Seller financing: Definition and how it’s used in real estate

Quick insights

• Seller financing is when the property owner extends financing to a buyer without involving a financial institution.
• Holding mortgages, land contracts and lease-options are the most common types of seller financing.
• Potential risks of seller financing include fewer legal protections, lack of oversight and increased responsibility.

If you’re looking to buy a house, you typically apply for a loan from a mortgage lender. While most people finance their homes through a lender, seller financing or owner financing is a private agreement between a buyer and seller.

What is seller financing?

Seller financing is a private transaction between buyer and seller, where the property owner extends financing to the buyer without the involvement of a financial institution. In a seller financing arrangement, the home loan’s terms are agreed upon directly between the buyer and seller, who also acts as the lender. Without a third-party lender, the terms of the seller financing agreement may vary widely from case to case.

In theory, seller financing can apply to any home purchase. In practice, however, it's usually under certain conditions. The seller typically needs to hold significant equity or own the home. If the bank remains the main owner of the home, it’s unlikely the seller will gain approval for a private transaction. The buyer is usually (though not always) someone who has found it challenging to secure a conventional mortgage, for whatever reason. For example, this could be due to a low credit score.

Seller financing may also emerge as a consideration when selling a house to family or friends, or when the parties already know each other.

How does seller financing work?

Since seller financing is a private arrangement, the seller and buyer must work together to agree on the loan terms, from the purchase price to the payment schedule. Given this flexibility, the types of seller financing tend to vary widely.

Common types of seller financing

Holding mortgage

The simplest arrangements are typically all-inclusive, meaning the seller extends the loan for the full purchase price, minus any down payment. This holding mortgage arrangement is perhaps closest to a conventional mortgage, except in this case the seller—rather than a financial institution—is acting directly as the lender.

Land contracts

In a land contract, the buyer and seller agree on some form of joint ownership of the property, often until the final payment is made. At this point, ownership of the property typically transfers outright to the buyer. Such an arrangement can give the buyer a chance to build equity in the property, increasing their chances of securing a conventional mortgage at the end of the repayment term. The buyer may also need to contribute to property upkeep and repairs during this period.

Lease-options

With lease-options, the buyer lives as a tenant in the property. However, unlike traditional tenancy, the renter retains the option to purchase the home after a predetermined length of time.

Hybrid arrangements

Hybrid arrangements, where a financial institution stays involved, exist as well. With a junior mortgage, for example, the seller lends a portion of the purchase price, with the rest covered by a combination of a conventional mortgage and the buyer’s down payment. Assumable mortgages, where the seller’s outstanding loans on the property transfer to the buyer, may also be possible in some cases.

The pros of seller financing

Pathway to financing: For the buyer, one of the main upsides of a seller-financed mortgage is a pathway to financing when they may otherwise have trouble securing a traditional mortgage.

Lack of formal oversight: Buyers and sellers get to directly negotiate the details of the purchase price and the size of the down payment with seller financing. They may also avoid the kinds of closing costs a conventional mortgage usually requires, as well as any potential obligation for the buyer to purchase private mortgage insurance (PMI).

Attract more buyers: Given the potential speed and flexibility of the arrangement, seller financing may also help the owner attract more prospective buyers for their property.

Forego repairs: Sellers may skip making the kinds of repairs that are typically advised when preparing a property for sale.

Consistent payments with higher interest: Sellers also potentially benefit from interest payments levied on the loan.

Up-front payment potential: Sellers can sell the promissory note to an investor.seller-financing-morgan-westfield

What are the disadvantages of seller financing?

As with any lending agreement, seller financing comes with risks.

Fewer legal protections: Unlike a conventional loan, both the buyer and seller are typically subject to fewer legal protections, particularly in the event of a buyer payment default or foreclosure proceedings. This relative lack of legal protection could cause significant headaches if there's a dispute between the signatories.

Lack of supervision: In a seller financing arrangement, it's the responsibility of the seller, in conjunction with the buyer, to generate the legal agreement. While both parties may secure the services of a real estate attorney to help draft the terms, there's no financial institution involved to supervise its execution.

More responsibility: The seller is responsible for managing the transfer of the property’s title and ordering a title search rests with the seller and the buyer respectively. Meanwhile, the servicing of the mortgage loan—generating bills, collecting payments and chasing unpaid amounts—sits squarely on the seller’s shoulders.

Higher interest rates and fees: Seller financing can have higher rates than traditional mortgages. Those higher rates are typically due to the added risk the seller takes as the lender. As a result, even if a buyer saves on closing costs and avoids buying PMI, they may still pay more in the long run.

Conventional mortgage vs seller financing

As we have seen, there are many significant differences between conventional mortgages and seller financing agreements.

One final major difference is the structure and duration of the loan itself. Conventional home loans usually have repayment periods of 15 or 30 years. With seller-financed mortgages, five years is a more common term, although every arrangement differs.owner-financing-forbes-june-2023owner-financing-forbes-june-2023

The loan may also be structured differently, with a balloon payment, or lump sum, potentially due toward the end of the term. To meet the terms of any balloon payment, the buyer may need to seek financing through a traditional lender. By this point, changes in the buyer's credit or the appraised value of the house may help the buyer secure conventional financing.

In summary

Seller financing may provide a path to homeownership for buyers who have trouble securing a conventional mortgage. However, these private arrangements come with risks and costs of their own. When deciding the right approach for you, it’s helpful to consider all factors and seek professional advice.