Purchase-Money Mortgages: Defined And Explained
Sam Hawrylack5-minute read
May 07, 2021
Purchase-money mortgages or seller financing, as they’re most commonly known, provide buyers with less-than-perfect credit the chance to buy a home. While it may seem like a great idea to become a homeowner no matter what it takes, there are downsides to seller financing that you should know.
What Is A Purchase-Money Mortgage?
A purchase-money mortgage or seller/owner financing is a loan given to the buyer from the property seller. It’s common in situations where the buyer doesn’t qualify for standard bank financing.
As the “bank,” the seller sets down payment, interest rate, and closing fee requirements. The buyer pays the seller a down payment and an executed financing instrument that outlines the loan details. Like a typical mortgage, the financing instrument is recorded with the county protecting both the buyer’s and seller’s interests.
Why would buyers choose seller financing versus a traditional bank mortgage?
This typically happens when buyers have bad credit, a high debt ratio, or a low down payment and won’t qualify for traditional bank financing. Willing sellers can provide the financing by accepting the down payment and setting the terms for the loan based on the buyer’s qualifications and the seller’s needs.
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, and with seller financing, the seller holds the deed.
Types Of Purchase-Money Mortgages
When buyers use a purchase-money mortgage, they work out a deal with the seller. Since it’s a private mortgage, there aren’t many regulations or requirements buyers or sellers must meet. It depends on your agreement, but there are some typical purchase-money mortgages most buyers and sellers use.
A land contract is a mortgage but from the seller. The buyer and seller agree on the down payment amount, interest rate, and payment frequency. The buyer pays the seller in the agreed-upon amounts on the agreed-upon dates. Once the buyer pays off the mortgage, the seller transfers the deed to the buyer, and the buyer owns the property.
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. The buyer and seller work out the lease details and the chance to buy when negotiating the transaction.
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 to put toward the purchase.
A lease-purchase agreement is also a rental agreement, but rather than the option to buy the home during the lease, there is a requirement to buy it. If you can’t get traditional mortgage financing at this point, it could prove troublesome unless the seller is willing to offer seller financing.
Assuming The Seller’s Mortgage
If the seller has a mortgage on the property that won’t be paid off before the buyer takes possession, the buyer must assume the mortgage. This means the buyer takes over the loan where the seller left off, making the same payments at the same rates.
Since most homes sell for more than the existing mortgage amount, buyers have two mortgages, the assumable mortgage, and the seller financing mortgage that usually has a different interest rate and terms. It’s important to note that buyers must qualify with the lender to assume a mortgage before taking it over.
Hard Money Loans
Another option is a hard money loan is one from private investors who focus on the property itself rather than the borrower’s qualifications. The only problem with hard money loans is they are short-term and have much higher interest rates. They can be a viable option if the buyer doesn’t have great credit but will fix it within the next couple of years, allowing him/her to qualify for traditional financing to pay off the hard money loan.
Great news! Rates are still low to start 2021.
Missed your chance for historically low mortgage rates in 2020? Act now!
Pros And Cons Of Purchase-Money Loans For Borrowers
Purchase-money loans have pros and cons, just like any other financing option. Because each loan is up to the seller’s discretion, each loan agreement will have its own pros and cons for borrowers.
For sellers, there are several benefits. Most sellers secure a higher sales price because buyers are at their mercy since they need financing too. Sellers also enjoy monthly cash flow and sometimes earn a higher interest rate than they’d earn investing the money in other low-risk investment options.
As for borrowers, there are many pros and cons to consider.
Borrowers realize many benefits when asking the seller for financing, including:
Lower closing costs: Not using a traditional lender, borrowers often save on closing costs. Sellers usually charge closing costs to cover any expenses they incur putting the loan together, but they are generally much lower than the 2% - 5% of the loan amount that traditional lenders charge.
Flexible down payments: Most sellers are flexible with the down payment requirement. They typically want some money down, but they understand when a buyer doesn’t qualify for bank financing that it may be because they don’t have a large down payment.
Flexible guidelines: Most borrowers use seller financing when they don’t have great credit or have a high debt-to-income ratio. Sellers provide the financing because they want to sell the home and possibly help borrowers out, which usually means less restrictive underwriting requirements.
Faster closing: Since there’s no bank to deal with, sellers can often close the loan in a matter of a week or two, depending on the requirements they set and how fast both legal teams (buyer and seller) work.
Unqualified borrowers can buy a home: Borrowers who don’t qualify for bank financing may think they’re stuck renting forever, but with seller financing, it’s possible to buy a home sooner than they thought.
Like any financial transaction, there are downsides for borrowers you should understand:
Foreclosure risk: If borrowers get in over their head in a mortgage loan they can’t afford, they run the risk of losing the home because the seller has the right to foreclose on the property, just like a bank would.
Higher monthly payment: If you assume the seller’s mortgage and take a purchase-money loan from the seller to cover the difference, your monthly payments could be much higher than if you got traditional financing.
Higher interest rates: Sellers take a large risk loaning you money and selling you the home. They don’t walk away with a lump sum like they would if you used bank financing. To make up for the risk, they usually charge higher interest rates than banks would charge.
Balloon payments: Many seller financing loans include a provision for a balloon payment. Sellers lend buyers money for the short-term, hoping they will refinance the loan with a traditional bank in a year or so after they fix their credit and/or have the money to afford it.
The Bottom Line
A purchase-money mortgage is a good alternative when you can’t secure traditional bank financing but know you can afford a loan. Explore your options with the seller, including rent-to-own or lease option agreements, to determine which one fits your situation the best as this isn’t a one-size-fits-all approach.
A purchase-money loan is a considerable risk, just like a standard mortgage. You use the home as collateral and if you miss your payments, you could lose the home. The main difference between seller financing and a traditional mortgage is how you qualify.
If you can help it, opt for traditional financing from a bank. You’ll get better interest rates, lower fees and won’t have to worry about a balloon payment in a few years that you may not be able to afford.
If you don’t qualify for traditional financing yet, learn how to strengthen your mortgage application, so you have options with conventional lenders, including options for FHA or conventional financing.