What is a purchase-money mortgage?

A purchase-money mortgage, also known as seller financing, can be a path toward homeownership if you want to buy a house but don’t qualify for a mortgage. This nontraditional, nonconforming, private form of financing involves borrowing money from the home seller instead of a traditional bank or lender. A willing seller can provide funds by accepting your down payment and setting the terms for the loan based on your qualifications and their needs.

In this guide we’ll show you how purchase-money mortgages work, different types of purchase-money mortgages, and the benefits and drawbacks of these loans for borrowers and sellers.

How does a purchase-money mortgage work?

A purchase-money mortgage is a form of seller financing. The seller operates as your bank, lending you money directly to purchase their home. These agreements are typically created when you aren’t eligible for traditional financing or when a seller seeks to facilitate a quicker sale in a high-interest-rate market.

To formalize the deal, the seller sets the down payment, interest rate, and closing fee requirements. You pay the seller a down payment and sign the formal loan documents. This involves drawing up a promissory note, which serves as the buyer’s personal promise to repay the debt, and a security instrument (either a deed of trust or a mortgage), which secures the loan against the property itself. As with a typical mortgage, the financing document is recorded with the county to provide public notice of the debt and safeguard the interests of both parties.

The main differences between a purchase-money mortgage and a mortgage from a bank are the qualifying requirements and who holds the deed. In a traditional mortgage, the bank holds the deed. With a purchase-money mortgage, the seller holds the deed if it’s a land contract (more on this next). Otherwise, the buyer receives the deed at closing, but the seller holds a mortgage lien as collateral, documented by a mortgage or a deed of trust, depending on the state.

Sellers who decide to sell their property by offering a purchase-money mortgage to the buyer may still need to adhere to rules set up by the Truth in Lending Act (TILA) and the Dodd-Frank Act, which was designed to prevent predatory lending. It’s important to review exceptions, which can exist for private sellers, before proceeding with this kind of mortgage. It’s advisable to consult a real estate attorney to find out which rules may apply in your unique situation.

It’s also a good idea to have a real estate attorney review any contract set up between the buyer and the seller to make sure all aspects of the financing are clearly established. This can protect both parties from misunderstandings or costly mistakes.

Types of purchase-money mortgages

When you use a purchase-money mortgage, you work out a deal with the seller. Since it’s a private mortgage, both you and the seller have few regulations or requirements to meet. Let’s take a closer look at the purchase-money mortgages used most often by buyers and sellers.

Land contract

A land contract is a mortgage from the seller. Here, the seller owns their home free and clear or has an existing mortgage, which would change how the title reads.

In either case, a land contract involves you and the seller agreeing on the down payment amount, interest rate, and payment frequency. You pay the seller the agreed-upon amounts on the agreed-upon dates. The seller holds the deed, but once you pay off your mortgage, the seller transfers the deed to you, and you own the property outright.

Land contracts are recommended for purchasers who can’t qualify for traditional bank loans and for properties that don’t meet strict appraisal standards. Sellers who own their homes outright and want to earn consistent interest income while facilitating a faster sale can also benefit.

Lease option agreement

A lease option agreement is a rental agreement with the option to buy the home during the lease or when it expires. When negotiating the real estate transaction, you and the seller work out the lease details and the opportunity to purchase.

Most lease option agreements use a portion of the monthly rent toward the down payment to purchase the home. If you don’t exercise your right to buy the house, you forfeit the extra money paid each month that can be applied toward the purchase.

Good candidates for lease option agreements include buyers who need time to fix their credit or save up for a down payment while locking in a home's price today, as well as sellers in slow markets seeking committed tenants who will treat the property with a sense of ownership.

Lease-purchase agreement

A lease-purchase agreement is also a rental agreement, but you commit to purchasing the home at a later date. Typically, you pay an option fee for the exclusive right to buy the property and secure financing to complete the purchase.

Additionally, you usually pay extra money each month that gets applied to your down payment. If you are unable to secure financing, you usually forfeit the option fee and the additional monthly amount you’ve been paying toward the future purchase of the home.

One key difference between a lease-purchase agreement and a lease-option agreement is that you are legally obligated to buy the property at the end of the lease. If you do not follow through on this part of the agreement, you will likely lose your security deposit, face financial penalties, and may risk being sued for breach of contract, which could result in significant losses and credit damage.

