Seller financing is just what it sounds like: the seller provides the financing. In other words, the owner of the property acts as the bank, and although legal ownership of the property changes hands, the payment is sent directly to the previous owner, rather than to a bank, for a specific duration and with a defined monthly payment.
For example, I may want to purchase a rental house, but I do not want or am unable to get traditional bank financing. The seller would like $100,000 for the property but is willing to “carry the contract” (aka “carry paper”), which is investor jargon for when someone agrees to finance a property (or part of the property) they currently own so the buyer doesn’t need to get external financing from a lender. In this case, the owner would ask for $5,000 down and a 10% interest rate on the remaining $95,000 amortized over 30 years, for a monthly payment of $833.69, before taxes and insurance. I’d agree to his terms and after doing my due diligence, I would close on the property through my local title company. I’d then look for a tenant who would rent the home for $1,600 per month and collect the cash flow difference each month.
In this scenario, the seller gets a great interest rate on their money, I get to buy the house for just $5,000 down, and I don’t have to deal with a bank at all. Seller financing can be another great win-win for all parties involved. But what’s the catch?
Why aren’t these arrangements more popular?
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The Problem with Seller Financing
One major problem with seller financing puts a wrench in the whole strategy for the millions of American homes that currently carry a mortgage: the due-on-sale clause. We talked about this clause in the previous chapter when I outlined the risks of a lease option, but allow me to repeat the gist of it: the due-on-sale clause is a legal part of nearly every mortgage paperwork that gives the bank the right to demand that the loan be paid back in full, immediately, if the property is sold (hence the name “due on sale”).
So you can see the core problem with seller financing: in such an arrangement, the property is being sold. In other words, if there is a mortgage on a property, and the property is sold using seller financing, then the bank could come and demand to be paid back in full that moment or it could foreclose.
Will That Actually Happen?
Well, remember that the due-on-sale clause gives the bank the right to demand full payment; it doesn’t require the bank to do so. The bank may be perfectly accepting of the arrangement and never say a word. However, the risk you carry is great whenever you sell a property that has a due-on-sale clause. If the bank does demand full payment immediately and you can’t pay the bank the entire loan balance, the property may be foreclosed on. If you are buying from a homeowner, the homeowner may get foreclosed on, and both of you would lose the property. Obviously, this is not a situation you want to find yourself in. There is one simple solution:
Only use seller financing when the seller owns the home free and clear (i.e., when the seller has no loans on the property).
In other words, if you truly want to eliminate the risk of being foreclosed on for violating the due-on-sale clause, don’t use seller financing to buy a home unless the existing loan is first paid off. Your goal when using seller financing is to find sellers who don’t have a mortgage. Although this may seem difficult, the Los Angeles Times reports that 29.3% of American homeowners do not have a mortgage on their property. Therefore, literally millions of properties are prime for you to buy using seller financing.
Why Buy Using Seller Financing?
Seller financing offers numerous benefits, so let’s look at a few of the most common:
1. Ease of Financing
As mentioned earlier, when you use pure seller financing to purchase a property, you avoid having to use a bank, which can mean the difference between a deal and no deal for many people. If you are tapped out on the number of mortgages you can get, seller financing can be a great tool in your toolbox to obtain additional rental property.
2. Possible No or Low Down Payments
Because you are dealing directly with a homeowner seller, there are no cut-and-dry rules regarding the down payment. You aren’t dealing with rigid rules imposed by Fannie Mae or Freddie Mac, which require 20%–30% down on an investment property. Instead, you get what you negotiate with the seller. The seller may want nothing down, or they may want 50%, but you won’t know until you ask and negotiate.
3. Option for Creativity in Structuring the Deal
As I mentioned earlier, the rules when dealing with banks can be extremely rigid, but this is not the case with seller financing. Seller financing allows you to get creative to solve a problem. Rates, terms, the payment amount, payment dates, and everything else is completely negotiable, which can turn a mediocre deal into a great deal.
4. Purchase “Unfinanceable” Properties
Sometimes, the condition of a property may be too poor to allow you to use traditional financing. In these cases, seller financing can give the buyer a chance to own the property, begin fixing it up, and possibly refinance into a more traditional form of financing down the road (or never—the possibilities are numerous!).
5. Doesn’t Show on Your Credit Report
Unless the seller of the home signs up with one of the credit reporting agencies to report the debt (very unlikely), chances are your seller financed deal will not end up on your credit report. This can make obtaining other loans and mortgages in the future much easier. There are, no doubt, numerous other reasons you may want to use seller financing, so don’t be afraid to seek out opportunities where you can apply it. It truly can be a great way to finance properties of any size.
[This article is an excerpt from Brandon Turner’s The Book on Investing in Real Estate With No (and Low) Money Down.]
Have you ever used seller financing for your deals? What did you like or dislike about it?
Let me know with a comment!