SELLER FINANCING MADE EASY
Seller or Owner financing is when a buyer’s purchase of a property is financed by the seller instead of a bank or other lender. In Texas this process is governed by the Texas Real Estate Law, when a Realtor and real estate attorney are involved, provides for the security for both parties.
Seller Financing is a popular way for a buyer, with less than stellar credit, to purchase a home and for a seller to keep the asset of the home bringing in extra income without the headaches of being a landlord! An additional reason for a buyer to use seller financing could be that the property needs repairs that a traditional lender requires to be completed before they fund the loan.
Seller financing is generally rare because it is not widely discussed among Realtors. It’s also rare in a hot real estate market where sellers have their pick of buyers; however, it is a favorite of investors who do not want to manage rental property. Seller financing becomes more common in tough real estate markets when bank lending tightens up and/or buyers have been hit by hard economic times that make it difficult to qualify for a traditional bank loan.
To do seller financing, sellers usually own their home outright, or have enough equity in their home for the sale transaction to pay off their existing loan. However, it is possible to do a 'wrap.' What is a wrap? A mortgage wrap transaction is simply the seller financing of a property that does not pay off the current mortgage lien on the property. The property is conveyed and the existing mortgage lien stays in place with a second, junior lien held by the seller.
A wraparound mortgage creates one loan that is big enough to pay on the existing loan plus any additional equity in the property. With a “wrap” mortgage, the buyer makes this larger payment to the seller. In turn, the buyer entrusts the seller to pay the underlying mortgage. The contract must be written in a way that protects both the buyer and seller. There is much more to say about this kind of loan but I will discuss that in another article. As with every loan, there are pro’s and con’s about a ‘wrap.’ Fill out the form at the bottom of this page to get more details.
In any case, seller financing is a way to buy a home without being subject to traditional lender requirements or a home that has 'condition' issues that would negate normal mortgage lender financing.
Pros of Seller Financing
Key benefits for buyers using seller financing include:
- Less stringent loan approvals. Even the most sophisticated sellers are unlikely to subject a borrower to the same rigorous federally-required loan approval procedures and documentation banks use.
- No mortgage insurance for low-down-payment deals. Most bank loans with less than 20 percent down require mortgage insurance ranging from about 0.45 percent to 1.05 percent of a loan amount. Take for example a $270,000 loan and this mortgage insurance translates to $101 to $236 per month in monthly payment.
Key benefits for sellers using seller financing include:
- No maintenance, taxes or tenants to deal with. Some maintenance the seller may want to contract for to ensure that things are maintained: lawn & sprinkler system service, pool service and a home maintenance contract.
- Control over timing of closing. In bank-financed deals, sellers are subject to timing and viability of bank financing coming through. With seller financing, they can close faster because they’re the lender. Also, a lender's appraisal or buyer's inspection could identify issues not previously known that could give the buyer legal grounds to cancel the purchase. A buyer has 38 ways to terminate a purchase contract. See Geni's book for more information on selling your home, 'Industry Secrets that Get Your Home Top Dollar!'
- Good source of income. Seller financing creates a monthly income stream the seller can rely on in lieu of a lump sum payment at closing. This income includes a rate of return (the interest rate they charge the buyer) on top of eventually getting their equity in the property back when the loan is paid off.
- Easily build net worth. Passive income and increasing equity in the property provide asset growth and increasing net worth.
- Secure if the borrower defaults. When properly drafted (why a Realtor and attorney are recommended) the Promissory Note is a contract outlining all terms you negotiated in the Purchase Contract and Seller Finance Addendum. The term note usually refers to this contract - it is a ‘debt note.’ This basically states the amount you owe to the seller and how it will be paid back. The Deed of Trust, unique to Texas and several other states, is loosely referred to as a mortgage. This is a contract connecting the Promissory Note to the property that is pledged as security or collateral for the debt. This basically gives the seller the right to foreclose and take back the property, without having to go to the Court system to obtain a foreclosure if the borrower defaults on the Promissory Note.
Cons of Seller Financing
Key drawbacks for buyers using seller financing include:
- Buyer can unknowingly assume seller risk. If the seller has liens or other claims from creditors in title that the buyer doesn’t know about (or even the seller doesn’t know about), the buyer could inherit these obligations as the new owner. If a Realtor and real estate attorney are used in this process they will strictly adhere to recent changes in the Texas law that now requires a seller to disclose any of these, if known, and produce a copy of a clear title.
- Less organized monthly payment processing. With seller financing, it’s harder to do automatic monthly payments. Without a condition in the contract a seller might provide monthly payment statements and loan balance updates reliably because most private lenders won’t have a systematic billing process like a bank does unless they use an accountant which we highly recommend.
Key drawbacks and risks for sellers using seller financing include:
- Less cash on hand at closing. The seller is trading lump sum cash that would be used for a conventional loan down payment and closing costs for monthly payments.
- Risk about equal to lease. The seller will never truly know if a buyer will pay over time. A buyer could lose their job, die, etc. A seller is taking on the same risk a bank does. This is why a smart seller (lender) maintains an accrual account to pay all of the home costs for at least six months: homeowners insurance, taxes, HOA dues, maintenance and other miscellaneous costs.
- Upkeep and maintenance of the property. If left to the buyer and the buyer does not properly maintain the property in proper condition this will have a material impact on the property valuation and the seller’s equity. This is why we recommend that the seller include lawn and pool maintenance and purchase a home warranty to ensure that the property is maintained. The cost of these, which would be paid by the buyer (borrower) anyway are included in the monthly payment amount.
Key drawbacks for both buyers and sellers include:
- Less strict legal process. When a bank approves a loan, federal regulations make it clear what they’re supposed to do and how they’re protected if they follow the regulations. The process for a Seller Finance, although more defined than even last year, is still less structured than a bank or mortgage lenders process.
- Protection dependent on the contract. As with all contracts, when a seller approves a loan for a buyer, both parties are only protected by the language crafted with the help of attorneys. The Texas Real Estate Commission (TREC) has a mandatory Addendum (TREC 26-7) “Seller Financing Addendum.” This is required for any Texas licensed Realtor to use in a real estate contract involving Seller Financing. This addendum provides some guidance and requirements; however, it is not a Promissory Note or Deed of Trust and these other documents must also be used to protect both buyer and seller. It is strongly recommended that in addition to an experienced and knowledgeable Realtor that either or both buyer and seller utilize a real estate attorney knowledgeable in seller financing to prepare the Promissory Note and other documents as well as record the executed agreement in the local county records.
- Foreclosure risk mitigation. The foreclosure process can be complicated unless the contract includes the traditional language used in Texas real estate contracts. This language gives the seller (lender) the right of non-judicial foreclosure when the buyer (borrower) is in default in accordance with the terms and conditions in the Promissory Note. Without this clause, both buyer and seller could be in for a long, expensive foreclosure process.