Is a Seller Financed Mortgage a Good Idea?

No. Seller financing is a great way to end up in the poorhouse for both sellers and buyers. Buyers who need seller financing typically can’t qualify for a conventional mortgage because they’re not financially qualified.

As a result, you can expect borrowers to default in an owner financed deal more than 50% of the time. Keep in mind that when a borrower defaults, there will be massive costs associated for both parties. The borrower’s credit will be ruined and the seller will have to deal with a messy and costly eviction process.

Cons of an owner financed mortgage

Be prepared for the buyer to default on the loan

There’s a reason that banks won’t lend to a buyer who needs an owner financed mortgage. The buyer might not have enough saved for a standard down payment (i.e. let’s say 20% on a jumbo, non-conforming mortgage), though that wouldn’t necessarily be bad if the buyer has a sufficient and steady source of income.

However, it’s more likely that the buyer simply isn’t financially qualified even if he or she had the money for the down payment. More likely than not, the buyer simply doesn’t make enough income to sufficiently cover anticipated  housing expenses with an acceptable margin of safety.

For example, the maximum debt-to-income ratio allowed for a conforming loan is 43%, although banks may have some flexibility for non-conforming jumbo loans.

More likely than not, the buyer simply doesn’t qualify for a regular mortgage because he or she simply doesn’t make enough income to keep anticipated housing expenses under 40/50% of their total income.

As a result, if you agree to finance their purchase when banks won’t, you’ll be much more likely to be underwriting a non-creditworthy borrower who will more likely default on your loan than not.

Let’s be honest, why do you think you’ll do a better job of vetting a potential borrower than the underwriting department at a major bank?

So be prepared for a default, as we’ve heard statistics from lenders that owner financed mortgages have a default rate of approximately 60%.

Foreclosure and eviction can take months

Once the borrower inevitably defaults on your seller financed mortgage, you’ll have to spend an enormous amount of time, money and energy to actually foreclose on the property and evict the borrower.

Remember that it’s illegal in many states to try to evict a tenant without a court order and a sheriff to do it.

Borrowers who need a seller financed mortgage will typically default greater than 50% of the time. Pros, cons & tax implications of owner financed deals.

In fact, the foreclosure and eviction process varies greatly between states, and in states like New York with an enormous amount of tenant protections, the process can take many months and even years.

You may have to make significant repairs

Remember that during all of this time, you’ll be receiving zero rental income and the tenant most likely will be tearing the place apart. If you have a poorly written loan agreement, the tenant might even strip out all of your furnishings and appliances to sell for some extra pocket change.

As a result, once and if you’re finally able to recover your property and vacate the premises, you’ll most likely have to do quite a bit of renovation work to repair it back to its former condition.

Even if you don’t have the money to fully restore the property to prime condition, you’ll still most likely need to do some basic repairs to increase your chances of being able to market the property again for sale or rent.

You’ll have to try to sell all over again

This brings us to the last point, after all the stress and hassle of evicting the borrower and repairing your property, you’re back to square one with probably less money than you started with.

You’ll have to spend money to market the property once more, and pay a new real estate broker commission if you wish to try selling again.

Even if you give up and don’t try to sell again, given how high seller closing costs are in places like NYC, you’ll be lucky to break even despite getting some cash flow from the buyer’s 10% down payment.

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Benefits of a seller financed transaction

Despite how poor of an idea we believe agreeing to a seller financed deal is, there are some benefits as well as a few exceptions on when it might make sense.

When the bank won’t finance a property due to liens or violations

It might make a lot of sense for sellers to consider offering owner financing if they know that banks will be loathe to lend against their property.

The most common reasons are because of underlying issues with the property’s title, liens or judgments against the property, or local department of buildings violations.

For example, perhaps the owner installed a sauna illegally without getting the proper permits from the city, or has already gotten caught and been issued a violation noticed by the NYC Department of Buildings.

Either situation might make the home unfinanceable for most traditional lenders, which means the owner stepping in might be a great idea if it’ll expand the universe of potential buyers.

Keep in mind that contracts usually stipulate that properties are to be delivered free and clear of title and any violations, liens or judgments. Therefore, some explaining and negotiation will be necessary if you wish for a buyer to purchase it anyway.

