Risks of Taking Seller Financing on a House

Seller financing, also referred to as owner financing, means that the owner of a property serves as the buyer’s lender rather than taking out a mortgage loan from the bank. Like any home loan, the buyer will make payments every month, with specified terms and an interest rate. According to Note Investor, in 2018, there were over 91,600 of these types of loans publicly recorded, totaling nearly $26 billion, so it’s not as uncommon as you might think. 

For buyers who don’t necessarily have the financing options, credit, or capital to purchase a home the traditional way, seller financing offers a solution. If the seller provides the financing, a contract is created that outlines the payment terms as there are different kinds of owner financing, with the most common including:

Mortgage and note. A mortgage note vs. mortgage is two separate things. The note is the promise to repay the amount that was borrowed, while the mortgage is the document pledging the property as security of the loan. This is the least risky type of financing and the same kind that the bank uses when lending on a home. The mortgage will be – in most cases, recorded, and the buyer is placed on the title with a deed.

Lease option. With this type of financing, initially, the buyer enters into a lease, meaning the buyer leases the property for a specified time frame, typically three to five years. After that, they may decide to purchase the home; in other words, take the lease option. The seller and buyer agree on the home’s sale price before the beginning of the lease. When it ends, the buyer may either forfeit their option to buy, along with any monies paid at the start of the agreement or buy the home. When the buyer chooses to purchase the home, any payments made throughout the lease period are typically deducted from the sales price. While the repayment terms differ, the seller usually sets them – of course, the buyer can negotiate. In most cases, these loans have a higher interest rate than banks would offer as the seller has a greater risk, lending to a buyer who is probably not able to get approved for a traditional mortgage loan from a bank. 

The question is, what risk is there to the buyer who takes seller financing on the house? 

Recordkeeping. One of the most significant risks to the buyer who purchases a home with seller financing is the owner’s method of recordkeeping. Sellers track payments in different ways, such as recording them by hand or paying a third-party servicing company to keep the record. The buyer needs to keep a record of every payment made over the life of the loan so each payment and the balance due can be verified should there be any conflicts. 

Balloon payments. Many seller financing arrangements require a large balloon payment to be paid after five years. That can be a problem if a buyer is unable to secure financing at that point as they could lose all the money paid to date, plus the house.

Due on sale clause. If the seller is still paying a mortgage on the home, the lender or bank can demand immediate payment of the debt in full if the house is sold as most mortgages include this clause. If the lender isn’t paid in full, they can then foreclose. This risk can be avoided by ensuring that the seller’s lender either agrees to owner financing or owns the property free and clear.

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