The Dark Art of Seller Financing Explained

It's very common to see questions about seller financing on Bigger Pockets and other forums, and there is often a general lack of understanding and awareness about the subject among new and inexperienced real estate investors. 

Seller financing is a very legitimate, legal, and responsible method to finance the purchase and sale of real estate, and it has many advantages for both buyers and sellers. The purpose of this post is to demystify the process of seller financing and give investors a basic understanding of this powerful financing tool.

Mortgage Financing 101

In order to explain seller financing, we first need a basic understanding of the "typical" process of financing a real estate transaction with a mortgage. 

To explain this process, let's assume that you are buying a $100k rental property with a conventional mortgage from BP Bank and Trust:

1. Since conventional mortgages require 25% down for an investment property, the buyer needs to have $25k (plus closing and settlement costs, plus loan origination fees, and prepayments for tax and insurance escrows) ready to bring to closing.

2. The buyer applies for a mortgage for the remaining $75k, and the bank agrees to provide these funds at closing, based on a detailed review (called underwriting) of the borrower's credit, income, employment, and debt-to-income ratio.

3. The lender orders an appraisal to verify the value of the property being purchased. The appraised value of the property must support the purchase price and LTV%, or the transaction must either be modified or canceled.

4. The buyer/borrower signs a mortgage note (which creates a lien on the property, meaning the lender gets paid off if the property is ever sold, and has the right to foreclose if the buyer/borrower stops paying) and a promissory note, which outlines the terms of repayment. 

5. The lender wires the money to the title/closing agent to be disbursed at closing, and the mortgage note gets recorded in the public records of the jurisdiction where the property is located, so it shows up as a "cloud" on the title of the property - something that has to be settled before free and clear title can be conveyed in any future sale or refinance of the property.

6. The buyer/borrower pays as agreed and either carries the note to its full term (often meaning it's "paid off" in the case of residential mortgages), or they refinance the property and pay off the existing mortgage when they take out a new one, or they sell the property and pay off the first mortgage at closing so they can convey the property to a new owner.

The rates and terms of the mortgage in this case are set by the lender (and by prevailing economic conditions and competition with other lenders), and a 30-year fully amortized term is the most common residential mortgage. 

Seller Financing 101

Now that you have a basic understanding of conventional financing, it's much easier to explain seller financing, because it works almost exactly the same way!

Let's assume you are making an offer on the same property, but you want that offer to include seller financing. You make an offer of $100k for the property, but you include an addendum to the contract outlining the following seller financing terms:

• -You will give the seller $15,000 as a down payment.
• -The seller will finance the remaining $85k on a 15 year mortgage note, amortized for 20 years at 7.5% interest.

Once you and the seller agree to terms, the process is very similar to the one outlined above (just replace BP Bank and Trust with the seller's name):

1. Since a $15k down payment was agreed upon, the buyer needs to have $15k (plus closing and settlement costs, and any costs for preparing the loan documents associated with the seller financing) ready to bring to closing. 

2. The title/closing agent prepares (or has an attorney prepare) a mortgage note (which creates a lien on the property, meaning the seller, who "holds the note", gets paid off if the property is ever sold, and has the right to foreclose if the buyer/borrower stops paying) and a promissory note, which outlines the terms of repayment*. 

3. The mortgage note gets recorded in the public records of the jurisdiction where the property is located, so it shows up as a "cloud" on the title of the property - something that has to be settled before free and clear title can be conveyed in any future sale or refinance of the property.

4. The buyer/borrower pays as agreed and, at some point, they typically either refinance the property and pay off the existing seller-financed mortgage when they take out a new conventional mortgage, or they sell the property and pay off the first mortgage at closing so they can convey the property to a new owner with free and clear title.

The rates and terms of the mortgage in this case are determined by a negotiation between the seller and the buyer. Seller financing often comes with a higher rate and shorter term than conventional financing (most sellers don't want to wait 30 years to be cashed out), but everything is negotiable. 

As you can see, there is nothing shady or underhanded about seller financing. It's not a handshake deal between the buyer and seller. The vast majority of seller-financed deals include a professionally prepared mortgage and promissory note that are executed and recorded at closing. A seller would be ill-advised to do it any other way.

Benefits to the Seller

Why would the seller accept your seller-financed offer, rather than accepting the one with conventional financing that would get them all of their money up front?

There is a general misconception among inexperienced real estate investors that seller-financing mainly benefits the buyer. That is certainly not always the case. There are numerous very valid reasons a seller would prefer seller financing:

1. Reduced Taxes - Let's assume the seller's cost basis on the above property is $50k and they've owned it for a few years. Ignoring complicated CPA-stuff like depreciation recapture, the seller would make $50k in profit on the sale, which would likely require a 15% long term capital gains tax. That's a $7,500 tax bill due in the year of the sale!

