How Seller Financing Works: Benefits and Risks for Buyers and Sellers

Understand the Pros and Cons of Seller Financing Your Home

Seller financing is an alternative to a traditional mortgage loan. Instead of the buyer applying for a mortgage to pay for a home, the seller helps the buyer purchase the property.

There are different methods of seller financing, including the buyer paying the seller directly each month or the buyer assuming the seller's mortgage.

There can be significant benefits for both buyers and sellers with these arrangements, but also big downsides. 

This guide explains how seller financing works, as well as the pros and cons, so you can make an informed choice about financing your home.

What Is Seller Financing?

In most home sales, buyers get a mortgage from traditional mortgage lenders, including financial institutions like banks, credit unions, or online lenders. The buyer uses the money to pay the seller, and there is no further involvement between the buyer and seller after closing.

Seller financing works differently because sellers play an instrumental role in helping the buyer purchase the property, either by transferring their own mortgage to the buyer or under some type of arrangement (such as a land contract) where the seller collects payments from the buyer over time. Seller financing is also called owner financing or a purchase-money mortgage. 

Sellers may help buyers fund the purchase because it gives them access to a wider pool of buyers and makes it easier to close the sale. Additionally, buyers can sometimes get more favorable terms or qualify for a mortgage when they otherwise couldn't. 

How Does Seller Financing Work?

When someone who is selling a house is willing to offer financing, they typically advertise this in the listing as a selling feature or a benefit to the buyer. Buyers interested in an alternative to traditional financing may be more interested in looking at homes advertised as having seller financing. 

When a buyer makes an offer in a seller-financed transaction, the buyer and seller negotiate on all typical terms like the purchase price of the home. But they also must agree on how the seller will help the buyer finance the home. Some of the terms of a seller financing agreement may include:

• The method of seller financing, such as the seller acting as a mortgage lender; transferring an assumable mortgage to the buyer; the buyer entering into a rent-to-own arrangement, or the buyer and seller co-owning the home with the buyer making payments to the seller over an agreed-upon amount of time.
• The down payment the buyer makes.
• The interest rate on a loan, if applicable. This may be negotiated between the buyer and seller if the seller is acting as a traditional mortgage lender, or it may be the rate on the seller's existing mortgage that the buyer assumes.
• The repayment period. This is the period of time the buyer makes payments to the seller under a rent-to-own arrangement, co-ownership arrangement, land contract, or any arrangement where the seller acts as the lender.  

Once the buyer and seller have agreed on all terms, they close on the sale. In addition to the normal closing paperwork, the buyer may need to sign a promissory note promising to pay the seller as agreed. The seller may also remain the owner on the deed until the buyer has completed all of their payments. 

Seller Financing Example

It can be helpful to look at an example of seller financing to understand what this type of arrangement could look like.  Here's how this process could work:

• Sarah wants  to purchase a home from Joe but can't qualify for a traditional mortgage. 
• Joe agrees to finance the home at 7.00% (slightly higher than the market rate because of the added risk for the seller). 
• Joe agrees to allow Sarah to make payments for him for five years, after which time Sarah will have a balloon payment due for the remaining balance on the loan. 
• Joe may require Sarah to make a down payment to protect his interests. 
• Sarah makes her down payment and makes payments to Joe over the next five years at the agreed upon rate. Payment amounts could be calculated based on how much they would be if Sarah paid off the loan over 30 years (aka using a standard amortization schedule). However, Sarah would owe the entire remaining balance due in a balloon payment at the end of five years. 

This is just one of many ways that a seller-financed home loan could work. Since buyers and sellers are negotiating this arrangement between themselves, there is always a lot of flexibility in setting the terms. 

Pros and Cons of Seller Financing

It is important to understand the pros and cons of seller financing in real estate so you can decide if this approach is right for you. It's also worth noting that you can minimize the risks and mitigate some of the downsides by working with a professional real estate attorney. 

Benefits and Risks for Homebuyers

Here are some of the biggest benefits and disadvantages of seller financing for home buyers.

