5 Seller Financing Options for Home Buyers

By Gwynneth Anderson
June 22, 2011

Think now is a great time to buy a home? Good luck finding financing.

Tightened lending standards still cripple homeownership dreams for those with the income to support a mortgage but without the squeaky clean credit history and minimum 720 credit score

For these folks, it’s a tough market -- one that doesn’t appear to be loosening up any time soon.

Enter seller financing. Once popular in the 1980s, seller financing is once again emerging as a way for buyers to circumvent today’s heightened mortgage lending restrictions.  

According to Bloomberg Businessweek almost 53,000 homes in 2010 were purchased with owner financing, most of them taking place in hard-hit Michigan, Florida, Ohio, California, Wisconsin, Minnesota and Texas.  

While this is only roughly 1.5% of 2010’s real estate transactions, it gives a hint that for buyers, necessity has once again become the mother of invention.

A Brief History of Seller Financing

Seller financing took off during the early 1980s after interest rates rocketed as high as 20%, forcing home buyers to seek out other options. 

Seller financing stepped into the breach, partnering homeowners with lower mortgage interest rates with buyers willing to assume the loan

The idea became a popular financing tool until the late 1970s when banks struck back with the due-on-sale clause that allowed them to call the loan due if a house was sold to a third party. 

The due-on-sale clause actually served a double purpose. Not only did it help banks battle a competitor, it also allowed them to move borrowers from the old, lower interest mortgages into new, higher interest loans

Stanley Bronstein, an Arizona-based attorney and CPA, believes seller financing is coming back into vogue. 

“It's been harder and harder to get loans from banks and mortgage companies,” he says. “It's probably going to grow even tougher, especially if some of the proposed rules come to pass requiring buyers to put 20% down in order to qualify for traditional financing.”

Making Seller Financing Work

While today’s diverse seller financing options are a far cry its 1980 roots, the premise (and caveats) have remained the same. Seller financing is similar to traditional, third party bank lenders

The buyer signs a promissory note and promises to pay the seller installment payments (typically monthly) that contain principal and interest. 

Just like a traditional loan, there will be a signed mortgage or a deed of trust, or a security agreement that allows the seller to foreclose if the buyer doesn't pay.  

Currently, home buyers can choose from five different seller financing options:

Seller Financing Option #1: Free and Clear

The simplest seller financing option is when an owner sells a home free and clear of all liens. The buyer makes a down payment and pays the negotiated, monthly principal and interest payments to the seller who then carries the loan balance in a private note. 

Seller Financing Option #2: Lease with an Option to Buy (Rent to Own) 

In this scenario, the potential homeowner retains the option to buy the home but without the actual obligation. The borrower gains equitable interest in the home with a down payment while also making regular, monthly rent payments. 

At the end of the lease term, he/she has the option to pay off the remaining balance through a refinance.

Kevin Amolsch, president of the Pine Financial Group, advises sellers pursuing this option to obtain a large enough, non-refundable down payment in case the person doesn’t opt to buy.

“But on the other hand, buyers can also protect their options by recording the lease which will cloud the title, thus making it difficult for the seller to sell it to someone else,” he says.

Seller Financing Option #3: The Second Lien Position  

This where a seller carries a second mortgage lien behind the bank to either make a no, or small money down deal. The buyer will then make two payments each month -- one to the senior bank lien holder and a second to the private seller. 

The seller risks with this option are obvious. If the buyer pays only the first lien holder, the seller must have enough equity or funds to foreclose and pay off the first, larger lien holder.

Likewise, if the buyer only pays the smaller second lien, the seller still risks losing the property if the senior lien holder forecloses.

Seller Financing Option #4: Wrap-Around Mortgage 

Offered by those reluctant to take a riskier, second lien holder position, wrap-around mortgages are also an opportunity for sellers to earn a good rate of return

“If I am a seller with a $100,000 mortgage loan at 4% and the property is worth $150,000, I’d sell it to the buyer with $10,000 down, carrying the entire difference [$140,000] at 7% on a wrap-around mortgage or all inclusive trust deed,” says Lance Churchill, an attorney with the Frontline Education Group.  “I’d rather make 2% or 3% on the $100,000 rather than just 7% on the $40,000.”

Yet buyers should know the risks involved with wrap-arounds. “If you are going with a wrap-around mortgage, always go with an escrow company,” advises Amolsch. “You don’t know what the seller is doing with your money.” 

Escrow companies will ensure that payments make it to both the seller and the senior bank lien holder.  

Another risk involves the bank discovering this particular lien.

“This type of arrangement violates what's known as a due-on-sale clause that basically says the existing lender has to be paid off when the seller sells the property to a new buyer,” warns Bronstein.

“If the seller doesn't do this and the lender finds out, the lender could declare the note in default and ask to be paid off in full.”  

Yet Churchill counters that in today’s market, the risk of this happening is small. “Why bother risking a performing loan for a non-performing loan if it’s paying as agreed?"

The only reason why banks might call a loan is if the interest rates rise again. Then they’ll want to make another loan at the higher rate.” 

Seller Financing Option #5: Installment Land Contract

Possibly the riskiest option few experts would recommend, an installment land contract gives the home buyer merely the equitable interest in the property while the legal, titled interest remains with the seller. Final title ownership does not pass to the buyer until the last contracted loan payment has been received. 

The Investing Answer: Seller financing creates a way for home buyers with the income to support a mortgage but having less than stellar credit, to finally own their own home. Yet with any business transaction, those opting for this method should keep the following caveats in mind. 

  • Don’t do it alone. The money saved on avoiding traditional bank closing costs should be applied toward getting expert guidance.
  • Seller financing is a business deal and should be handled as such. Properly document everything through a deed (or mortgage), title insurance, inspections, appraisals, etc.
  • Use an escrow company to close the deal and to properly remit mortgage payments.
  • Remember that while sellers are great at cashing checks, getting the final deed release can be problematic. Have a provision for getting the signed release held in escrow for when the loan is finally paid off. 

Photo courtesy of Flickr: Woodleywonderworks.