Whereas, if they accept the seller-financed deal, they are most likely only paying taxes on $15k in year one, and then only on a few thousand dollars per year thereafter while they hold the note. This can significantly reduce the seller's overall tax burden on the sale of the property.

2. Increased Profit - With the seller financing terms outlined above ($85k at 7.5% interest, amortized for 20 years, with a 15 year balloon), the seller is going to earn an extra $500 per month in interest for the first couple of years! The monthly interest payment slowly decreases, and the monthly principal reduction increases, as the term of the loan progresses. But, over the course of a 15 year note, the seller would earn over $70,000 in interest, above and beyond their profit on the sale of the property! 

And, by the way, the principal balance due to the seller after 15 years would still be over $30k, since the loan wasn't fully amortized.

(Don't believe me? Google "mortgage calculator" and plug in the numbers yourself!)

3. No concerns about the appraisal coming in short. This is actually a huge benefit to both parties. Aside from the inspection contingency, the appraisal is the next big hurdle in the financing of a typical mortgage loan. A short appraisal has derailed many a deal. This risk generally does not apply to seller financing.

4. Preservation of Monthly Cash Flow - Let's say the property above rents for $1,000/mo, and after paying operating expenses and debt service, the owner/seller was earning $500/mo in net operating income. Guess what - his cash flow actually improves after selling the property with seller financing, with one key difference: He isn't the landlord anymore!

Benefits to the Buyer

There are many benefits to the buyer as well, such as:

1. Lower Down Payment - In some (not all) cases, the buyer may be able to negotiate a lower down payment than would otherwise be required for conventional financing.

2. Flexible Terms - Remember, everything is negotiable. It's not uncommon for seller-financed mortgages to include things like interest-only payments for 1-2 years (which increases the properties cash flow while the new owner is stabilizing or repositioning it). 

3. No Credit Check or Approval Process - While most sellers will want to vet the buyer carefully before agreeing to seller financing, it's likely to be a much less intensive process than underwriting a conventional mortgage.

4. The loan (in most cases) doesn't show up on your credit report - This may help improve your credit score and/or DTI ratio and keep more financing options open for other deals.

Can Real Estate Agents be Involved?

I've been asked many times, "Can I propose seller-financing through my buyers agent, or if the seller has a real estate agent"? Of course you can! Again, there is nothing shady, secretive, or underhanded about seller-financing, and real estate agents put together seller-financed deals all the time.

Most standard real estate contracts have a preformatted addendum or rider that agents can use to outline seller financing terms. Once the buyer and seller agree to these terms, in many ways a seller-financed deal is easier for a realtor to keep on track than one with conventional financing (the contract goes to the title/closing agent and they handle the rest, and there's no risk of the mortgage underwriter blowing things up at the last minute and derailing the transaction). 

That being said, many traditional real estate agents are not familiar with the benefits seller-financing can provide to their seller, so share this post with them!

Limitations on Seller Financing

Another common question is: Can I propose seller financing if the seller has a mortgage? It depends. As you'll recall from our explanation of conventional mortgage financing earlier, the mortgage creates a lien on the property that has to be paid off if the property is sold. In our example above, if the seller owed $60k on her first mortgage, there's no way she could accept $15k as a down payment and seller finance the rest (she'd have to pay off the remaining $45k somehow in order to convey the property with free and clear title). 

Generally speaking, seller financing works best on properties that are free and clear, or have a mortgage balance less than the down payment being offered that can easily be paid off at closing. 

(It is sometimes possible to work with a seller who has a mortgage balance prohibitive to seller financing by using creative methods such as a wrap or subject-to transaction. Those are outside the scope of this post, but you'll find plenty of info about them elsewhere on Bigger Pockets.)

Closing 

Hopefully this post has helped to pull back the curtain and clarify some of the myths and misconceptions about seller financing. Have other questions about how seller financing works, please fee free to leave a comment below, or hit me up via my Bigger Pockets profile!

*Note: The mortgage lien and promissory note process outlined above applies to lien theory states, which includes around 33 states in the U.S. In other states, the nuts and bolts of the mortgage and lien process is handled slightly differently (often with a deed of trust), but the benefits of seller financing are largely the same.

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Jeff Copeland is a real estate broker and property manager in St Petersburg, Florida, and broker/owner of Copeland Morgan LLC. You can find him on Bigger Pockets under @Jeff Copeland.