Seller financing: How it works, pros, cons, and is it a good idea?

With seller financing, the owner of a home acts as the mortgage lender when selling the property to a buyer. Some buyers and sellers may prefer this arrangement to a traditional mortgage.

But be careful: Seller financing has its pros and cons. Buyers and sellers can run into financial problems if the agreement fails to fully address everything that could go wrong with the deal.

Before agreeing to this type of nontraditional mortgage option, consult a legal professional to review the contract and make sure you’re protected.

What is seller financing?

In seller financing, a buyer makes monthly payments to the seller of a home instead of using a traditional mortgage from a lender to buy it outright.

The seller of the home spells out the terms of the buyer’s payments, including how often the buyer makes payments, how much they are, and what interest rate is attached to them.

Instead of sending a monthly payment to a traditional mortgage lender, the buyer will pay the seller. When the buyer has paid the seller the full purchase amount plus interest, the seller will transfer full ownership to the buyer.

Seller financing is also known as owner financing or a purchase-money mortgage.

How does seller financing work?

The buyer and seller can choose from a variety of seller financing models.

If buyers and sellers choose a purchase-money mortgage, the buyer makes monthly payments directly to the seller, who handles the mortgage process.

The seller also can hire a company to collect mortgage payments from the buyer and create an escrow account to collect the buyer’s homeowners insurance and property tax payments.

Why choose seller financing? It allows both sides to set the terms of the loan.

For buyers, it could mean a lower minimum down payment. A low credit score also would not disqualify them from buying a home as long as the seller is OK with it.

For sellers, advantages include a quicker sale and easier transaction without a mortgage lender to deal with. Seller financing might also open a home to an increased pool of buyers, including those who might struggle to qualify for a traditional mortgage.

5 types of seller financing agreements

First-time home buyers or buyers with a lower credit score might find seller financing an attractive way to buy a home.

Just be careful when agreeing to one of these arrangements. Many seller financing agreements act more like rental agreements. Some offer unfavorable terms, such as higher interest rates, that offset any benefits.

But if you are interested in seller financing, here are five common types:

1. Land contracts

In a land contract agreement, the buyer makes payments directly to the owner of a home that is for sale until they cover the property's purchase price. The seller keeps the title until the buyers complete the repayment. This means that buyers are essentially renting the property until they pay back its full purchase price.

Land contracts often include a balloon payment at the end of the repayment period. Buyers and sellers will negotiate the size of this payment and the number of regular monthly payments buyers will make before the balloon payment kicks in.

If you are the buyer, make sure you can afford the balloon payment before signing a land contract.

2. Assumable mortgage

In an assumable mortgage arrangement, buyers purchase the existing mortgage held by the home’s sellers. This can attract buyers if the seller’s mortgage comes with an interest rate below current market rates.

You can assume government-insured mortgages, such as Federal Housing Administration, Veterans Affairs, and U.S. Department of Agriculture loans. Conventional mortgages, which are not insured by a government agency, cannot be assumed.

Another challenge? Buyers will also need to pay the home’s seller the difference between the purchase price and the remaining balance on the seller’s mortgage. If the seller owes $300,000 on a mortgage and you buy the home for $400,000, you’d need to provide the seller $100,000 in cash. This will act as your down payment.

3. Lease purchase

In a lease purchase agreement, also known as a rent-to-own contract, buyers pay rent to the owner of a home. The buyers also pay an option fee that gives them the right to buy the home at an agreed-upon fee after a certain number of rental payments. This right to purchase is known as a lease option.

Buyers might be able to use a portion of their rental payments as part of a down payment if they decide to exercise their lease option to buy the home. If they decide not to buy the home, they will lose their option fee and often any additional money they paid to cover an eventual down payment.

4. Land loan

Buyers also can use seller financing when buying land to build a home. This involves taking out a land loan. But instead of paying a bank or other lender, the buyers will pay the owner of the land.