Sellers expand the range of possible buyers for their home

Besides greatly expanding the possible range of buyers from being able to offer financing if banks won’t lend, the range of buyers expands even if banks will lend.

That’s because some buyers won’t qualify for a mortgage from a traditional bank lender, perhaps because they don’t meet a variety of financial requirements such as post-closing liquidity (i.e. banks typically require 6 months, while co-op boards can require up to 1 or 2 years worth), minimum down payment, or debt-to-income ratio.

A great example is a high income buyer who works at Google. Let’s say he’s a talented software programmer who makes $2,000,000 a year with the title of Principal Engineer (i.e. one of the highest ranks for an engineer at Google).

However, for some reason he doesn’t have a lot of savings, even though he makes a ton of income and clearly has job security. Let’s say this buyer can only put down 10% and won’t have any post-closing liquidity.

Would it make sense for the seller to finance his purchase if banks won’t lend to him? Of course it would!

Sellers can cash out by selling their loan to an investor

Don’t forget that just because you extend seller financing to a buyer doesn’t mean you can’t still cash out. In fact, there are plenty of investors out there who are willing to purchase mortgages and promissory notes on the secondary market.

Of course, you’ll have to keep in mind that you’ll most likely be taking a haircut from the face value of the loan if you do sell to an investor. The secondary market for one-off mortgages like this isn’t exactly liquid, and investors will be looking to make a nice return for the additional risk involved.

You can expect to receive offers for anywhere between 60% to 90% of the principal value of the loan from an investor.

Easy underwriting process and faster closing

An often understated benefit of seller financing is the significantly faster contract to closing process, which may help you seal the deal with a buyer.

You won’t have to wait around for the bank’s conservative mortgage underwriting department to jump through its hoops and approval processes.

You can perform your own, expedited version of underwriting to make sure you’re comfortable with the risks involved, and as a result you can choose a closing date significantly sooner.

Shorter loan terms can be structured

Sellers do not need to grant a long term mortgage like a traditional 30 year, fixed rate mortgage. In fact, sellers can structure the note to be more of a bridge loan to more conventional financing.

For example, sellers might structure a five or seven year note with a balloon payment at the end of the term, with the understanding that the buyer intends to secure a traditional mortgage by that time.

Sellers can earn a higher return vs banks

Sellers can typically expect to earn a percentage point or two more than the market rate for traditional mortgages due to the irregularity and additional risk involved.

Of course, all of this is negotiable, but on average and typically given the lack of options by the buyer, the seller is able to get away with charging a higher interest rate than a conventional mortgage of the same tenor.

Does seller financing count as an installment sale?

Yes, a deal where the seller provides owner financing to the buyer can be counted as an installment sale, which can lead to favorable capital gains treatment.

This can be quite useful to sellers who do not qualify or are over the limit for certain tax benefits associated with real estate sales, such as the 1031 exchange for investors or IRC Section 121 for primary residences.

For example, an investor trying to sell a rental property may have missed the window to qualify for a 1031 exchange, and would therefore be subject to regular capital gains taxes.

In order to minimize those taxes, the investor could spread out the gains over a greater number of years via an installment sale, and therefore also qualify for a lower tax bracket each year.

A home owner trying to sell a primary residence can benefit as well if he or she doesn’t qualify for IRC Section 121.

For example, this tax exemption for primary residence sales exempts up to $500,000 of capital gains for married filers, and $250,000 for single filers. However, what if the amount of capital gains will be significantly over the limit? In that case, it might make quite a bit of financial sense to defer those capital gains over more years via an installment sale.

Another requirement of IRC Section 121 is that the home owner must have lived in the home for at least 2 out of the past 5 years. What if the owner moved a few years ago and no longer qualifies? An installment sale once again might help reduce the seller’s capital tax burden by spreading gains over more years.

You can learn more about the taxes related to buying and selling property in this white paper on NYC real estate taxes on our blog.

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Disclosure: Hauseit® and its affiliates do not provide tax, legal, financial or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, financial or accounting advice. No representation, guarantee or warranty of any kind is made regarding the completeness or accuracy of information provided. Hauseit LLC is a Licensed Real Estate Broker, licensed to do business in New York under license number 10991232340. Principal Office: 148 Lafayette Street, New York, NY 10013.

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