The Pros and Cons of Seller Financing

Cutting out the middleman typically represents progress. Can you imagine depending on a telephone operator to put your call through? (Come to think of it, going through an operator might save us from making those calls we really shouldn’t make.)

But back to the point: Who wants to deal with a third party when you don’t have to?

That’s part of the philosophy behind seller financing. There’s a certain appeal to cutting out banks and mortgage lenders and having the seller finance the transaction — but there are risks involved.

That said, both sellers and buyers can benefit. “Where else can you receive a rate of return in the 4 to 7% range with almost no risk?” asks Jesse Gonzalez, president of North Bay Capital Inc. “Your investment is backed by a tangible asset.”

What exactly is seller financing?

The seller is also the lender in a seller-financed transaction. But the seller doesn’t just hand over money to the buyer in the form of a loan as banks and mortgage lenders do. In this scenario, the seller allows the buyer make payments instead.

Sometimes, as was the case with Mary Pitman from Vero Beach, FL, you can first be a renter.

“I had a proven track record of paying on time and taking care of the house,” says Pitman who successfully went from renter to owner through a seller-financing deal.

Pitman, when pitching the idea, told her landlord that he would be collecting about the same amount of money but would no longer have the expenses of property tax, homeowners insurance, and maintenance, which falls to the buyer under seller-financing deals.

The details

Typically, the buyer signs a promissory note to the seller. The promissory note lists the interest rate, the repayment schedule, and default consequences.

Seller-financing arrangements are usually short-term ones. (Most sellers don’t want the hassle of collecting payments for the next 30 years.) A typical deal might be for the loan to be amortized for 30 years with a balloon payment after five years. “Balloon payment” refers to the repayment of the outstanding principal sum, made at the end of a loan period.

Pros for buyers:

• Seller financing lets people who might not be able to secure a mortgage buy a home. A seller might OK you even if a bank or other traditional lender turned you down.
• The closing process is faster and cheaper.
• The down payment can be whatever amount you and the seller agree upon.

Cons for buyers:

• The interest you pay might be high.
• Just because the seller is not a bank doesn’t mean he or she won’t run a credit check on you. You could be turned down if you’re a credit risk.
• You need to ensure you can pay the balloon payment.

Pros for sellers:

• If you’re having trouble selling, offering seller financing makes your home stand out, potentially getting it sold faster. Simply add the words “seller financing available” to the listing to let people know.
• You may be able to sell the house “as is,” instead of making costly repairs that might be required by traditional lenders.
• You could get a better interest rate than you could get from other investments.
• If the buyer stops making payments, you get the house back and can keep the down payment — plus any money that was paid.
• You can sell the promissory note (usually at a discounted amount) right away to an investor, if desired. That would give you a lump-sum payment.

Cons for sellers:

• You typically need to own the home free and clear. If you still hold a mortgage, you must get approval from your lender before going forward with the deal.
• The buyer could stop making payments at any time. “Most of the time, when buyers default on the loan, they feel bad and just walk away,” says real estate professional Barb Getty of Indianapolis. But if the buyer doesn’t leave, you need to go through the foreclosure process. “I had to do this once, and it took three months and $700 in fees,” she explains.
• You might “incur repair costs, depending on how the buyer cared for the property,” if you need to take back the house, says Cindy Welu, a real estate professional from Minneapolis/St. Paul.
• Taxes could be complicated.

Some tips

1. Whether you’re a buyer or a seller, consider it mandatory to work with a real estate attorney (in addition to a real estate agent), who can write the sales contract and the promissory note.
2. Sellers should run a credit check and check references.
3. Sellers should require a down payment, which gives buyers a stake in the home, making it less likely they will walk away. Chad Corbett, a real estate agent from Roanoke, VA, suggests that buyers put down 10% “if you want the seller to take you seriously.”
4. Corbett also suggests that sellers “talk with a CPA about the tax benefits of selling with owner financing vs. selling outright.”
5. Buyers with poor credit should focus on raising their credit score so they can refinance before the balloon payment is due.