Seller Financing – What Is It?
The Real Scoop
Seller Financing (a.k.a., Owner Financing) is a form of financing where the seller of a property is willing to finance the home for the buyer.
This kind of financing can be a great way for a buyer to get into a home when he has challenges on his credit that prevents him from buying.
Who Would Do This?
There are many reasons why a buyer may not be able to qualify for a home loan.
Some of the reasons include (but are not limited to)…
- Going through a Foreclosure within the past 2 to 3 years.
- Having a Short sale within the past 2 to 3 years.
- Having a Bankruptcy within the past 3 years.
- Starting in a new job industry that is under 2 years.
- Bad credit because of a divorce, becoming a widow, or other mitigating factors. Do you know your real scores?
- Recent late payments on credit cards or other creditors who report to the big three repositories.
Types of Seller Financing
When you are buying a home there are a few other things that you may want to know more about. This can be what you need before buying a home. If you are the seller then there are things you need to know before selling a home.
There is a lot of lingo that goes around in the Seller Financing arena that you need to become aware.
Let us start with the two types of seller financing.
AITD – All Inclusive Trust Deed (a.k.a. Wrap-Around Mortgage)
This type of Seller Financing is when the seller of the property has an existing mortgage on the place. Thus, when he sells the difference is added onto (i.e., “wrapped”) around the existing mortgage.
As an example let’s say you are buying a home from a seller who is willing to carry a $300,000 note. He has an existing $200,000 loan on the home. The difference (“spread”) is wrapped around the first. When you sell or refinance the home in the future both notes are paid off.
There are some cautions that you need to be aware.
First, you must make sure that your payment is equal to or higher than his payment. This helps negate a negative cash flow where it could be possible that you get foreclosed upon, unknowingly.
Second, many traditional loans on residential housing have a “Due on Sale” clause which means that when the title of ownership has changed hands that the loan could be called due in full. Commercial deals and VA residential deals often can be assignable.
OWC – Owner Will Carry
This is a type of financing when the seller of the home owns the home “free and clear” of any mortgages.
Unlike an AITD where a loan is in place, the seller of this home will carry the full amount of the note. There are many advantages to this type of financing for the seller. There are also advantages to the buyer.
One of the big advantages to the seller is that there is no need to worry about a Due on Sale clause since there is no mortgage.
The other big advantage is that the seller can sell the note on the secondary market just like any bank can do. There are many investors who buy notes especially after about 6 months of good payment history.
It is not the scope of this article to talk about the world of note buying.
Since the seller has no other mortgage on the home there is a very small chance that anything could happen with other institutions. There are no Due on Sale clauses either. A buyer who is going through an OWC transaction is in a very safe position.
There are some terms that you must become aware before you enter into one of these transactions. These terms will be thrown around a lot so you must fully understand them.
Principal & Interest (P&I) Note – There are only two types of loans you can get on a home, for the most part. The one that is most common is a principal & interest note. Every month you are making the agreed-upon payment but the amount that goes to principal and interest will change on every payment.
At the very early part of the payment, most is going toward interest and very little is going toward principal. As the note matures more will go toward principal and less is going toward interest. At the very end, most of your payment is principal and very little is going toward interest. (This is why people buy and sell notes is for the interest benefits.)
Interest Only (I.O.) Note – This is the second most common type of note. In this type of payment, you will pay less every month but you are only making interest payments. This is great for short-term notes but does not work to the buyer on longer-term scenarios.
This payment will always be less than a P&I payment. It is because there is no principal being paid. This may seem like a great idea until you know the truth. Since there is no principal being paid down the interest payment will stay the same. On the second payment, you have already paid slightly more in interest than a P&I payment. The longer the loan goes the more interest you have paid.
Amortization Schedule – An amortization schedule is tied directly to a P&I note. It shows the amount which is being paid to both the interest portion and the principal portion for each payment is made.
A typical home loan is 30 years of monthly payments. This is 360 (30 * 12) payments. Thus you can know exactly, to the penny, how much you owe at any time.
Payoff Amount – This is how much you owe on a note at some given time into the history of making your monthly payments. This is calculated from the Amortization Schedule. If the sale or refinance of the home is done on a day other than the first day of the month then this is calculated to the day of the month (i.e., prorated) that the transaction actually occurs.
30-Year Note (a.k.a. 30 -Year Am) – Most home loans are based on a 30-year amortization schedule. You will often see 15-Year and even 40-Year Notes. The number just indicates the length of time the amortizations schedule will be based upon.
Down Payment – This is the amount of money you are paying to the seller to buy the home and for her to carry the note (i.e., “paper”) for you. Typically in seller financing, it can range between 10% to 50% of the purchase price. The most common form that I find is 20% down.
Interest Rate – This is the interest rate that you will be paying based on an annualized rate.
Balloon Payment – This is the one main thing you need to know about a note, regardless if it is I.O. or P&I. This is the time when the seller of the home expects to be paid in full. This is always before the full duration of the contract.
Frequently 5 or 7 years are used. They can be longer or shorter depending on what is negotiated. If we assume a 5-year balloon then that means on the 60th payment the total loan amount would be due (including all unpaid principal remaining).
The way to get around a balloon payment when it is getting close is to either sell the home or refinance it. You may also attempt to get an extension of the balloon if you have a good payment history with the seller.
Putting It All Together
Now that we have covered some of the terminology used in seller financing, let’s use a couple of examples to test your understanding.
- You are buying a $300,000 home. They are asking 20% down ($60,000) on a P&I note at 7% interest on a 30-Year AM with a 5-year balloon.
- You are buying a $300,00 home. They are asking 15% down ($45,000) on an I.O. note at 6% interest with a 7-year balloon. (Notice there is no amortization schedule on an I.O. note.)
If you decide to buy or sell using Seller Financing I hope you are a bit more knowledgable on the process and procedures of this type of deals. The more educated you can become the more options which open for you. As a REALTOR® I can further assist you with my experience.