Let’s imagine – you have a buyer who wants to buy your home for the asking price. However, due to some issues (e.g., previous bankruptcy, foreclosure, etc.), the bank refused to grant them a loan. What do you do?
For many home sellers, the next step is to start the search for another buyer. But this is because they have no idea about seller financing.
So, what is seller financing? How does seller financing work?
In this article, we provide you with a full rundown of what seller financing is. We explain how it works as well as other things you need to know about the process.
What Is Seller Financing?
Seller financing, also known as owner financing, is a real estate agreement between a homeowner and a buyer. In this agreement, the owner provides the mortgage loan instead of the bank. It works almost precisely as bank financing. But in this deal, the buyer pays the seller (instead of the bank) the monthly installment payment.
This payment includes a specified interest rate and will continue for a period of time.
Homeowner financing often occurs when a homebuyer cannot meet bank loan requirements. This problem ranges from personal factors like the buyer’s employment status to economic factors like a recession.
However, some homeowners include seller financing as an incentive to attract buyers. Owner financing is also a great option when selling to an investor. Or when you need to sell your property to an occupying tenant.
While not as popular as the traditional methods, the Advanced Seller Data Services reported that about $9.59 billion worth of owner-financed loan deals occurred in 2018 alone.
Seller financing is not restricted to any particular type of property or seller/buyer. Houses ranging from single-family homes to apartment complexes, and even hotels can be owner-financed for sale. In fact, seller financing is more common for commercial transactions, such as when selling businesses or apartment complexes. This is because these sellers are often more comfortable with higher transaction complexity for an increased total profit on the sale due to collecting interest on the purchase price.
How Does Seller Financing work?
You should know that the typical seller financing occurs when a buyer cannot qualify for — or does not want to use — traditional financing. With that said, here is how the transaction goes:
A homeowner, who puts the house’s value at $300,000, accepts the buyer’s offer. The owner then creates a mortgage note that requires payback over a ten-year period at 8% interest. Here is a step-by-step guide on how a typical seller financing deal goes down:
1. Vet your home buyer
The first and riskiest part of offering a seller financing option is choosing your buyer. You must vet the potential buyer to ensure they can pay back the loan. Some of the things you need to know about a buyer before moving on with the process are:
- Their tax information
- Their employment history
- Pending litigation against them (check court records)
- Their credit reports
- The bank reserve they use
Doing your due diligence will help you know if your buyer is capable of paying you back. On the flip side, if your buyer defaults, assuming the transaction was done right, you get your house back without needing to repay them a single penny and can then sell it a second time!
2. Employ the service of a professional
Seller financing is a pretty complicated process for the uninitiated. It would be wise to start by employing the service of a real estate company to help structure the deal. A company like Bost Redevelopment would help you set up a favorable deal for you and would utilize the services of a competent title company to ensure that the transaction occurs smoothly and guarantee that the seller has a legal remedy in case of buyer default (so they can legally get their house back if the buyer stops payment).
However, your work as the homeowner does not end after getting a professional to help you. This brings us to the next step.
3. Reach an agreement
This is perhaps the trickiest part of setting up a seller financing transaction. As the seller, you have much more to risk. Therefore, you need an agreement that will protect you and be fair to the buyer. There are three common types of seller financing agreements:
A promissory note: This contract outlines the amount borrowed by the buyer and the terms for the payment. A promissory note comes with a mortgage (or deed of trust) document that helps ensure that the seller gets the property back in the event of a payment default.
The buyer’s name is put on the title with a deed, but the original note is held by the seller, who could sell it to an investor when in need of urgent money. A promissory note is the most common and secure contract of owner financing.
A contract for deed: Also known as an agreement for deed, this form of owner financing is slightly different from a promissory note. In this agreement, the seller remains on the title until payment completes.
One of the significant reasons sellers opt for a contract for deed agreement is that it provides a more comfortable and cost-effective opportunity for them to regain the house in the event of a payment default. This makes it a less secure form of agreement.
The seller is still responsible for the property until the buyer pays up. However, you should note that this type of agreement is not accepted in some states, and its procedures may differ from state to state.
Lease option: A lease option agreement occurs when the homeowner leases the property to the buyer to buy it at the end of a specific period. Both parties agree on the terms of the contract before the lease starts with a down payment being made.
At the end of the stipulated period, the home buyer either buys the house or forfeits the lease option. If the agreement allows, the buyer can also pay a fee to extend the lease option to obtain more time. Any payment made during the lease period will be part of the payment agreement.
4. Get a down payment
The down payment is the money the buyer pays upfront. It shows that they are committed to acquiring the property even though they don’t have the full amount at hand. The average down payment in a seller financing transaction ranges from 10% – 20%.
A U.S. Department of Urban Housing and Development study revealed that the higher the down payment, the lesser the default risk.
As a seller, you could negotiate for a high down payment with the buyer to make sure they are less likely to walk away or stop paying. However, you should know that a high down payment does not always reduce the risk of default.
5. Decide the length for the loan
The length of a seller financing deal usually relies on several factors – the buyer’s income, the value of the property being sold, etc. While many homeowner financing transactions are short-termed (5 – 15 years), it is not uncommon to see a 30-year owner-financed home sale agreement. Usually, a more extended loan period involves low monthly payments and higher interest.
6. Optionally include a balloon payment clause
A balloon payment is a substantial one-time sum paid at the end of a loan. Seller financing loan deals with balloon payment clauses require a monthly payment for a few years and a lump sum at the end of the loan.
The main reason why many seller financing agreements often include a balloon payment is that by then the buyer may have enough equity (and the property may be in a good enough condition) to qualify for a bank mortgage loan. If the buyer is an investor, they could obtain a cash-out refinance at that time and use the cash to buy another investment property.
However, not all seller financing loans need to include a balloon payment, and you may be able to obtain more favorable terms if a balloon payment is not included. So, this is something you’d want to discuss with your buyer to determine what best meets both of your needs.
7. Choose the right interest rate
The average interest rate for seller-financed loans is higher than that of traditional financial institutions. This is because the risk of this deal largely rests on the shoulders of the seller. This makes most sellers wonder, ‘What is the fair interest rate in a seller financing sale?”
We suggest you put your buyer’s finances into consideration by offering a rate only slightly higher than the bank. Remember your interest rate may play a role in how fast you get a buyer. Bankrate.com indicates the 30-year fixed mortgage rate is 3.18% as of May 22, 2021. The three most common interest rate loans are:
- Fixed-rate loan: The most common of the repayment plan. In this deal, the payment and interest rates are constant. The balance is paid regularly (usually monthly) until all payments are made.
- Adjustable-rate mortgage: The interest rate in this deal adjusts over time. This type of interest rate is complicated and could lead to changes in the principal and interest being miscalculated if not adequately monitored.
- Interest-only loan: Popularly used real estate investors when buying a house; in this deal, the buyer pays the interest for a specific period. Then afterward, they make a balloon payment of the principal in the end.
Having a seller financing offer on your home is a great way to entice buyers when selling your home. You should note that a seller financing transaction is much easier when you own the house you are selling. To know when to opt for this option, check out “When is Seller Financing Right for Me?”
Let Bost Redevelopment sell that house for you!
Are you considering selling your home via seller financing? Do you need help marketing your home and attracting the right buyers? We are here to help you. At Bost Redevelopment, we are experts at handling every home selling problem you may be facing.
We would use our marketing expertise to ensure you get the best buyer for your home at the maximum value possible. Want to talk more about your options? Please leave us a message below with your contact information and let us know how we can be of help to you.