“This is similar to a lease-option agreement, but with one critical distinction: The buyer is legally obligated to purchase at the end of the lease term. There’s no walking away without consequences,” says Lokenauth.

Worthy prospects for lease-purchase agreements are buyers who are confident they can secure a mortgage within a tight window and desire a structured means to save for their down payment, along with sellers who need a legally binding commitment to purchase rather than an option to buy.

Assumable mortgage

Let’s say the seller has a mortgage on the property that has more favorable terms than are generally available for new mortgages at the time of your home purchase. If so, you may be able to assume the existing mortgage. This means you take over the loan where the seller left off, making the same payments at the same rates.

An assumable mortgage and a purchase-money mortgage usually have different interest rates and terms. It’s important to note that you must qualify with the existing lender to assume that mortgage before taking it over. Generally, the option to assume a mortgage only applies to government-backed mortgages such as FHA, VA, or USDA loans.

Assumable mortgages are ideal in high-interest-rate markets when a purchaser can take over a seller's lower-rate government-backed loan to decrease long-term costs. Buyers with sufficient cash to cover the equity gap between the property’s purchase price and the remaining loan balance can also benefit.

Hard money loans

Another option is a hard money loan, offered by a private investor that focuses on the property itself rather than your qualifications as a borrower. Hard money loans are typically short-term and carry much higher interest rates. They are commonly used for commercial property transactions.

A hard money loan can be a viable option if you don’t have great credit but plan to improve it within the next couple of years. This can allow you to qualify for traditional financing to pay off the hard money loan.

Pros and cons of purchase-money loans for borrowers

Purchase-money loans have pros and cons, just like other types of mortgages. Because each loan is at the seller’s discretion, every loan agreement will have upsides and downsides for borrowers. Here are some pros and cons you should consider.

Pros

• Lower closing costs: By not using a traditional lender, you may save on closing expenses. Sellers usually charge closing costs to cover any expenses they incur while putting the loan together, but these expenses are generally lower than standard mortgage homebuying closing costs, which are often around 3% to 6% of the loan amount.
• Flexible down payments: Sellers can be more flexible with the down payment requirement. A seller may prefer some money down, but they can also consider that a large down payment could prevent you from qualifying for bank financing.
• Flexible guidelines: Most borrowers use purchase-money mortgages when they don’t have good credit or have a high debt-to-income ratio (DTI). Sellers provide the financing because they want to sell the home and possibly help borrowers out, which usually means less restrictive underwriting.
• Faster closing: Since you don’t have to navigate the same lender requirements that a bank may have, the seller can often close the loan in a shorter period of time, depending on the loan requirements.
• Expands access to homeownership: Borrowers who don’t qualify for bank financing may think renting is their only option. Seller financing can make it possible for more people to purchase a home.

Cons

• Foreclosure risk: If you get in over your head with a mortgage loan you can’t afford, you run the risk of losing the home. The seller has the right to foreclose on the property just like a bank would.
• Higher interest rates: A seller takes a large risk by loaning you money and selling you their home. They won’t walk away with a lump sum like they would if you used bank financing. To make up for the risk, the seller can charge higher interest rates than banks. That can result in you needing to make higher monthly payments.
• Balloon payments: The seller can lend you money for the short term but may require a balloon payment within a few years to motivate you to refinance the loan with a traditional bank as soon as your credit is improved and you have the financial means to afford it. A balloon payment can be much larger than your typical monthly loan payment, and it is usually due at the end of your loan term.

Pros and cons of purchase-money loans for sellers

Here’s what sellers can expect and should consider before they offer seller financing.

Pros

• Receive full list price or higher: Most sellers secure a higher purchase price because buyers must agree to the terms of the seller for their financing.
• Earn profit: Sellers can benefit from greater access to monthly cash flow and sometimes earn a higher interest rate than if they had invested the money in other low-risk investment options.
• Taxes may be lower: Since a purchase-money mortgage is an installment loan, the seller may pay a lower amount in taxes. That’s because the IRS allows taxpayers to defer a portion of the gain on the sale of an investment property.

