If you’re looking to buy a house, you typically apply for a loan from a mortgage lender. While mortgages are the conventional way to borrow for a home purchase, you may also have heard of seller financing. This private arrangement between a buyer and a seller is different from a traditional mortgage in many ways.
What is seller financing?
Seller financing is a private transaction between buyer and seller where the property owner extends financing to the buyer without the involvement of a financial institution. In a seller financing arrangement, the terms of the home loan are agreed upon directly between the buyer and the seller, who also acts as the lender. In the absence of a third-party lender, the terms of the seller financing agreement may vary widely from case to case.
In theory, seller financing can apply to any home purchase. In practice, however, it usually arises under certain conditions. Firstly, the seller typically needs to hold significant equity in the house they’re selling, if not own the home outright. If the bank remains the main owner of the home, it’s unlikely the seller will gain approval for a private transaction. Secondly, the buyer is usually (though not always) someone who has found it difficult to secure a conventional mortgage, for whatever reason.
Seller financing may also emerge as a consideration when selling a house to family or friends, or when the parties already otherwise know each other.
How does seller financing work?
Since seller financing is a private arrangement, the seller and buyer must work together to reach agreement on the terms of the loan, from the purchase price to the payment schedule.
Given this flexibility, types of seller financing tend to vary widely. The simplest arrangements are typically all-inclusive, meaning that the seller extends the loan for the full purchase price, minus any down payment. This arrangement is perhaps closest to a conventional mortgage, except in this case the seller — rather than a financial institution — is acting directly as the lender.
Land contracts are another potential arrangement. In a land contract, the buyer and seller agree on some form of joint ownership of the property, often until the final payment is made. At this point, ownership of the property typically transfers outright to the buyer. Such an arrangement can give the buyer a chance to build equity in the property, increasing their chances of securing a conventional mortgage at the end of the repayment term. The buyer may also need to contribute to property upkeep and repairs during this period.
Lease-options are another type of arrangement. In this scenario, the buyer lives as a tenant in the property. However, unlike traditional tenancy, the renter retains the option to purchase the home after a predetermined length of time.
Hybrid arrangements, where a financial institution stays involved, exist as well. With a junior mortgage, for example, the seller lends a portion of the purchase price, with the rest covered by combination of a conventional mortgage and the buyer’s down payment. Assumable mortgages, where the seller’s outstanding loans on the property transfer to the buyer, may also be possible in some cases.
The appeal of seller financing
For the buyer, one of the main upsides of a seller-financed mortgage is a pathway to financing when they may otherwise have trouble securing a traditional mortgage.
Another potential appeal of seller financing is the relative lack of formal oversight. For example, buyers and sellers get to directly negotiate the details of the purchase price and the size of the down payment. They may also avoid the kinds of closing costs that a conventional mortgage usually requires, as well as any potential obligation for the buyer to purchase private mortgage insurance. Plus, without financial institutions involved, the purchase itself may move along faster.
Given the potential speed and flexibility of the arrangement, seller financing may also help the owner attract more prospective buyers for their property. Sellers may skip making the kinds of repairs typically advised when preparing a property for sale. They will also potentially benefit from interest payments levied on the loan.
Seller financing risks and downsides
As with any lending agreement, seller financing comes with risks. Unlike a conventional loan, both the buyer and seller are typically subject to fewer legal protections, particularly in the event of a payment default or foreclosure proceedings. This relative lack of legal protection could cause significant headaches in the event of a dispute between the signatories.
Another potential downside is the paperwork itself. In a seller financing arrangement, it is the responsibility of the seller, in conjunction with the buyer, to generate the legal agreement. While both parties may secure the services of a real estate attorney to help draft the terms, there is no financial institution involved to supervise its execution.
Additionally, responsibility for managing the transfer of the property’s title and ordering a title search rests with the seller and the buyer respectively. Meanwhile, the servicing of the mortgage loan — generating bills, collecting payments and chasing unpaid amounts — sits squarely on the seller’s shoulders.
For the buyer, there are potential further downsides. Perhaps one of the largest is that seller financing often involves higher interest rates than a traditional mortgage. Those higher rates are typically a function of the additional risk the seller is taking on as the lender in the relationship. As a result, even if a buyer saves on closing costs and avoids purchasing private mortgage insurance, they may still find they pay more in the long run. Also, since seller financing doesn’t typically require a home appraisal, there’s a possibility that the buyer might end up paying above market value for the home.
Conventional mortgage vs seller financing
As we have seen, there are many significant differences between conventional mortgages and seller financing agreements.
One final major difference is the structure and duration of the loan itself. Conventional home loans usually have repayment periods of 15 or 30 years. With seller-financed mortgages, five years is a more common term, although every arrangement is different.
The loan itself may also be structured differently, with a balloon payment potentially due toward the end of the term. To meet the terms of any balloon payment, the buyer may need to seek financing at that time through a traditional lender. By this point, changes in the buyer's credit or in the appraised value of the house may help the buyer secure conventional financing.
Seller financing may provide a path to home ownership for buyers who have trouble securing a conventional mortgage. However, these private arrangements come with risks and costs of their own. When deciding what is the right approach for you, it’s helpful to fully consider all factors and seek professional advice.