What Is A Purchase-Money Mortgage?

Purchase-money mortgages can give people the chance to buy a home if they don’t qualify for traditional financing due to having a poor credit score, a high debt-to-income (DTI) ratio, and/or a small down payment. While it may seem like a great idea to become a homeowner no matter what it takes, the purchase-money loan process comes with some downsides that you should know about.

Analyze the journey of buying a home through a purchase-money mortgage and learn some of the risks involved to determine if this financing method is right for you as a buyer.

Also known as seller financing, the definition of a purchase-money mortgage is a loan the property seller provides to the home buyer. Willing sellers can provide financing by accepting the down payment and setting the terms for the loan based on the buyer’s qualifications and the seller’s needs.

This type of mortgage is common in situations when the buyer has a low credit score, a high DTI or a low down payment and doesn’t qualify for standard bank financing, much like other non-conforming loans.

How Does A Purchase-Money Mortgage Work?

As the “bank,” the seller sets the down payment, interest rate and closing fee requirements. The buyer pays the seller a down payment and signs an executed financing instrument document representing the traded asset (the home) and outlining the loan details. Like a typical mortgage, the financing document is recorded with the county, protecting the buyer’s and seller's interests.

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.

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, buyers and sellers have few regulations or requirements to meet. Below are the purchase-money mortgages that buyers and sellers most often use.

Land Contract

A land contract is a mortgage from the seller. The seller could own their home free and clear or have an existing mortgage, which would change how the title reads.

In either case, a land contract occurs when the buyer and seller agree on the down payment amount, interest rate and payment frequency. The buyer pays the seller 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. When negotiating the real estate transaction, the buyer and seller work out the lease details and the chance to buy.

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.

Lease-Purchase Agreement

A lease-purchase agreement is also a rental agreement, but the buyer commits to purchasing the home at a later date. The buyer generally pays an option fee for the exclusive right to buy the property and secures financing to complete the purchase.

The buyer usually pays additional money each month to apply toward a down payment. If the buyer is unable to secure financing, they typically forfeit the option fee and the additional monthly amount they’ve been paying toward the future purchase of the home.

Assumable Mortgage

If the seller has a mortgage on the property with more favorable terms than are generally available for new mortgages at the time of the home’s purchase, the buyer may be able to assume the mortgage. This means the buyer takes 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 buyers must qualify with the lender to assume a mortgage before taking it over. Generally, the option to assume a mortgage is applicable to government-backed mortgages such as FHA, VA or USDA loans.

Hard Money Loans

Another option is a hard money loan, which is from private investors who focus on the property itself rather than the borrower’s qualifications. 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 the buyer doesn’t have great credit but will fix it within the next couple of years, allowing them to qualify for traditional financing to pay off the hard money loan.

Not sure if these options sound right for you? Make sure you explore all your choices.

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, each loan agreement will have upsides and downsides for borrowers. Here are some pros and cons borrowers should consider.

Pros

• Lower closing costs: By not using a traditional lender, borrowers often save on closing costs. 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 home buying closing costs which are around 3% – 6% of the loan amount.
• Flexible down payments: Sellers can be as flexible as they want with the down payment requirement. They typically want some money down, but they understand that a large down payment might be preventing a buyer from qualifying for bank financing.
• Flexible guidelines: Most borrowers use purchase-money mortgages when they don’t have good credit, or they have a high 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 there’s no bank to deal with, sellers can often close the loan in a matter of a week or two, 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 makes it possible for more people to buy a home.

Cons

• Foreclosure risk: If borrowers get in over their heads in a mortgage loan they can’t afford, they 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: Sellers take a large risk by 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. That can lead to higher monthly payments for borrowers.
• Balloon payments: 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. Sellers may lend buyers money for the short term, hoping they’ll 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.