Seller financing is a type of real estate lending transaction where you, as the property owner, are also the mortgage lender. This means a financial institution is not required to handle negotiations or financing agreements. Seller financing functions in a similar way to a traditional mortgage loan, with the buyer paying the seller in installments.
Some of the advantages of seller financing include no minimum down payment and fewer regulations. This can be an advantage in a tight credit market, and with seller financing, only two main players are involved, so it can be quicker and cheaper. However, it can also have some disadvantages. Here are ways you can reduce your risks as a seller.
Do some due diligence on buyers
As the seller, you will need to make sure that a buyer is well-capitalized with a good track record. You need to get buyers to complete detailed loan application forms and verify all the information buyers provide in these forms. This may include vetting their employment status and running a credit check. Looking at assets, financial claims, and references is also part of the process.
Property management companies in Denver, like Evernest, Evolve and HomeVault, comprehensively screen tenants for landlords. They will do employment checks, credit checks and reference checks to find suitable tenants. Sellers wanting to do checks on buyers must follow a similar process. Any written sales contract should be made contingent on your approval of the financial situation of the buyer.
Set the purchase price to reflect the risks of an installment sale
There are more risks that come with agreeing to accept installments, and your purchase price should reflect this. As the seller, you are justified in adding a premium to the purchase price for an installment sale as compared to a cash deal.
You may charge more for purchase or reflect this in terms of the financing, like the interest rates. Negotiation of interest rates between you and the buyer should try to balance the needs of both parties. It should be noted that sellers usually pay capital gains tax on the purchase price, whereas they pay ordinary income rate taxes on interest. Depending on the interest rates you charge, you can get a better rate of return on the money you lend than you get with many other types of investments.
Secure the promissory note and get guarantees from the buyer
A promissory note is legally binding and promises that the borrower will repay a loan to the lender. The lender has discretion on who to lend to and what the terms of repayment should be. The main difference between it and a mortgage is that the note is a written agreement that contains the details of the mortgage loan, but a mortgage is a loan secured by real property.
A promissory note typically contains provisions regarding grace periods, late charges, default interest rates and attorneys’ fees. It can help individuals who do not qualify for traditional mortgages to purchase a home. You, as the seller, are the source of the loan, and the home is the source of the collateral.
Securing the promissory note involves procedures similar to the procedures a bank uses when securing a loan to a buyer. You need to negotiate for protections to make sure the buyer does not strip a property of its value. If the buyer doesn’t maintain the home, you could end up repossessing a property that’s in bad shape.
Ensure deferred payment is a proportionate portion of the purchase price
To minimize the risk of an installment sale, you should require a buyer to make a substantial down payment. It is usually in your best interests not to finance any more than a third or half of the purchase price. A buyer who has made a significant down payment will have more incentive to pay off the balance.
If buyers default, they lose the down payment, and you keep it. You can retake a property if a buyer defaults. Borrowers own the home as long as they continue to pay.
Typically, you don’t hold the mortgage for longer than five to 10 years. After that, the mortgage comes due in the form of a balloon payment the buyer has to pay. To make the payment, the buyer must qualify for a mortgage refinance or get a first mortgage from a bank or another lender.
Conclusion
Seller financing can be a helpful option in a challenging real estate market, but it also has pros and cons for both sellers and buyers. Taking the steps suggested above can help to reduce the risks and make it a safe way to purchase a home. Having a real estate attorney prepare and view all the documents can help to protect both parties’ interests.