What Is Seller Financing?
Seller financing, also known as owner financing, is one of the most misunderstood, mysterious topics in real estate. Much like mustaches and aviator glasses, seller financing was last popular in the 70’s and 80’s when mortgage interest rates climbed well into double digits, and is seeing a resurgence today.
Seller financing cuts out the banking middlemen (either entirely or partially), and the seller becomes the bank, holding a mortgage for the buyer, drastically reducing closing costs and potentially devising a custom repayment schedule that is optimal for both buyer and seller that a bank may not have the appetite for. Since this structure gives the buyer more flexibility regarding repayment options and reduced costs to close, they can generally afford to pay more for the property. From a seller’s perspective, not only can they fetch a higher price for the property, but they now have the ability to negotiate a rate of return on a secured (mortgage-backed) investment for an extended period of time, all while deferring capital gains and enjoying potentially huge tax savings.
The Recipe For Success
So if seller financing is so great, why doesn’t everyone seller finance? Well, the moons have to align just right in order for it benefit all parties, as it should. The critical elements for this to work are:
- The seller must have some equity in their home.
- The seller doesn’t need the money to spend on something else right now.
- The buyer should have strong credit, income, and some money in the bank.
If these 3 criteria aren’t met, it’s not going to work. But, if you’re a seller with equity in your home and will likely just sink whatever remains of your net proceeds after paying Uncle Sam into some other investment vehicle (annuity, stock market, IRA, bonds, etc.), you should strongly consider offering seller financing to maximize returns, minimize risk, and potentially reduce your tax liability. Once this becomes a consideration and you begin seeking advice and opinions from friends and family, be prepared for looks and responses as though you just announced you’re joining the circus.
This is to be expected as most are either totally unfamiliar with the concept, or have heard the myths surrounding private financing. To help you better understand the reality of seller financing, we’ve compiled the following list of the most common misconceptions you’re probably asking yourself right now. Full disclosure: you absolutely MUST consult with an accountant and an attorney with experience in seller financing before proceeding with any seller financed transaction.
Seller financing is just for buyers who can’t get traditional financing.
Although this is certainly a reason that a buyer may wish to seek seller financing, it is also the source of most seller financing horror stories, and a seller should probably steer clear of financing to a buyer who can’t get financing elsewhere. Instead, the primary motivation of many investors looking to purchase properties with seller financing is to maximize their cash-on-cash investment return, which is the annual cash flow of a property divided by the cash outlay required to close. Here’s an example of what the numbers might look like on a very typical deal for a duplex in Rotterdam, NY:
|Conventional Financing||Seller Financing|
|Total Cash Needed:||$36,000||$15,000|
|Mortgage Payment (20 yrs):||$594||$806|
|Annual Net Operating Income (Rent Collected Minus Expenses):||$12,000||$12,000|
|Annual Cash Flow (Net Income Minus Mortgage Payments):||$4,872||$3,328|
|Cash-On-Cash Return (Cash Flow/Initial Cash Outlay):||13.5%||22.2%|
As you can see, by utilizing seller financing and reducing the down payment required, in this example our buyer could afford to pay a $5,000 premium for the property, pay a higher interest rate to the seller, and still receive a better rate of return compared to conventional financing. At the same time, the buyer has conserved enough cash to enable him to buy a second property, with money left over.
Seller financing is just for sellers who can’t sell their property on the open market.
This is the other side of the coin to myth #1. Yes, this is a reason why a seller may offer to finance, but a buyer should be extremely cautious of buying properties that aren’t traditionally financeable unless they’re experienced in purchasing distressed/non-conforming/weird properties. The 2 primary drivers for a seller to finance are generally:
- The seller doesn’t need the sale proceeds immediately and will need to invest those proceeds somewhere anyway, so holding a mortgage on a property they are already familiar with, with a guaranteed rate of return, secured by a tangible asset is a pretty sweet deal.
- The seller is going to take a massive tax hit if they receive one giant proceeds check this fiscal year rather than spreading out the income in installments over several years. Obviously, check with your accountant on this one.
Seller financing deals are highly unusual.
In the residential, owner occupied real estate world, yes, less than 4% of transactions involve some form of seller financing. However, in the investing, commercial property, and business world, seller financing is commonplace. Since banks will generally only lend on 75% of the value of a commercial transaction, sellers often carry a portion of the remainder (10-15% typically), reducing the down payment required of the buyer, thus increasing the buyer’s rate of return as illustrated in Myth #1.
