Sometimes, home sellers find a buyer eager to purchase but unable to finance the property with traditional mortgage financing. Sellers then have a choice: lose the buyer, or lend the mortgage to the buyer themselves.
If you want to sell a property you own free and clear, with no mortgage, you can theoretically finance a buyer’s full first mortgage. Alternatively, you could offer just a second mortgage, to bridge the gap between what the buyer can borrow from a conventional lender and the cash they can put down.
Should you ever consider offering financing? What’s in it for you? And most importantly, how do you protect yourself against losses?
Before taking the plunge to offer seller financing, make sure you understand all the pros, cons, and options available to you as “the bank” when lending money to a buyer.
Advantages to Offering Seller Financing
Although most sellers never even consider offering financing, a few find themselves forced to contemplate it.
For some sellers, it could be that their home lies in a cool market with little demand. Others own unique properties that appeal only to a specific type of buyer or that conventional mortgage lenders are wary to touch. Or the house may need repairs in order to meet habitability requirements for conventional loans.
Sometimes the buyer may simply be unable to qualify for a conventional loan, but you might know they’re good for the money if you have an existing relationship with them.
There are plenty of perks in it for the seller to offer financing. Consider these pros as you weigh the decision to extend seller financing.
1. Attract & Convert More Buyers
The simplest advantage is the one already outlined: You can settle on your home even when conventional mortgage lenders decline the buyer.
Beyond salvaging a lost deal, sellers can also potentially attract more buyers. “Seller Financing Available” can make an effective marketing bullet in your property listing.
If you want to sell your home in 30 days, offering seller financing can draw in more showings and offers.
Bear in mind that seller financing doesn’t only appeal to buyers with shoddy credit. Many buyers simply prefer the flexibility of negotiating a custom loan with the seller rather than trying to fit into the square peg of a loan program.
2. Earn Ongoing Income
As a lender, you get the benefit of ongoing monthly interest payments, just like a bank.
It’s a source of passive income, rather than a one-time payout. In one fell swoop, you not only sell your home but also invest the proceeds for a return.
Best of all, it’s a return you get to determine yourself.
3. You Set the Interest Rate
It’s your loan, which means you get to call the shots on what you charge. You may decide seller financing is only worth your while at 6% interest, or 8%, or 10%.
Of course, the buyer will likely try to negotiate the interest rate. After all, nearly everything in life is negotiable, and the terms of seller financing are no exception.
4. You Can Charge Upfront Fees
Mortgage lenders earn more than just interest on their loans. They charge a slew of one-time, upfront fees as well.
Those fees start with the origination fee, better known as “points.” One point is equal to 1% of the mortgage loan, so they add up fast. Two points on a $250,000 mortgage comes to $5,000, for example.
But lenders don’t stop at points. They also slap a laundry list of fixed fees on top, often surpassing $1,000 in total. These include fees such as a “processing fee,” “underwriting fee,” “document preparation fee,” “wire transfer fee,” and whatever other fees they can plausibly charge.
When you’re acting as the bank, you can charge these fees too. Be fair and transparent about fees, but keep in mind that you can charge comparable fees to your “competition.”
5. Simple Interest Amortization Front-Loads the Interest
Most loans, from mortgage loans to auto loans and beyond, calculate interest based on something called “simple interest amortization.” There’s nothing simple about it, and it very much favors the lender.
In short, it front-loads the interest on the loan, so the borrower pays most of the interest in the beginning of the loan and most of the principal at the end of the loan.
For example, if you borrow $300,000 at 8% interest, your mortgage payment for a 30-year loan would be $2,201.29. But the breakdown of principal versus interest changes dramatically over those 30 years.
- Your first monthly payment would divide as $2,000 going toward interest, with only $201.29 going toward paying down your principal balance.
- At the end of the loan, the final monthly payment divides as $14.58 going toward interest and $2,186.72 going toward principal.
It’s why mortgage lenders are so keen to keep refinancing your loan. They earn most of their money at the beginning of the loan term.
The same benefit applies to you, as you earn a disproportionate amount of interest in the first few years of the loan. You can also structure these lucrative early years to be the only years of the loan.
6. You Can Set a Time Limit
Not many sellers want to hold a mortgage loan for the next 30 years. So they don’t.
Instead, they structure the loan as a balloon mortgage. While the monthly payment is calculated as if the loan is amortized over the full 15 or 30 years, the loan must be paid in full within a certain time limit.
That means the buyer must either sell the property within that time limit or refinance the mortgage to pay off your loan.
