Whether you’re trying to sell in a buyer’s market or you’d just like to make more money, it’s important to consider the various methods and the pros and cons of seller financing. Here’s what you need to know.
How Does Seller Financing Work?
Sellers can choose to finance the entire transaction or just the down payment by selecting an owner carryback, installment sale, lease option or a wraparound mortgage. Here’s a quick rundown of these options:
- Owner Carryback. An owner carryback is a second mortgage that provides part or all of the buyer’s down payment. For example, your buyer might offer five percent, you might finance 15 percent and the bank might lend the remaining 80 percent. Your loan is subordinate to a bank’s loan (i.e., the first mortgage), so if the buyer defaults, resulting in a foreclosure sale, the bank is repaid before you.
- Installment Sale. If you own your house outright, you can finance the sale yourself. With an installment sale, the buyer signs a promissory note and either a mortgage or a deed of trust, which allows you to foreclose, if necessary. The loan and change of ownership are recorded with your county.
- Wraparound Mortgage. If you have a mortgage on the property, you might be able to finance your sale with a wraparound mortgage. With a wraparound mortgage, you continue making monthly payments to your current mortgage lender, while your buyer makes payments to you. For example, if you owe $50,000 on your home and wish to sell it for $100,000, you can finance the $100,000 for your buyer. They pay you each month, and in turn, you pay your mortgage lender.
- Lease Option. A lease option involves two factors: a rental agreement and a sale agreement. Your tenants pay an option fee for the privilege of purchasing your property later at an agreed-on price. They may also pay higher than market rent, with the excess credited toward their purchase price, if they decide to exercise the option to buy.
There are a few hazards to consider when it comes to seller financing. It’s recommended you consult an attorney when setting up owner financing.
- Mortgage Reforms. Recent mortgage reforms could apply to you if you finance more than three properties a year, don’t own the home you’re selling or are the builder. Under Dodd-Frank reforms, balloon payments are prohibited, and the rate must be fixed for at least five years. If you finance more than one property a year, you’ll also have to determine if the buyer can afford the mortgage.
- Due-On-Sale Clauses. With a wraparound mortgage, your loan almost certainly has a due-on-sale clause, which means the lender can immediately call in the loan if the property changes hands. Lenders rarely exercise this clause, but they can.
- Default. Default is expensive. Foreclosing on a property can cost tens of thousands in lost income, attorney fees, and more. You’ll also need to ensure the buyer pays the property taxes and homeowners insurance premiums.
These disadvantages can be offset by careful selection of buyers and setting up the contract — hence, the attorney recommendation.
Advantages of Seller Financing
There are several advantages of seller financing. Here are the top benefits:
- Tax Benefits. Many home sellers don’t worry about capital gains tax when they sell a primary residence, because they can usually exclude the proceeds from taxation. For those who can’t, an installment sale allows them to be taxed over a longer period. This is especially useful if the gain on a home sale would send you into a higher tax bracket. For example, if you sell a home for $200,000 with a $150,000 profit, the $150,000 could move you into a higher bracket. By selling it over 10 years ($20,000 a year, plus interest), your taxable gain ($15,000) might be more manageable. We recommend consulting with a qualified tax specialist to assess your personal situation.
- Higher Price. Sellers who finance are in the minority. If you’re one of the few who can offer it, you can receive a higher price for your home, and you’re likely to sell it faster, as well.
Most people can’t or don’t wish to offer seller financing. If you can, you can beat out the competition for the sale and set up a nice monthly income. It’s not for everyone, but it might be for you.