Home sellers unable to find a qualified buyer may want to consider seller financing.
When the seller acts as the bank, there are no typical lender costs such as loan origination fees, discount points, mortgage insurance premiums, processing fees, or other added expenses.
Seller financing occurs when the seller agrees to lend a buyer part — or all — of the money to buy the property. The buyer signs a promissory note (the promise to repay the loan) and either a mortgage or a deed of trust (which allows the seller to foreclose or take back the property) if the buyer fails to make the required payments.
The closing can be done faster than with a conventional mortgage because there are no long waiting periods for loan approval or the requirement to receive a Closing Disclosure form no later than three business days before closing. (Lenders typically allow seven business days before closing to provide for any potential mail delays). If the loan would need to be modified, the three-day waiting rule would begin again, and cause further delay.
According to Advanced Seller Data Services, seller-financed notes increased by 4.7 percent in 2014, the latest year for which statistics are available. Sellers may be motivated by a variety of reasons to consider a “seller carry back” or ‘purchase money mortgage.” These include:
- A low tax basis in the property.
- Income distribution spread over a number of years for tax purposes.
- Awareness of the property’s true value.
- A higher interest rate than in “safe investments,” such as an annuity or CD.
The trend toward seller financing grew in popularity during the late 1970s and ’80s, when mortgage interest rates teetered between 7.38 and 13.74 percent on a fixed-rate, 30-year conventional loan.
In October 1981, the rate rose to a staggering 18.4 percent before it settled back to an annual adjusted rate of 13.4 percent. Faced with high monthly payments, buyers scrambled to find alternative ways to finance their home purchases, and seller financing became one of the best ways to accomplish that goal.
Confronted with the prospect of holding onto a home until the market improved, many sellers opted for a “private purchase mortgage” (PPM) — essentially becoming the lender and executing a note and mortgage or deed of trust with the buyer.
A variety of companies that specialized in seller-note creation sprang up across the country.
Fast-forward to 2016. Despite low interest rates, new federal rules governing loans may push a mortgage out of reach for many borrowers, ultimately making seller financing more attractive.
Take a look at the monthly payment on a $100,000 loan at 4 percent ($447.42) as compared with the payment on the same loan with a 13.4 percent interest rate ($1,137.55). If the mortgage were held to term (360 months), the $660.13 monthly savings would add up to $237,646.80. This is good news for buyers — but not so much for self-employed or credit-challenged borrowers who struggle to meet qualification standards set by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2014.
“Borrowers with bruised credit scores could consider an FHA [Federal Housing Administration] mortgage,” says Bob Walters, chief economist for Quicken Loans, the largest-volume FHA lender nationwide. “FHA loans are the best bet for those borrowers who can’t come up with a large down payment or who have a credit score in the high 500s.”
While FHA loans allow a lower down payment (in some cases 3.5 percent of the purchase price), relaxed qualifying criteria, and permission for the seller or lender to pay some of the borrower’s closing costs, a maximum limit on the size of the mortgage — determined by the property’s location — must be met.
Sellers may not always advertise that they are willing to carry back paper (finance the purchase), but when asked by a potential buyer, they may consider the option.
Sellers who offer to carry a note on their house sale as a “once-only” transaction are not governed by the strict rules of Dodd-Frank. “One-time individuals are given a free pass,” says William Bronchick, a real estate attorney with Bronchick and Associates in Aurora, Colo. “Sellers might ask a slightly higher price for the home and tack on two percentage points above market for the privilege of the note, but it may be advantageous to a buyer who otherwise would be unable to qualify for a bank loan.”
Tracy Z. Rewey, president of Diversified Investment Services in Orlando, recommends that sellers get a sufficient down payment from the buyer; review their credit worthiness and ability to repay the loan; and obtain a professional valuation of the house in case the buyers default on the loan (to ensure that the loan is not larger than the true value of the property in the event of a future sale).
If a seller-financed sale seems appropriate for your circumstances, take a few common- sense precautions to ensure the condition of the property. Have a title company check for any outstanding liens or other title issues, and hire a lawyer to prepare the paperwork, including the note, deed of trust, or mortgage documents.