Say you sign a $300,000 mortgage, amortized over 30 years but with a three-year balloon. The monthly payment would still be $2,201.29, but the buyer must pay you back the full remaining balance within three years of buying the property from you.
You get to earn interest on your money, and you still get your full payment within three years.
7. No Appraisal
Lenders require a home appraisal to determine the property’s value and condition.
If the property fails to appraise for the contract sales price, the lender either declines the loan or bases the loan on the appraised value rather than the sales price — which usually drives the borrower to either reduce or withdraw their offer.
As the seller offering financing, you don’t need an appraisal. You know the condition of the home, and you want to sell the home for as much as possible, regardless of what an appraiser thinks.
Foregoing the appraisal saves the buyer money and saves everyone time.
8. No Habitability Requirement
When mortgage lenders order an appraisal, the appraiser must declare the house to be either habitable or not.
If the house isn’t habitable, conventional and FHA lenders require the seller to make repairs to put it in habitable condition. Otherwise, they decline the loan, and the buyer must take out a renovation loan (such as an FHA 203k loan) instead.
That makes it difficult to sell fixer-uppers, and it puts downward pressure on the price. But if you want to sell your house as-is, without making any repairs, you can do so by offering to finance it yourself.
For certain buyers, such as handy buyers who plan to gradually make repairs themselves, seller financing can be a perfect solution.
9. Tax Implications
When you sell your primary residence, the IRS offers an exemption for the first $250,000 of capital gains if you’re single, or $500,000 if you’re married.
However, if you earn more than that exemption, or if you sell an investment property, you still have to pay capital gains tax. One way to reduce your capital gains tax is to spread your gains over time through seller financing.
It’s typically considered an installment sale for tax purposes, helping you spread the gains across multiple tax years. Speak with an accountant or other financial advisor about exactly how to structure your loan for the greatest tax benefits.
Drawbacks to Seller Financing
Seller financing comes with plenty of risks. Most of the risks center around the buyer-borrower defaulting, they don’t end there.
Make sure you understand each of these downsides in detail before you agree to and negotiate seller financing. You could potentially be risking hundreds of thousands of dollars in a single transaction.
1. Labor & Headaches to Arrange
Selling a home takes plenty of work on its own. But when you agree to provide the financing as well, you accept a whole new level of labor.
After negotiating the terms of financing on top of the price and other terms of sale, you then need to collect a loan application with all of the buyer’s information and screen their application carefully.
That includes collecting documentation like several years’ tax returns, several months’ pay stubs, bank statements, and more. You need to pull a credit report and pick through the buyer’s credit history with a proverbial fine-toothed comb.
You must also collect the buyer’s new homeowner insurance information, which must include you as the mortgagee.
You need to coordinate with a title company to handle the title search and settlement. They prepare the deed and transfer documents, but they still need direction from you as the lender.
Be sure to familiarize yourself with the home closing process, and remember you need to play two roles as both the seller and the lender.
Then there’s all the legal loan paperwork. Conventional lenders sometimes require hundreds of pages of it, all of which must be prepared and signed. Although you probably won’t go to the same extremes, somebody still needs to prepare it all.
2. Potential Legal Fees
Unless you have experience in the mortgage industry, you probably need to hire an attorney to prepare the legal documents such as the note and promise to pay. This means paying the legal fees.
Granted, you can pass those fees on to the borrower. But that limits what you can charge for your upfront loan fees.
Even hiring the attorney involves some work on your part. Keep this in mind before moving forward.
3. Loan Servicing Labor
Your responsibilities don’t end when the borrower signs on the dotted line.
You need to make sure the borrower pays on time every month, from now until either the balloon deadline or they repay the loan in full. If they fail to pay on time, you need to send late notices, charge them late fees, and track their balance.
You also have to confirm that they pay the property taxes on time and keep the homeowners insurance current. If they fail to do so, you then have to send demand letters and have a system in place to pay these bills on their behalf and charge them for it.
Every year, you also need to send the borrower 1098 tax statements for their mortgage interest paid.
In short, servicing a mortgage is work. It isn’t as simple as cashing a check each month.
4. Foreclosure
If the borrower fails to pay their mortgage, you have only one way to forcibly collect your loan: foreclosure.
The process is longer and more expensive than eviction and requires hiring an attorney. That costs money, and while you can legally add that cost to the borrower’s loan balance, you need to cough up the cash yourself to cover it initially.
And there’s no guarantee you’ll ever be able to collect that money from the defaulting borrower.
Foreclosure is an ugly experience all around, and one that takes months or even years to complete.
