Seller financing basics for real estate investors

How it works

The buyer and seller sign a purchase contract like any other. At closing, the buyer pays a down payment and signs a promissory note, which is the promise to repay, for the rest of the price. The note is secured by a mortgage or deed of trust on the property, depending on the state, so the seller can take the property back if the buyer stops paying.

You may hear it called owner financing, owner carry or a seller carry-back. The idea is the same. Sometimes a seller carries only part of the price, a second loan behind a bank loan, to close a gap in the buyer's down payment.

The deal works best when the seller owns the property free and clear, or nearly so. If the seller still has a mortgage, see the due-on-sale risk below.

Terms to agree on

Everything is negotiable, which is both the appeal and the danger. Write down each of these:

• Price and down payment
• Interest rate
• Amortization: the schedule the payment is based on, such as 30 years
• Term: when the loan is actually due. Often much shorter than the amortization, which creates a balloon payment
• Payment amount, due date and late fee
• Prepayment: can you pay early without a penalty?
• Who pays property tax and insurance, and how the seller confirms they are paid
• What happens on default

Worked example

Made-up terms for a small rental. They are not a quote, not typical terms and not the calculator's starting numbers.

• Price: $250,000
• Down payment: 10%, so $250,000 x 10% = $25,000
• Seller carries: $250,000 - $25,000 = $225,000
• Rate: 6%, amortized over 30 years
• Balloon: the full balance is due after 5 years

The monthly payment on $225,000 at 6% over 30 years is $1,348.99. You can check it in the mortgage calculator with a $250,000 price, 10% down, 6% and 30 years.

After 60 payments, how much is still owed? On a 30-year schedule at 6%, about 93.054% of the original balance remains after 5 years, because early payments are mostly interest.

• Balance at the balloon: about $225,000 x 93.054% = $209,372
• Principal paid in 5 years: $225,000 - $209,372 = $15,628
• Total payments: $1,348.99 x 60 = $80,939.40
• Interest paid: $80,939.40 - $15,628 = $65,311.40

The balloon is the key number. In year 5 you must pay about $209,372 in one go. Most buyers do that by refinancing with a bank or by selling. If rates are high, the property's value has dropped or your credit has slipped by then, that can be hard. Plan the exit before you sign. The math of a refinance is in cash-out refinance math.

Interest-only option

Some seller notes are interest-only. Same made-up terms, but no principal in the payment:

• Monthly payment: $225,000 x 6% / 12 = $1,125
• Interest over 5 years: $1,125 x 60 = $67,500
• Balloon: the full $225,000

The payment is $223.99 lower each month, which helps cash flow. But you owe $15,628 more at the balloon and pay about $2,189 more interest over the five years. That trade-off is worth seeing in numbers before you pick one.

Why each side says yes

For the buyer: there may be no bank approval, fewer fees, a faster close and room to negotiate the down payment or rate. It can work on a property a bank will not lend on because of its condition.

For the seller: a steady monthly income at an agreed rate, possibly a higher price, and a wider pool of buyers. Sellers may also want to spread their gain over several years. That has tax effects, so the seller should talk to a tax professional.

Risks to check

• Balloon risk. If you cannot refinance or sell in time, you can lose the property and your down payment.
• Due-on-sale clause. If the seller has a mortgage, the lender may be able to demand full payment when the property changes hands. Deals that leave the seller's loan in place need an attorney's review.
• Title. Get title insurance and a title search, just as with a bank loan.
• Legal rules. Federal and state rules can apply, especially when the buyer will live in the home. Have a real estate attorney or title company prepare the papers.
• The deal itself. Good terms do not fix a bad property. Check the cash flow and the DSCR at the seller's payment, using honest NOI.

FAQ

What is a balloon payment?

A large lump sum due at the end of a loan that is shorter than its payment schedule. With a 30-year schedule and a 5-year balloon, you pay the whole remaining balance in year 5.

Can a seller finance a home that still has a mortgage?

Sometimes, but most mortgages have a due-on-sale clause that lets the lender call the loan when the property is sold. Have a real estate attorney review any deal that leaves the seller's loan in place.

Are seller-financed rates higher than bank rates?

They can be higher, lower or the same. The rate is whatever buyer and seller agree to, within any legal limits. Sellers often trade a lower price for a higher rate, or the other way around.

Who writes the seller financing paperwork?

Usually a real estate attorney or title company prepares the promissory note and the mortgage or deed of trust. Federal and state rules can apply, especially when the buyer will live in the home.