Cons

• No lump sum: The seller will not receive the full purchase price amount at closing; instead, seller financing provides monthly payments as the buyer makes payments on the property.
• Higher risk of default: Purchase-money mortgages are often used by buyers who have imperfect credit and/or a high DTI, which generally makes them a higher risk to pay the loan in full.
• It’s costly and slow to get the home back: The seller can’t just move back in if the buyer stops paying. They’ll have to hire an attorney and pursue a formal foreclosure process in court, which can cost thousands and take months or years.
• Trouble with the seller’s own bank: If the seller still owes debt on the property, their own lender could demand the full balance immediately as soon as the deed transfers to the buyer.

Alternatives to purchase-money loans

Seller financing is far from your only choice when you need to borrow money for a home purchase. Instead, you can pursue one of many different types of mortgages that conform to standardized federal guidelines and typically offer lower interest rates. You will need to meet the standards set by a lender to qualify for a mortgage, and it will still come with the risk of foreclosure if you don’t repay your debt.

Here are other financing options to consider:

• Conventional loans: These are private mortgages not backed by the government, distinguishing them from FHA, USDA, or VA loans. They typically require stronger credit scores and a DTI around 45%. If the loan is also a conforming loan it will adhere to loan limits set by Fannie Mae and Freddie Mac.
• FHA loans: FHA loans are different from conventional loans in several ways. These are government-backed mortgages designed to make homeownership accessible if you have a lower credit score or limited savings. Most mortgage loans require a 620 credit score, but FHA borrowers can often qualify with a score as low as 580 with a 3.5% down payment, or even 500 with a 10% down payment.
• VA loans: These are government-guaranteed loans that provide veterans, active military members, and some surviving spouses with affordable financing via low interest rates, with no down payment required. Although issued by private lenders, these nonconforming loans offer flexible credit requirements because the VA protects the lender against default.
• USDA loans: These are also government-backed mortgages that help low-to-moderate-income borrowers purchase or construct residences in eligible rural and suburban areas with no down payment. By guaranteeing these loans, the USDA allows private lenders to offer lower interest rates and more flexible credit terms than conventional financing. To be eligible, both the borrower’s income and the property location must meet specific department guidelines.

FAQ

Here are some frequently asked questions and answers about purchase-money mortgages.

Who benefits most from a purchase-money mortgage?

Purchase money mortgages tend to benefit buyers who have robust income or intent but fall outside conventional lending criteria, as well as sellers who are willing to trade immediate liquidity for long-term income and a potentially broader buyer pool. The arrangement works best when both parties are aligned on risk tolerance and time horizon.

Does the buyer get the deed with a purchase-money mortgage?

This depends on the structure of the agreement. In some cases, such as a traditional seller-financed mortgage, the buyer receives the deed at closing while the seller holds a lien. In other cases, such as a land contract, the seller retains title until the loan is fully repaid, which creates a different ownership dynamic.

Do purchase-money mortgages require an appraisal?

Lenders will typically require an appraisal on the home being purchased, but since the transaction is between the buyer and seller, it may not be necessary. Regardless, an appraisal is still recommended to be sure of the home’s value.

Who holds the title in a purchase-money mortgage?

With a land contract, the seller will generally hold onto the house title until the loan is fully paid off. The seller does this to protect themselves in case the buyer is unable to fulfill the terms of the purchase-money mortgage. But in a standard purchase money mortgage that is not a land contract, the buyer holds the legal title and deed to the property from the day of closing, while the seller simply holds a recorded mortgage lien as collateral.

What is the collateral for a purchase-money mortgage?

The property itself is the collateral, as is also true of a traditional mortgage loan. If the buyer defaults, the seller can pursue foreclosure to recover the asset. The process and timelines vary by state, but the core principle holds: The property backs the debt, and both parties should understand what that means before the deal closes.

The bottom line: A purchase-money mortgage gives you options

A purchase-money mortgage can be a good alternative when you know you can afford a home but can’t secure traditional bank financing, likely due to credit issues, an insufficient down payment, or a high debt-to-income ratio. You can explore your options with the seller, including rent-to-own or lease-option agreements, to determine which purchase-money loan agreement aligns with everyone’s goals.

If you’re ready to buy a home, you can reach out to Rocket Mortgage and learn more about your loan options.