5. The Buyer Can Declare Bankruptcy on You
Say the borrower stops paying, you file a foreclosure, and eight months later, you finally get an auction date. Then the morning of the auction, the borrower declares bankruptcy to stop the foreclosure.
The auction is canceled, and the borrower works out a payment plan with the bankruptcy court judge, which they may or may not actually pay.
Should they fail to pay on their bankruptcy payment plan, you have to go through the process all over again, and all the while the borrowers are living in your old home without paying you a cent.
6. Risk of Losses
If the property goes to foreclosure auction, there’s no guarantee anyone will bid enough to cover the borrower’s loan debt.
You may have lent $300,000 and shelled out another $20,000 in legal fees. But the bidding at the foreclosure auction might only reach $220,000, leaving you with a $100,000 shortfall.
Unfortunately, you have nothing but bad options at that point. You can take the $100,000 loss, or you can take ownership of the property yourself.
Choosing the latter means more months of legal proceedings and filing eviction to remove the nonpaying buyer from the property. And if you choose to evict them, you may not like what you find when you remove them.
7. Risk of Property Damage
After the defaulting borrower makes you jump through all the hoops of foreclosing, holding an auction, taking the property back, and filing for eviction, don’t delude yourself that they’ll scrub and clean the property and leave it in sparkling condition for you.
Expect to walk into a disaster. At the very least, they probably haven’t performed any maintenance or upkeep on the property. In my experience, most evicted tenants leave massive amounts of trash behind and leave the property filthy.
In truly terrible scenarios, they intentionally sabotage the property. I’ve seen disgruntled tenants pour concrete down drains, systematically punch holes in every cabinet, and destroy every part of the property they can.
8. Collection Headaches & Risks
In all of the scenarios above where you come out behind, you can pursue the defaulting borrower for a deficiency judgment. But that means filing suit in court, winning it, and then actually collecting the judgment.
Collecting is not easy to do. There’s a reason why collection accounts sell for pennies on the dollar — most never get collected.
You can hire a collection agency to try collecting for you by garnishing the defaulted borrower’s wages or putting a lien against their car. But expect the collection agency to charge you 40% to 50% of all collected funds.
You might get lucky and see some of the judgment or you might never see a penny of it.
Options to Protect Yourself When Offering Seller Financing
Fortunately, you have a handful of options at your disposal to minimize the risks of seller financing.
Consider these steps carefully as you navigate the unfamiliar waters of seller financing, and try to speak with other sellers who have offered it to gain the benefit of their experience.
1. Offer a Second Mortgage Only
Instead of lending the borrower the primary mortgage loan for hundreds of thousands of dollars, another option is simply lending them a portion of the down payment.
Imagine you sell your house for $330,000 to a buyer who has $30,000 to put toward a down payment. You could lend the buyer $300,000 as the primary mortgage, with them putting down 10%.
Or you could let them get a loan for $270,000 from a conventional mortgage lender, and you could lend them another $30,000 to help them bridge the gap between what they have in cash and what the primary lender offers.
This strategy still leaves you with most of the purchase price at settlement and lets you risk less of your own money on a loan. But as a second mortgage holder, you accept second lien position
That means in the event of foreclosure, the first mortgagee gets paid first, and you only receive money after the first mortgage is paid in full.
2. Take Additional Collateral
Another way to protect yourself is to require more collateral from the buyer. That collateral could come in many forms. For example, you could put a lien against their car or another piece of real estate if they own one.
The benefits of this are twofold. First, in the event of default, you can take more than just the house itself to cover your losses. Second, the borrower knows they’ve put more on the line, so it serves as a stronger deterrent for defaults.
3. Screen Borrowers Thoroughly
There’s a reason why mortgage lenders are such sticklers for detail when underwriting loans. In a literal sense, as a lender, you are handing someone hundreds of thousands of dollars and saying, “Pay me back, pretty please.”
Only lend to borrowers with a long history of outstanding credit. If they have shoddy credit — or any red flags in their credit history — let them borrow from someone else. Be just as careful of borrowers with little in the way of credit history.
The only exception you should consider is accepting a cosigner with strong, established credit to reinforce a borrower with bad or no credit. For example, you might find a recent college graduate with minimal credit who wants to buy, and you could accept their parents as cosigners.
You also could require additional collateral from the cosigner, such as a lien against their home.
Also review the borrower’s income carefully, and calculate their debt-to-income ratios. The front-end ratio is the percentage of their monthly income required to cover all housing costs: principal and interest, property taxes, homeowner’s insurance, and any condominium or homeowners association fees.
For reference, conventional mortgage lenders allow a maximum front-end ratio of 28%.