My lawyer/accountant/agent/great aunt/hairdresser/someone on the subway/etc. said it's a bad idea.
Like any investment, bad deals do happen, but most seller financed deals that go south do so because either the buyer, seller, or both, were under duress at time of purchase and had no choice but to finance privately, which is extremely risky and inadvisable. For example, a seller needs to sell their home with a crumbling foundation and since no bank will finance it, they entice an unsuspecting buyer with generous finance terms, then the house falls apart. Or, a buyer with poor credit and no money available for down payment offers to purchase a home from an unsuspecting seller for well above market price and pay a high interest rate to entice a seller to finance, only to default shortly thereafter.
Both of these scenarios, almost surely, will end badly, and are the scenarios most often cited by naysayers. The key is to consult with those who are experienced with seller financing transactions, and conduct relentless due diligence beforehand. Even your typical real estate attorney may have little to no experience with seller financing and likely holds the same misconceptions about the benefits and pitfalls of seller financing as the rest of the world, so remember to ask how many seller financed transactions they have been involved in, and if you’re having trouble finding experienced advisers, try contacting attorneys specializing in investment real estate.
A successful seller financed transaction should generally involve buyers and sellers that could finance conventionally, but are pursuing seller financing as a strategy and investing decision rather than as a last resort.
It’s super risky.
With every investment comes some risk, and in order to receive higher returns, one must generally tolerate higher risks, regardless of the investment vehicle. This is why volatile small-cap stocks generally provide greater returns than blue-chip stocks, and why blue-chip stocks provide greater returns than ultra-secure government bonds. However, even blue-chip stocks have risk.
For example, if you had invested $100,000 in General Electric stock back in 2000, your investment would be worth a whopping $39,000 today, a 61% decline! Compare that with real estate, where the worst US real estate decline in history occurred from 2007 to 2010, where the average decline was only 20%, and has since more than recovered. When a seller holds a mortgage for a buyer, there are 2 potential sources of risk: the buyer (defaulting), and the property (declining in value).
To minimize the risk of a buyer defaulting, a seller can and should strictly screen the buyer just as a bank would prior to making a loan. However, unlike almost any other investment type, the interest rate is guaranteed by the borrower, and the mortgage is backed by a tangible asset (the property), so even if the borrower defaults, the seller can regain possession of the property through foreclosure.
It takes 30 years to get paid.
This is really up to the seller, but for buyers not planning to occupy the property, seller financing is generally amortized over 20 or 30 years, but usually involves a “balloon payment” where the entire loan balance is due in 3, 5, or 7 years. This means that the borrower’s payment is based on a 20 or 30 year term like a traditional mortgage, but that the entire loan must be paid off at a sooner date. This gives the borrower time to accumulate enough equity in the property so that when the balloon payment comes due, they can refinance with a traditional lender, and the seller receives their principal in addition to all the interest they’ve been collecting along the way.
When deciding on balloon payment terms, it’s always best to forecast what the borrower’s equity position will be in the property on the date the balloon payment is due to ensure adequate loan-to-value with a conventional borrower for refinance.
It’s going to be an administrative headache to maintain.
If the seller prefers to be completely hands-off and not bill the borrower directly, there are hundreds of loan servicing companies that will handle these tasks for very reasonable fees, which can often be passed on to the buyer if mutually agreeable.
I need to own my house free and clear to offer owner financing.
Not necessarily. Refer back to the scenario from Myth #3, where a bank finances 75%, and a seller finances 10-15%, leaving the remainder for the buyer as a down payment. A seller could potentially offer financing in this way on the amount of equity they have in their home, using the bank funds to pay off their loan balance, but will have to accept a 2nd mortgage positon to a bank (if the bank will allow it). This means that if the bank finances 75%, the seller finances 15%, and the borrower defaults, the bank gets paid first, and there may not be any proceeds left for the seller if the property has declined in value.
Seller financing became illegal after the recession.
In 2010, the Dodd-Frank Act was signed into law and does provide certain protections to borrowers in seller-financed transactions, but only for borrowers that will occupy the property, and only under certain conditions that are beyond the scope of this article. To learn more, check out this article, and definitely check with your attorney before finalizing loan terms.
If it’s so great, everyone would do it.
This is the same argument I hear from people who think it’s a bad idea to be a landlord, or start your own business, or trade stocks, or any other means of making a buck rather than collecting it in the form of a W2 paycheck. Sure, it’s not for everybody, but if you’re looking for pretty darn safe investment that provides a monthly stream of income, seller financing may be the way to go.