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In this article:
- How Does Seller Financing Work?
- Pros and Cons of Seller Financing
- Does Seller Financing Affect Your Credit?
- Is Seller Financing Right for You?
- Other Homebuying Options
When you're trying to finance a home purchase, one of the options you may come across is seller financing. Seller financing happens when the owner of the home extends a loan to the buyer, sidestepping traditional mortgage lending. The loan may cover all or part of a home's purchase price.
Seller financing, also known as owner financing, may be one potential borrowing path for a homebuyer who has poor credit or is running into other issues with qualifying for a traditional mortgage. At the same time, buying a home using seller financing could present significant risks. Here's what you need to know if you're considering seller financing.
How Does Seller Financing Work?
In a seller-financing scenario, the seller acts as the lender in the purchase of a home. The lending agreement is between the buyer and the seller, with no bank, credit union or other lender participating in the deal. It's estimated that fewer than 10% of home sellers serve as lenders.
The seller does not provide cash to the buyer for the home purchase. Rather, the seller extends credit to the buyer for the purchase, and the buyer makes regular payments to the seller.
While no bank or other lending institution plays a part in seller financing, the buyer and seller often use real estate agents or attorneys to generate the purchase and lending agreements. Among other things, the buyer and seller will need to negotiate the loan's interest rate and length.
Seller financing can go down one of two avenues:
- The buyer receives the title to a house after promising to pay off the loan from the seller. In this scenario, the buyer can sell or refinance the home, but still must make payments under the seller-financing arrangement.
- The seller retains the title to a house until the buyer pays off the loan. This means the buyer can't sell or refinance the home until the loan is paid off and the title becomes theirs.
Regardless of how the seller financing is carried out, the seller frequently requires the buyer to fill out a loan application, go through a credit check and come up with a down payment. In addition, the seller often insists on an appraisal of the home's value and retains the right to foreclose on the home in the event the buyer defaults on the loan.
As with any mortgage, you should work to improve your credit score before you begin your home search. Since you won't know whether a seller will perform a credit check (and whether you'll even go this route), you should ensure your credit is in the best shape possible before you apply for a home loan.
Pros and Cons of Seller Financing
Just as with a traditional mortgage, seller financing comes with pros and cons.
While many of the details will depend on the agreement reached between buyer and seller, possible pros of seller financing include:
- Simpler access to credit: Seller financing may allow a buyer to get a home loan when it's not available from a traditional lender because of poor credit or other hurdles.
- No minimum down payment: A seller-financing deal may not feature a minimum down payment, unlike traditional mortgages, though some experts advise sellers to collect a down payment of at least 10%.
- No mandated credit check: Some sellers may not check a buyer's credit report.
- Low closing costs: Closing costs may be lower with seller financing than with a traditional mortgage.
- No private mortgage insurance: Sellers may not require private mortgage insurance (PMI), which traditional lenders typically mandate if a buyer makes a down payment of less than 20%.
- Negotiating power: A buyer may be able to obtain better terms, such as a lower interest rate or longer repayment schedule, than they'd get from a traditional lender.
- Speedier transaction: Seller financing may be finalized more quickly than a traditional mortgage.
Despite potential benefits, seller financing is a riskier approach to a home purchase than using a traditional mortgage lender. Potential negatives include:
- Hefty down payment: In an effort to protect themselves financially, some sellers may ask a buyer to provide a down payment of at least 20%.
- High interest rate: Because they're taking on significant risk, some sellers may charge an interest rate exceeding the average interest rate charged by a traditional lender.
- Overvalued home: If a seller doesn't order a property appraisal, the buyer may wind up paying too much money for the home.
- Less buyer protection:: Because a seller, rather than a traditional lender, extends the loan, the buyer may have fewer consumer protections available under state and federal laws. The purchase contract may also contain provisions and language that increase the buyer's risk.
- Short repayment period: A seller-financing loan may be offered with a short term, such as five years, rather than a longer traditional term, such as 30 years. At the end of a short repayment period, you may be forced to refinance the loan if you cannot pay a potentially required balloon payment or complete the loan term as agreed.
Because of the increased risks of purchasing a home directly from the homeowner, buyers should hire an attorney, if possible, to make sure their rights are being upheld in a seller-financing agreement.
Does Seller Financing Affect Your Credit?
Payments made on a seller-financed loan may not show up on your credit report. Banks and other mortgage lenders normally report payment activity to credit bureaus, but a seller-lender might not. While this means an occasional late payment may not hurt your credit score, all your on-time payments won't help it as it would with a traditional mortgage.
To report activity to a credit bureau, a lender typically must operate as a business. If you're not sure whether your seller operates as such, you can ask them and also request that they report your payment activity to the credit bureaus if possible.
While a seller might not report payment activity to credit bureaus, negative marks still may end up on your credit report if you default on the seller-financed mortgage. If you fall behind on payments, the seller-lender may pursue a court judgment against you or may turn over your account to a debt collector. In both cases, those moves may be shared with credit bureaus and appear on your credit report, damaging your credit score.
Is Seller Financing Right for You?
Maybe you'd like to buy a home that costs a bit more than you can afford. Or perhaps you can't qualify for a traditional mortgage. In either case, seller financing may be an attractive option. You also may find seller financing is a good route if you can't come up with a big down payment, hope to score a low interest rate or want to avoid thousands of dollars in closing costs.
But those potential rewards must be balanced against the risks, such as onerous contract terms, the possibility of a higher-than-normal interest rate, needing to make a massive down payment, or being locked into a short repayment period.
Other Homebuying Options
Before you commit to a seller-financing agreement, do your research. Having little money for a down payment or a credit score that could use some work doesn't mean a mortgage is out of the question. In fact, certain programs help buyers who need a little extra assistance to purchase a home. Here are four alternatives to seller financing:
- Conventional mortgage: These mortgages are private loans, not government-backed loans. To qualify for a conventional mortgage, you typically must have a credit score of at least 620.
- FHA loan: An FHA loan, backed by the Federal Housing Administration, features lower credit score and down payment requirements than conventional mortgages do.
- VA loan: Guaranteed by the U.S. Department of Veterans Affairs, VA loans are available to military veterans, servicemembers and some military spouses. Benefits of VA loans include no down payment requirement (for qualified buyers) and no PMI.
- USDA loan: A USDA loan, guaranteed by the U.S. Department of Agriculture, is designed to make homebuying more affordable for low- to moderate-income consumers in rural and suburban areas.
The Bottom Line
Whether you choose seller financing or another mortgage option, be sure to obtain your free credit report and free credit score from Experian so you can ensure your finances are in the best condition possible to qualify for the best lending terms. If your credit needs work, take steps to improve it before starting the homebuying process. Whether or not you finance your new home through a seller, a good credit score could save you thousands of dollars over the life of the loan—especially if you end up going the more traditional mortgage route.
