Real Estate Guide

Your Mortgage - Questions and Answers
'Seller Financing'

• What is seller financing?
• What are the benefits and risks of seller financing?
• What is a wrap-around loan?
• What is a Land Contract?
• How are the interest rates set for seller financing?

What is seller financing?

All real estate need not be purchased with the help of a bank loan. Sometimes the seller, especially in slow buyer's markets, will agree to help finance the purchase his property. If a buyer is having difficulty qualifying for a conventional loan or meeting the purchase price, the seller might agree to take back a second note and finance a portion of the buyer's total loan with a conventional lender. He may even agree to finance the entire purchase, whereby, the seller himself gives the buyer what is known as a purchase-money mortgage.

With the purchase-money mortgage, the seller doesn't actually give any money to the buyer, as would a conventional lender. He simply extends credit, as it were, to the buyer against the purchase price of his property. The buyer signs a promissory note and trust deed agreeing to pay the seller a certain amount each month to be applied against the principal, plus an agreed upon interest amount at a specified rate on the unpaid balance. Should the buyer default, all avenues of foreclosure given a traditional lender are open to the seller.

The agreement contract, promissory note, trust deed, and all legal documents should ultimately be prepared by a competent attorney for the protection of both buyer and seller; and the transaction properly recorded giving public notice of the title transfer and mortgage.

Seller financing can bring a higher price, and help a buyer, who under ordinary circumstances, may not be able to complete the transaction. However, it is critical for the seller to thoroughly evaluate the credit-worthiness of the buyer.

Seller financing may also take the form of a Land Contract (lease-to-purchase), lease-option, or equity sharing.

See also

• About Mortgages - Alternate Forms of Financing
• Internal Revenue Service Publication 537 "Installment Sales"
• Land Contract or Installment Sales Contract
• Lease-Option
• Equity Sharing

What are the benefits and risks of seller financing?

Seller financing offers tax breaks for sellers and alternative financing for buyers who can't qualify for conventional loans. If you are a seller, the risks you face are the same as those facing any lender:

• Is the borrower a good credit risk?

• Will the property hold enough value over time to allow for the repayment of all loans made against it?

You should run a full credit check on the borrower, require hazard insurance on the property and include a due-on-sale clause. There also are financing, disclosure and repayment-term requirements that need to be met. It is wise to consult a lawyer when putting together this kind of transaction.

What is a wrap-around loan?

The wrap-around loan method of seller financing is best described by an example.

Suppose Mr. Sellers currently has a $70,000 mortgage on his home. Mr. Byers makes an offer to purchase the home for $100,000. Mr. Byers says he can pay $5,000 down if Mr. Sellers will finance the remaining $95,000..

Mr. Sellers sees an opportunity to make some money. The interest rate on his current loan is only 5.5%. The going current market interest rate is 7.5%. He then offers to carry Mr. Byers' $95,000 mortgage for 8%.

Because Mr. Byers' credit history isn't what it should be, he jumps at the chance to avoid the hassle of getting a conventional loan. To protect both of them, they execute a legal "deed of trust" and properly record it. (Note: this is the second deed of trust recorded for this property! )

Mr. Byers' $95,000 mortgage "wraps around" Mr. Sellers' $70,000 mortgage. Mr. Byers moves into the house, and makes his 8% interest and principal payment monthly to Mr. Sellers on his new $95,000 mortgage. Mr. Sellers  continues to make his 5.5% monthly interest and principal  payment to the original lender on the $70,000 mortgage and pockets the difference as profit.

Everybody's happy? Maybe.

Although the agreement between Mr. Sellers and Mr. Byer is perfectly legal, it is not without risk. This arrangement works as long as Mr. Sellers' original loan agreement does not contain a "due-on-sale" clause, and it is highly likely it does. Should there be a 'due-on-sale' or a 'due-on-transfer' provision, the remaining balance of the underlying loan might be 'called due' and 'payable' when the original lender becomes aware that the property has been 'sold' and title has transferred. The original lender might then invoke their first "deed of trust" and sell the property for the amount of principal that has not yet been repaid. Mr. Sellers could lose his $95,000 mortgage and Mr. Byers could lose the house.

At the very least, the original lender has the right to increase the interest-rate and probably charge a hefty assumption penalty to Mr. Byers, and possibly a pre-payment penalty to Mr. Sellers.

Mr. Sellers would argue that the original lender would never, especially in this age of the foreclosure, go through the time and expense to invoke the "due-on-sale" clause if his payments were timely made. Maybe so, but, never, never enter into it without the help of a competent title attorney to advise you of the inherent risks and to write a contract that protects both your interests, as well as the seller's.

The "wrap-around loan" can be a useful tool to both buyer and seller if it's applied correctly and under the right circumstances.

What about Land Contracts?

See >> Financing: Land Contracts.

How are the rates set for seller financing?

You will negotiate the interest rate with the seller, who usually is far more agreeable to negotiating than a conventional lender. However, keep in mind that sellers probably won't be willing to carry a loan for less return than they would earn if their money were invested in a routine conventional instrument.

You should first find out what rates conventional lenders are currently charging. Freddie Mac's Primary Mortgage Market Survey® is one place to search. You can also ask your RE/MAX Valley agent to check with several local lenders or mortgage brokers. Although, you may end up paying a slightly higher interest rate, seller financing will usually be far less costly than conventional financing because sellers won't charge points, loan origination and processing fees.