Seller Finance

Definition and Overview

Seller financing, also known as owner financing or owner carry-back, is a creative financing method where the seller of the property acts as the bank. Instead of the buyer getting a loan from a traditional lender, the seller finances the purchase directly for the buyer. The buyer makes payments to the seller over a pre-determined period until the loan is paid in full. Ownership is transferred to the buyer at the time of sale.

When to Use This Strategy

This method is ideal when the seller owns the property free and clear (i.e., there is no existing mortgage on the property).

Benefits and Advantages

• Win-Win Scenario: It can be a beneficial arrangement for both the buyer and the seller.
• Little to No Money Down: Buyers can acquire property with little to no initial cash investment.

In-Depth Definition

In a seller finance arrangement, the seller uses their equity or their free and clear status to fund the buyer's purchase via payments. The amount and timing of these payments are agreed upon in the deed of trust. In essence, with a seller-financed, debt-free property, the seller acts as the bank.

Calculations/Formulas

While the terms of a seller financing agreement are negotiable, the following general real estate investing rules can be used as a framework for assessing the deal's potential:

• The 2% Rule: This rule helps to quickly screen potential rental properties. It states that the monthly rent should be at least 2% of the purchase price. For example, if a property is purchased for $100,000, the monthly rent should be at least $2,000.

• The 50% Rule: This rule helps to estimate the profitability of a rental property. It suggests that, on average, 50% of the income a property generates will be spent on operating expenses (excluding the mortgage payment). These expenses include taxes, insurance, utilities, repairs, and vacancy.

• The 70% Rule: This rule is often used by house flippers and wholesalers to determine the maximum allowable offer (MAO) for a property. It states that an investor should pay no more than 70% of the after-repair value (ARV) of a property, minus the cost of repairs.

Seller Financing Structures

There are several ways to structure a seller financing deal. The most common structures include:

• Land Contracts: The buyer makes payments to the seller, but the seller retains legal title to the property until the loan is paid in full. The buyer has equitable title and can build equity in the property.
• Assumable Mortgages: The buyer takes over the seller's existing mortgage. This is an attractive option if the seller has a low interest rate on their loan. The buyer pays the seller the difference between the purchase price and the remaining mortgage balance.
• Lease-Purchase Agreements (Rent-to-Own): The buyer leases the property from the seller with an option to purchase it at a later date. A portion of the rent payments may be credited towards the purchase price.
• Wraparound Mortgages: The seller has an existing mortgage on the property. The buyer makes payments to the seller, who then uses a portion of that payment to continue paying their own mortgage. The buyer's interest rate is typically higher than the seller's interest rate.

Documentation

The following documents are typically required for a seller financing transaction:

• Promissory Note: This is a legal document that outlines the terms of the loan, including the loan amount, interest rate, payment schedule, and any penalties for late payments or default.
• Mortgage or Deed of Trust: This document secures the loan and gives the seller the right to foreclose on the property if the buyer defaults on the loan.
• Purchase Agreement: This is the main contract that outlines the terms of the sale, including the purchase price, down payment, and other key details.

Best Practices

For the Buyer

• Get Everything in Writing: Ensure that all terms of the agreement are clearly documented in a legally binding contract.
• Consult with a Real Estate Attorney: Have a qualified attorney review all documents before signing.
• Conduct Due Diligence: Thoroughly inspect the property and research the title to ensure there are no liens or other encumbrances.

For the Seller

• Vet the Buyer: Carefully screen potential buyers to ensure they are financially responsible and have the ability to make the loan payments.
• Get Everything in Writing: Ensure that all terms of the agreement are clearly documented in a legally binding contract.
• Use a Loan Servicing Company: Consider hiring a third-party company to collect payments, manage the escrow account, and handle other administrative tasks.
• Consult with a Real Estate Attorney: Have a qualified attorney draft or review all documents to ensure they are legally sound and protect your interests.

Common Terms

The following are some common terms found in a seller financing agreement:

• Purchase Price: The total amount the buyer will pay for the property.
• Down Payment: The amount of money the buyer will pay upfront.
• Interest Rate: The rate at which the buyer will pay interest on the loan.
• Amortization Schedule: A table that shows the breakdown of each payment into principal and interest over the life of the loan.
• Payment Schedule: The frequency and due dates of the loan payments.
• Balloon Payment: A large, lump-sum payment that is due at the end of the loan term.
• Default and Foreclosure: The consequences of the buyer failing to make their payments, including the seller's right to foreclose on the property.

Common Mistakes to Avoid

• Not Screening the Buyer: The seller should always screen the buyer to ensure they are financially responsible and have the ability to make the loan payments. This may include running a credit check and verifying their income.
• Not Using a Promissory Note: The promissory note is a crucial legal document that outlines the terms of the loan. It is essential to have a well-drafted promissory note that is signed by both parties.
• Failing to Secure the Loan: The seller should always secure the loan with a mortgage or deed of trust. This gives the seller the right to foreclose on the property if the buyer defaults on the loan.
• Not Complying with State and Federal Laws: There are several state and federal laws that govern seller financing. It is essential to comply with all applicable laws to avoid legal trouble.

Real-world Application Scenarios

• A retiree who wants to sell their home and receive a steady income stream: A retiree who owns their home free and clear can sell it using seller financing and receive a steady stream of income from the buyer's payments. This can be a great way to supplement their retirement income.
• A buyer who cannot qualify for a traditional mortgage: A buyer who cannot qualify for a traditional mortgage due to a low credit score or other reasons can use seller financing to purchase a home.
• A seller who wants to sell their home quickly: A seller who wants to sell their home quickly can offer seller financing to attract a wider pool of buyers.