When lending requirements tighten, finding the funds to build your real estate portfolio can become a challenge. In these situations, seller financing can present an appealing alternative.
Sadly, most people don’t know what seller financing is or how it works, so they tend to overlook it as a creative way to purchase property.
This is unfortunate because seller financing is a way to acquire real estate without having to go to the bank.
Because it can be a win-win for buyer and seller, it’s important to know what seller financing is, how to ask for it, and the way it works. Let’s take a look at the process, as well as the pros and cons you’ll need to keep in mind as you explore seller financing as a potential option.
What Is Seller Financing?
At its core, seller financing means that the seller will extend credit to the buyer instead of a bank or other lending institution. It’s not technically a loan because no money changes hands. Instead, the buyer makes a down payment, then makes installment payments to the seller over time in order to own the property in full at a later date.
In essence, the seller delays receiving the full sales price for their property until a later date by “carrying back” all or part of the purchase price.
With seller financing, the buyer receives lending from the seller rather than a financial institution.
Because a bank isn’t involved, there can often be more flexibility around the conditions of the deal, particularly the interest rate, payment amount, and duration of the financing.
You’ll also hear the terms owner financing, seller carry-back financing, and installment sale, which are all different names for the same thing: seller financing.
How Seller Financing Works
There are many variations for seller financing, but the basic process works like this:
- Seller has equity in the property
- Seller deeds property to the buyer
- Buyer gives seller a promissory note
- Buyer gives seller a mortgage to secure the promissory note against the property
Essentially, the buyer agrees to pay on credit over time to purchase the property. The seller takes on the role of lender, but instead of giving cash to the buyer, extends credit for the purchase price minus the down payment.
The promissory note lays out the terms of the deal, including the interest rate, schedule of payments, and the consequences for default.
Most seller-financed deals are shorter than traditional loans. The amount might be amortized (spread) over 30 years, but a balloon payment could be due in five.
The idea is that in a few years the property will grow in value, or the buyer will have improved their financial situation enough to be able to refinance the property with a traditional lender.
Why Ask for Seller Financing?
Buyers interested in seller financing are often those who find it difficult to get a conventional mortgage, sometimes due to poor credit. Plus, seller financing can be less expensive than a mortgage, because there are no-to-few closing costs and you might not be required to get an appraisal. Most deals settle quickly as well, often within a week.
The popularity of seller financing tends to rise when the credit market tightens. This is because seller financing can help buyers get into a home when banks are reluctant to lend money. Naturally, it can also make it easier for sellers to sell their home.
In particular, seller financing works great when you can pay down the installments due to the seller using cash flow from the property itself.
This is a great hack for investors because you don’t have to rely on a bank to fund your real estate deals. If you have bad credit or already have several loans, it can be tough to qualify for new lending.
Pros And Cons
From a buyer’s perspective, there is certainly much to like about the option for seller financing. If you don’t have to go through a bank to get money, it can make things easier as you hack your way to a bigger real estate portfolio. But there are potential downsides you should be aware of before you dive in.
Pros
- Easier to qualify for than for a bank loan
- Everything is negotiable
- No bank or government-required minimums for the interest rate or down payment
- Good option for buyers who can’t get traditional financing
- Faster closing
- Cheaper closing – no bank fees or appraisal costs
- Potential discount on loan balance – the seller might let you pay all or part of the loan balance off at a discount in exchange for a lump sum of cash
- Valuable relationship – you may be able to buy more deals from the same seller if they trust you from an earlier seller financed deal
Cons
- Everything is negotiable – a negative if you don’t know what terms to negotiate
- Potential issues with heirs if the seller dies
- Higher interest rate than a bank because the seller assumes greater risk
- Need seller approval – even if the seller wants to finance the property, they not might want to finance you
- A due-on-sale clause in seller’s current mortgage could stop the sale
- Balloon payments – there is usually a large payment due to the seller in 5 or 10 years, so you will need to plan to refinance the property by this time
Example of a Seller Financed Sale
Let’s walk through an example of what a seller-financed deal might look like.
Let’s say that a buy agrees to pay a seller $300,000 for a single family home.
With this particular deal, the buyer and seller agree to a $10,000 down payment with the remainder ($290,000) being seller-financed. They set the interest rate at 5% and amortize the loan over 30 years, with a balloon payment due at the end of five years.
Using a mortgage calculator, the buyer’s monthly payment would be $1,556 per month for the next five years.
When the balloon payment becomes due at the end of the five years, the buyer has a few options to be able to repay the seller the remaining balance in full:
- Refinance with a bank or traditional lender
- Use funds from other activities to pay
- Renegotiate the terms with the seller to extend the repayment timeline
You might be surprised as to why a seller would want to renegotiate the terms, but if you offered a higher interest rate (for example), they just might accept.
It is also possible they don’t want to take back possession of the property, which would happen if you were to default. Among older sellers, this motivation is common. Thus, they may be willing to work with you if you need to renegotiate your terms.
Plus, the seller may get tax benefits from serving as your lender that they want to keep. In particular, seller financing allows sellers to avoid paying capital gains taxes from the profit of a sale all at once. Instead, they can pay their tax bill in increments as they receive your monthly installment payments.
The Low Down on Seller Financing
If credit issues are keeping you from being able to buy a house or you’ve been finding it increasingly difficult to qualify for mortgage as your real estate portfolio grows, then seller financing could be an smart alternative.
Understanding the process will help you to make good choices and mitigate the various risks involved.
Best of all, seller financing can be used across all types of real estate transactions, including both residential and commercial properties.