Seller Financing (Definition, Example) | Advantages, Disadvantages

Seller Financing Definition

Seller financing is an agreement between buyer and seller of the real estate, in which instead of a financial institution, seller manages the mortgage process and provides loan; the buyer makes an initial down payment of the principal amount of property price and thereafter the remaining amount is through monthly payments with some percent of interest charged on the loan.

Types of Seller Financing

Below are the types of seller financing-

All-inclusive Mortgage: – In this owner sells home to the buyer for an all-inclusive trust deed and bears promissory note for the entire home price balance in compliance with less down payment if any.
Rent to Own: – Buyer has the option but not obligation to buy property from the seller but, the buyer gets the right to own the house with the down payment while also paying regular monthly rent. At the end of the given term of a contract, the buyer has an option to pay off the balance amount of the contract to the seller. In such contracts, sellers often charge a decent amount of non-refundable down payment in case the buyer decides not to buy. In other cases, the Buyer gets protection with a record of the lease contract by which the seller cannot sell the property to anyone else.
Second Lien/ Junior Mortgage: – Many times seller feels risk in making a seller-financing contract with a buyer, so instead buyer gets an option to take second mortgage i.e. for the major part of financing is done from a bank and the seller financing does remaining. In this type of contract Buyer makes two payments, every month i.e. first to the bank and second is to the seller. This type of contract reduces the risk of a buyer getting a default.
Wrap-Around: – Wrap-around mortgage is a good opportunity for the seller to earn a better rate of return. If the seller has a mortgage which wasn’t completely paid off but, the seller sells property with seller financing option in which he can charge a higher rate on the price of property less down payment and maintain continuous payment to his mortgage from a bank as well as earning extra rate of return. For e.g. Mr X bought a house with a mortgage of $200,000 at a rate of 4.5%. The current value of the house is $250,000. So, He makes a seller financing contract with a new buyer by taking down payment of $50,000 and remaining $200,000 with an interest rate of 7.5%. Such contracts are mostly done through escrow companies, which make sure that the payment process remains clear.
Land Contract: – In this type of contract, the title of the ownership is not transferred to the buyer, but gets equitable interest in a property. Only after making the final payment of the signed contract buyer gets legal transfer of the ownership from the seller.

Example of Seller Financing

Mr X is selling his house at $250,000. Mr Y is Self-employed and still not able to get a good credit score because of irregularity in his income. Mr Y cannot take the loan in the traditional method. Mr X runs a background check on Mr Y and able to develop confidence in his overall profession. Therefore, Mr X and Mr Y get into an agreement where Mr Y agrees to pay down payment of $50,000 and remaining $200,000 in EMI over the period of 20 years with an additional interest of 6%.

Solution

Below is given data for calculation of payment

Calculation of EMI is as follows –

=[($200,000 X 0.005) X (1 + 0.005)²⁴⁰] / [(1 + 0.005)²⁴⁰ – 1]
EMI = 1432.86

Total Payment

Total Payment = 343886.9

In the above example, the buyer and seller enter into a contract without involving any other financial institution. Important factors required –

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Seller Owns Property. (Zero debt / very low amount of debt which can be settled on the closing of this deal)
Seller intentionally completes all required legal documents for transfer to the buyer.
The contract between buyer and seller where the buyer agrees to pay as per terms of the seller-financing contract.

Advantages of Seller Financing

Advantages for Buyer

Less Paperwork: – Although the seller still needs to show complete trust on you to enter into such agreement, less paperwork and procedures make it easy.
Negotiable: – Unlike Bank or any other financial institution, the buyer can negotiate on amount terms, conditions, and rate of interest.
Lower Cost: – Without institutional lender, there are no processing charges, admin charges or originating charges.
Faster Closing: – No bureaucracy, repetitive process, inspections, etc.

Advantages for Seller

Seller may sell property, in the same condition without costly repairs or modifications needed by conventional lenders.
Familiar investment: – Mortgage secure by the property you actually owned for time is much comforting than any other unfamiliar investment.
Regular Income: – Continuous income without worrying about owning and managing a property.
In case of default, the seller gets to keep down payment plus ownership of the property.
Tax Advantage: – Selling in installment defers capital gain on the property, which helps in saving a high level of taxes.
Higher Returns: – Seller Financing contract provides higher returns over a period compared to one time long-term capital gain.

Disadvantages of Seller Financing

Disadvantages for Buyer

High Rate of Interest: – In many cases, the interest rate in seller financing is higher compared to banks.
Understanding of Terms: – Clauses like ‘due on sale’, which bank can foreclose deal if the seller still has not paid the complete mortgage. Buyer needs to read and understand all the terms and their legal meaning in the contract.
In case of default, after some time if a buyer is unable to secure financing, he can lose all money paid in down payment and monthly payment plus house.

Disadvantages for Seller

Risk analysis: – Seller needs to analyze the risk involved in Seller financing and need to make some necessary decisions regarding involvement.
Trust on Buyer: – Banks make a certain process to qualify for the loan is for a reason. In the case of the seller, the financing seller has to find a way to believe in the ability and reliability of the buyer.
Default: – In case of default, the process of foreclosure has to be processed by a seller in case the buyer does not move out.
Repair Cost: – Seller might have to make repair and changes in property in case of default from a buyer.

Conclusion

Seller financing is a better option for individuals who have irregularities in income or people with less credit score. Many factors do come into consideration like approach for the negotiation in such types of contracts, building trust between buyer and seller, understanding of the legal requirement to be fulfilled in such contracts, instead of using it as tool for financing, this option should be suitable only if it fits into your investment strategy over a period. It is important if such contracts completed through legal attorneys with important points to discuss like Price, Interest rate, accruing interest, date of payment, maturity date, and due on sale clause.