5. Wraparound mortgage

What if the seller has a mortgage on their property and is still interested in seller financing? That’s where a wraparound mortgage comes in. In this arrangement, the buyers make a monthly payment to the home’s owners, but for an amount higher than the seller’s monthly mortgage payment. The seller collects the payment and then pays its own mortgage lender.

Just be careful: The mortgage lender working with the seller might disapprove of this type of deal. Most mortgage loans include a due-on-sale clause stating that the lender can demand full repayment of the mortgage when the property is sold or the ownership of the home is transferred. Lenders, then, can demand that the sellers pay in full and not enter a wraparound mortgage arrangement.

Pros and cons of seller financing

While seller financing can be positive for both buyers and sellers, this way of buying a home also comes with potential pitfalls. Both buyers and sellers should consider all the pluses and minuses before entering a seller financing agreement.

Advantages

If you’re selling, some of the upsides of seller financing include:

• You can save on closing costs
• Seller financing can save you money on capital gains taxes over time.
• Seller financing agreements often close faster than traditional mortgages. Sellers might also sell their property as-is, saving on what otherwise might be expensive repairs.
• By selling their home, owners will no longer need to pay property tax, homeowners insurance, and maintenance expenses.
• Sellers who need quick cash can sell the promissory note from a seller financing arrangement to an investor, though they might have to sell at a discounted price.

Seller financing can pay off for buyers, too. Some of the advantages for buyers include:

• Low-income buyers might be more likely to land a loan directly from a home seller.
• They may save money on closing costs.
• Seller financing arrangements can be more flexible.
• Buyers might not have to pay private mortgage insurance premiums, which protects lenders in traditional mortgage loans.
• Buyers with poor credit might have better luck qualifying for a loan directly from a seller than a traditional lender.

Disadvantages

Here are some of the potential pitfalls of seller financing:

• Seller financing has fewer protections for buyers.
• Your monthly payment is private and probably won’t be reported to credit bureaus. Because of this, you won’t see any increase in your credit score when you make on-time payments.
• Buyers are still vulnerable to foreclosure if the seller doesn’t make mortgage payments to its own lender when seller financing involves a wraparound mortgage.
• Because sellers might not require a home inspection, buyers might be surprised by expensive home repairs in the future.
• Because many buyers who seek out seller financing have lower incomes and credit scores, they might have to pay higher interest rates and make a larger down payment.
• The seller faces financial risks if the borrower defaults. If the buyer defaults, the seller might have to navigate a lengthy and costly foreclosure to reclaim the home.

Seller financing FAQ

Questions about seller financing agreements? Here are answers to some common ones.

What is the difference between a purchase-money mortgage, seller financing, and owner financing?

These terms all mean the same thing. A purchase money mortgage is a loan a seller makes to a buyer. This process may also be referred to as owner financing or seller financing.

Is seller financing a good idea?

That depends on your personal situation and needs. If you are trying to buy a home, seller financing may make more buying opportunities available to you. Sellers might be able to sell their homes for a higher price.

Who holds the title in seller financing?

The seller of the home retains the title to the property as a form of leverage until the buyers finish making their scheduled payments. Once the buyers do this, the seller transfers the title to them.

How do I draft a seller financing deal?

Don’t attempt to draft a seller financing deal on your own. Instead, work with a real estate attorney who can draft the promissory note and a mortgage deed of trust. If you are a buyer, it also makes sense to hire a real estate lawyer to review any seller financing agreement before signing.

The bottom line

Seller financing presents upsides and downsides to home buyers and sellers alike. With these agreements, purchasers with lower credit scores or incomes may be able to obtain loans that they could not have been approved for otherwise.

At the same time, the interest rate that a seller may charge can often exceed that charged by a traditional mortgage lender. So, while seller financing can open up more possibilities to aspiring home buyers when it comes to real estate transactions (and potentially provide home sellers with added investment opportunities and tax savings), it won’t make sense to utilize in every case.

As an alternative to seller financing, we recommend working with Rocket Mortgage^® to see if you qualify for a more secure mortgage option. Ready to get started? Kickstart the process and get approved today to begin your new mortgage journey.