegal Due Diligence
All real estate deals in New York State must be conducted through a licensed real estate attorney. As such, you’ll want to have your attorney examine the terms of the seller financing agreement for anything that could cause problems later down the line. For instance, under the Dodd-Frank Act, new rules apply to seller financing that may prohibit balloon payments. In this case, the seller must involve a mortgage loan originator. These complications are why it’s always a good idea to ensure your attorney has experience handling seller financing deals.
Final ThoughtsFinal Thoughts
While seller financing agreements can be quite complex and unfamiliar to most buyers and sellers, they can benefit both parties, provided the sales contract and promissory note are correctly structured. However, both parties need to be aware of the seriousness of the deal they’re entering into. It’s not a simple handshake agreement but a legally binding arrangement that ties both parties to its terms.