When it comes to purchasing properties, there are only so many ways you can do it. Obviously, you can buy a house in cash, or take out a loan from a bank. However, when you don't have enough money to purchase a house in cash, and can't (or don't want to) qualify for a bank loan, there is another, lesser known way to purchase real estate.
While real estate investors often refer to this type of transaction as "Creative Financing" it's actually one of the oldest types of financing there is. Voluntary Exchange is a pillar of capitalism, and has been happening for thousands of years. While today we'll be discussing seller financing in regards to real estate, but keep in the back of your mind that this can be used to sell, or purchase, just about anything. I've purchased real estate, cars, and existing businesses all with different variations of seller financing.
1. Seller Financing - What is it?
Seller Financing, also known as Owner Financing, is when you make an agreement with the seller of a piece of property to make them payments over a set period of time in order to buy their property. Essentially, the owner of the house is giving you a loan... to purchase their home.
For example: You find a home you like and the owner of that home agrees to sell it to you for $100,000. Instead of giving him $100,000 in cash, or getting a loan from the bank, the seller agrees to let you put $5,000 down (Give him $5,000 now) and pay him $1,000/ month for the next eight years... plus interest of course. In this type of situation, the owner is playing the role of a bank for you. They are extending your credit, and allowing you to pay back that credit over time.
2. Seller Financing - Why would you want it?
All wealthy people in the world understand that while the cost of borrowing money is low,(interest rates are low) leveraging your money (financing things) will provide you substantially higher returns on your money than purchasing anything in cash would.
That being said, getting bank financing can be really tedious, not to mention, difficult. There are a million things that could kill your ability to get a loan from a bank. Bad appraisals, low income, poor credit, or condition of the property in question. Even when all your ducks are in a row, getting bank financing still requires quite a bit of time, and lots of documentation. When applying for a bank loan, all the terms are set for you. They want large down payments, and you don't get much of a say regarding the interest rate. It's always been their way or the highway.
When you negotiate a seller financing transaction, everything is an agreement between you and the seller. You will still need contracts and good paper between you of course, but as a rule of thumb, every aspect of the transaction is negotiable between the two of you. You don't need an appraisal unless you want one. You often don't even need to run a credit check. It's truly up to you and the seller. Furthermore, you can negotiate and tailor every term of your contract. For example, the going interest for a bank loan might be 6%, while you and the seller agree that a 4% interest rate is fair. Don't have the $25,000 to put down on the bank loan? Maybe the owner will agree to let you put down only $5,000 instead. You get the idea.
There's one more silver lining here. When you're buying or selling with seller financing, transactions can happen FAST. I have negotiated a contract this way, and closed on it the very next day. Although I definitely recommend that both sides always take the time they need to conduct proper due diligence, the fact of the matter is that unlike conventional bank financing, there are no 30 - 45 day waiting periods. You can close whenever you're ready to.
3. Seller Financing - What are the drawbacks?
While you can take different precautions to mitigate many of these drawbacks as you become more sophisticated, it's still important to know what to watch out for. Many times the seller will still have a loan on the property that they're selling to you. This is normally not a problem because you're purchasing the property for an amount that is higher than what they owe on their loan. AKA, you make a payment to the seller of $1,000 a month, and the seller makes a payment of $500/month to the bank they owe. Easy. However, if the seller doesn't actually make that payment, the bank could take the property, and you'll be the one who loses. The easiest way to make sure this doesn't happen is to use a 3rd party escrow service that will make both payments before either party gets any money. Guaranteeing the payments get made... as long as you make your payment on time that is.
Whenever the seller has a loan on the building that they're selling to you, there may be a due on sale clause within their loan. This means that when the property is sold or transferred to you, that the seller is technically supposed to pay off whatever they still owe to the bank. Since you're hopefully not putting much down, this isn't likely to happen. This means there is always a chance that the bank may choose to call the note due. It's extremely rare, and not very likely. If a bank calls the note due you can sell the property, you can refinance it, or you can pay off the loan yourself. You can also choose to only purchase properties that have no underlying loan on them, and avoid this risk completely.
Seller Financing - Can you give me an example?
Sure.
You're long time neighbor, Bill decides they're ready to move to Florida, and doesn't want to deal with managing a rental property from across the country. He doesn't want to deal with trying to sell his house on the market or paying capital gains tax right away, so instead, he agrees to carry a note on the house and sell it to you on seller financing.
Because he knows you, he is going to save money by paying nothing in real estate commissions. ($6,000 in this situation)
Bill knows you don't have a ton of money saved up, so he agrees to allow you to put only $1,000 down on the house in exchange for a higher interest rate (5%) and a purchase price of $100,000. He's willing to carry the note for 10 years but give you a amortization of 30 years.
The house can rent for $1,200/month. Here is how it shakes out.
Here are the terms:
Purchase Price: $100,000
Down Payment: $1,000
Interest Rate: 5%
Amortization: 30 years
Term: 10 years
Insurance: $200
Property Taxes: $1,200
Balloon: $79,000
Here's what they mean:
Each month you're going to have to make Bill a payment in the amount of $648.12. That includes the cost of your property taxes and insurance. Each month you're going to collect rent in the amount of $1,200.
That means each month you're going to profit $551.88. You'll get back the $1,000 you put into the property in just two months.
At the end of the term, you'll need to pay whatever you still owe on the loan to bill. In this scenario, at the end of 10 years, you'll still owe $79,000 on the loan. Before the 10 years is up, you'll need to sell, refinance, or otherwise pay off your loan to bill.
If the value of your property increases by the national average (3% compounded yearly) each year (Let's just say 30% to keep the math easy. It's actually more than that.) that means the new value of your property is $130,000.
When you sell that property, you'll make the $30,000 in appreciation, plus the $21,000 your tenants paid off the mortgage for you, for a total of $51,000.
You'll also have made $66,225.60 in net rents... assuming that you never raised your rents.
That's a total of $117,225.60 in created value. A really fantastic return on $1,000.
Almost every seller finance transaction I have ever done has been with less than $10,000 invested. Meaning that the ROI (Return on Investment) is just absolutely phenomenal if you negotiate things correctly.
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