Lending requirements in today’s real estate market have tightened substantially from a few years ago. One of the options that is possible in the sale of a home is seller financing, where the seller makes a mortgage to the buyer. This bypasses traditional lenders and perhaps help put together a deal that wouldn’t normally happen. However, the challenges to seller financing are numerous, and often it doesn’t make sense.
What are the advantages of seller financing?
The biggest advantage of seller financing is flexibility. In a tightened lending environment, there are both buyers who can’t qualify to buy a particular property and properties which have unique characteristics which work against typical lending guidelines. For a seller who owns a home free and clear of mortgages, they can specify their own loan terms to a prospective buyer, easing the lending requirements and potentially resulting in a quicker sale.
Seller financing probably doesn’t make sense
Seller financing of real estate is best used with extreme caution. There are numerous reasons why it won’t make sense for most sellers.
- You have an existing mortgage – Most sellers have an existing mortgage on their home. You can craft the legal documents that wrap a new mortgage around your existing mortgage. The buyer pays you and you then pay your existing mortgage. However, in 99.9% of the cases, you have violated the “due on sale” clause of your own mortgage by selling the home. “Due on sale” means that when the property is sold, your lender has to either be paid off completely or they have to issue written approval for the sale. They are not going to do the latter, so stay away from actions which force your mortgage to become payable in full. It is not worth the risk.
- Why can’t the buyer qualify? – The lending environment is more strict these days, but not unreasonably so. If a buyer cannot obtain a mortgage through traditional lending channels, ask why. Is their income too low? Do they have bad credit? Do they have excessive debt obligations? If you are becoming their lender, why would you incur these risks that banks are certain to avoid? Seems like a bad business decision.
- Low interest rates – Current interest rates are at record lows. No sane buyer would choose more expensive seller financing options if they can get a great rate on a traditional loan. Most sellers would want a premium over market interest rates to incur the risk of making such a loan, but it makes little or no financial sense to a buyer. If the interest rate situation were to reverse suddenly, then sellers may be able to offer below-market financing rates to help get their home sold in a high interest rate environment.
- Do you want to play the foreclosure game if you have to? – If the buyers stop paying their mortgage, you have the joyous task of foreclosing on them. Depending on where you live, the process is time-consuming and potentially expensive, not to mention stressful. I don’t know any sellers who would relish the process of foreclosing and potentially evicting their buyers.
- Do you want your equity tied up in a mortgage? – Let’s say you are making a $200,000 mortgage to a buyer for a 10-year term. Are you comfortable with being paid off over a long time frame? Will you need the money sooner? Most importantly, can your equity be put to better financial use elsewhere, rather than collecting interest and principal on a real estate note.
When seller financing does make sense
There are properties and situations where seller financing is really the only option. Non-conforming, unusual or undeveloped real estate can lead to situations where banks will not make loans on a particular piece of real estate. If the seller has equity in the property and can safely grant a mortgage to their buyer, then seller financing can help the sale of real estate that might not otherwise be possible. However, for the vast majority of homes and condos, this doesn’t apply. There are plenty of traditional lenders available to make standard home loans in those situations.
If you choose to pursue seller financing
If seller financing is a choice that you have to make to sell your real estate, be sure to do your homework. You need to qualify your buyer, much like a bank would. Spend the extra time and money to hire an attorney, and perhaps a CPA, to help you draft contracts and terms that best protect your interests.