Benefits and Risks for Sellers

Here are some of the biggest risks for sellers. 

Common Types of Seller Financing Agreements

Seller financing takes different forms, depending on the preferences of the buyer and seller and the financial situations of each party to the deal.  Here are some of the most common approaches.

Assumable Mortgage

Some mortgages, including Federal Housing Administration (FHA), Veterans Affairs (VA), and U.S. Department of Agriculture (USDA) loans, can be assumed by a home buyer. This means the buyer takes over the existing mortgage the seller holds.

Assumable mortgages can be very valuable, especially as mortgage rates have increased in the post-pandemic era. Some older mortgages have rates well below those available today. 

However, not all mortgages are assumable (conventional loans typically aren't) and the buyer must be able to pay the seller the difference between the purchase price of the home and the remaining mortgage balance. For example, if the purchase price is $400,000 and the seller's remaining mortgage balance is $200,000, the buyer would need to pay the seller $200,000 on top of assuming the mortgage loan. 

Land Contract

A land contract agreement allows the buyer to make payments directly to the owner of the home that's for sale. The buyer makes payments until the seller has collected the full purchase price. Until that time, the seller usually keeps the title to the property. 

Land contracts typically allow the buyer to pay the seller for a few years, then require a balloon payment at the end of the repayment period. It's up to the buyer and seller to determine how long the repayment period is and how large the balloon payment will be. 

This is risky for buyers because they are essentially renting until they make the large balloon payment and take title to the home.

Lease Option

Buyers and sellers can enter into a lease option if they are interested in a rent-to-own arrangement. With this arrangement, buyers pay rent to the homeowner and pay an additional option fee that allows them to buy the home at a set price after making a certain number of rental payments.

Typically, some part of the rent payment is dedicated to helping the buyer gain equity in the home. The rent essentially can serve as the down payment if they decide to buy the house. 

Unfortunately, if the buyer doesn't move forward with the sale, they'll lose the option fee and the extra rent they paid that was going toward building equity.

Wraparound Mortgage

A wraparound mortgage is an option when the seller has a mortgage but still wants to offer seller financing to help a buyer purchase the home.

Buyers will pay the seller an amount larger than the seller's own monthly mortgage payment, and some of this money is used for the seller's mortgage. The wraparound mortgage covers the amount paid to the seller, plus an added amount to cover the new purchase price.

Mortgage lenders don't always allow this, and lenders that do may include a due-on-sale clause requiring full payment of the mortgage if the property is sold or ownership is transferred.

Seller Financing FAQs

Still need to know more? Here are some additional details about how seller financing works.

How Can You Find Seller-Financed Homes?

Seller-financed homes can be more difficult to find because there is an added risk to sellers. You can find homes offering seller financing by networking with investors, checking rental listings for rent-to-own offers, searching the MLS with the relevant keywords, or marketing to sellers directly.

Do All Seller-Financed Homes Require a Down Payment?

Seller-financed homes usually require a down payment to protect the seller and make sure the buyer has a stake in the property.

However, one of the benefits of seller financed homes is that the buyer and seller can negotiate the terms of the transaction in a way that makes sense for them. So, it is possible you could enter into a seller-financing agreement with no down payment required if the seller agrees. 

Who Holds the Title in Seller Financing?

The specifics of who holds the title and deed in a seller-financing transaction vary depending on how the seller financing is structured. Often, the seller will hold property title, and the deed will have the seller's name on it (until the seller has been paid the full amount for the home).

Final Thoughts: Is Seller Financing a Good Idea?

While seller-financed transactions have some advantages, they aren't nearly as common as using a traditional mortgage to purchase a home. There's a good reason for that. 

Seller-financed transactions are often more complicated and they can expose buyers and sellers to more risk. More importantly, they are possible only when sellers can afford to wait a long time to be paid the full purchase price of a home.

If you are buying a property, you should carefully consider whether a seller-financed transaction makes sense or whether you would be better off with a regular loan. Freedom Mortgage can help you explore loan options and get pre-qualified for a loan that saves you money and comes without the added complications that seller financing can bring.