The back-end ratio includes not just housing costs, but also overall debt obligations. That includes student loans, auto loans, credit card payments, and all other mandatory monthly debt payments.
Conventional mortgage loans typically allow 36% at most. Any more than that and the buyer probably can’t afford your home.
4. Charge Fees for Your Trouble
Mortgage lenders charge points and fees. If you’re serving as the lender, you should do the same.
It’s more work for you to put together all the loan paperwork. And you will almost certainly have to pay an attorney to help you, so make sure you pass those costs along to the borrower.
Beyond your own labor and costs, you also need to make sure you’re being compensated for your risk. This loan is an investment for you, so the rewards must justify the risk.
5. Set a Balloon
You don’t want to be holding this mortgage note 30 years from now. Or, for that matter, to force your heirs to sort out this mortgage on your behalf after you shuffle off this mortal coil.
Set a balloon date for the mortgage between three and five years from now. You get to collect mostly interest in the meantime, and then get the rest of your money once the buyer refinances or sells.
Besides, the shorter the loan term, the less opportunity there is for the buyer to face some financial crisis of their own and stop paying you.
6. Be Listed as the Mortgagee on the Insurance
Insurance companies issue a declarations page (or “dec page”) listing the mortgagee. In the event of damage to the property and an insurance claim, the mortgagee gets notified and has some rights and protections against losses.
Review the insurance policy carefully before greenlighting the settlement. Make sure your loan documents include a requirement that the borrower send you updated insurance documents every year and consequences if they fail to do so.
7. Hire a Loan Servicing Company
You may multitalented and an expert in several areas. But servicing mortgage loans probably isn’t one of them.
Consider outsourcing the loan servicing to a company that specializes in it. They send monthly statements, late notices, 1098 forms, and escrow statements (if you escrow for insurance and taxes), and verify that taxes and insurance are current each year. If the borrower defaults, they can hire a foreclosure attorney to handle the legal proceedings.
Examples of loan servicing companies include LoanCare and Note Servicing Center, both of whom accept seller-financing notes.
8. Offer Lease-to-Own Instead
The foreclosure process is significantly longer and more expensive than the eviction process.
In the case of seller financing, you sell the property to the buyer and only hold the mortgage note. But if you sign a lease-to-own agreement, you maintain ownership of the property and the buyer is actually a tenant who simply has a legal right to buy in the future.
They can work on improving their credit over the next year or two, and you can collect rent. When they’re ready, they can buy from you — financed with a conventional mortgage and paying you in full.
If the worst happens and they default, you can evict them and either rent or sell the property to someone else.
9. Explore a Wrap Mortgage
If you have an existing mortgage on the property, you may be able to leave it in place and keep paying it, even after selling the property and offering seller financing.
Wrap mortgages, or wraparound mortgages, are a bit trickier and come with some legal complications. But when executed right, they can be a win-win for both you and the buyer.
Say you have a 30-year mortgage for $250,000 at 3.5% interest. You sell the property for $330,000, and you offer seller financing of $300,000 for 6% interest. The buyer pays you $30,000 as a down payment.
Ordinarily, you would pay off your existing mortgage for $250,000 upon selling it. Most mortgages include a “due-on-sale” clause, requiring the loan to be paid in full upon selling the property.
But in some circumstances and some states, you may be able to avoid triggering the due-on-sale clause and leave the loan in place.
You keep paying your mortgage payment of $1,122.61, even as the borrower pays you $1,798.65 per month. In a couple of years when they refinance, they pay off your previous mortgage in full, plus the additional balance they owe you.
Of course, you still run the risk that the borrower stops paying you. Then you’re saddled with making your monthly mortgage payment on the property, even as you slog through the foreclosure process to try and recover your losses.
Final Word
Offering seller financing comes with risks. But those risks may be worth taking, especially for hard-to-sell properties.
Only you can decide what risk-reward ratio you can live with, and negotiate loan terms to ensure you come out on the right side of the ratio. For unique or other difficult-to-finance properties, seller financing may be the only way to sell for what the property’s worth.
Before you write off the returns as low, remember that your APR will be far higher than the interest rate charged.
Beyond the upfront fees you can charge, you’ll also benefit from simple interest amortization, which front-loads the interest so that nearly all of the monthly payment goes toward interest in the first few years — the only years you need to finance if you structure the loan as a balloon mortgage.
Just be sure to screen all borrowers extremely carefully, and to take as many precautions as you can. If the borrower can’t qualify for a conventional mortgage, consider that a glaring red flag. Seller financing involves risking many thousands of dollars in a single transaction, so take your time and get it right.
