The Pros And Cons Of Seller Financing - Part 1

A Google search for “pros and cons of seller financing” will produce many results. How much of what you read is accurate? How much is helpful? It depends who is doing the writing, and who is doing the reading. Even if it is good advice, does it apply to you? In this article I will help you move past some of this confusion.
As an aside before starting, if you look at enough material on this topic, you will find some statements repeated, or stated in similar words. Whether to compliment or criticize, I will avoid direct quotes. From a copyright standpoint, much is industry knowledge. Keep in mind that owner financing is synonymous with seller financing.
What Is A Loan?
Depending on the user, there may be some variation, but the first definition from Funk & Wagnalls is “something lent, especially a sum of money lent at interest.”[2] So what is the common mistake that you will find knowledgeable people say about seller financing over and over again. Something like “seller financing helps a buyer complete the real estate transaction by lending part of the money for it." No it doesn't.
So if you are a property seller, don't worry. You won't be handing over money to the buyer. And if you are the buyer, sorry to disappoint you, but you won't be receiving money to purchase anything.
Isn't that the key to a loan? Someone lends money to you so you can buy a car, boat, house or something else.
Part of the confusion comes from common language. It's easier to talk about owner financing by using the word loan than without it. What really happens is the seller in most cases receives a down payment, and receives the remainder of the sales price in periodic payments. Often these are monthly payments. The jargon refers to it as “takes back a mortgage.” Or “owner carry back financing.” But the seller is not giving money (a loan) to the buyer in order to purchase the property. The seller is financing the purchase and accepting a series of payments instead of receiving a lump sum payment from a bank mortgage, or some other source.
Flexibility
For both seller and buyer, seller financing offers flexibility. This applies in many ways. Other articles on this topic give examples which demonstrate the flexibility without actually acknowledging it. Then they say something which sounds like it's set in stone. It might be if you were dealing with a bank. And the typical person is more familiar dealing with a bank, than arranging seller financing. So you might be convinced that there is only one way … Actually in seller financing most terms of sale offer flexibility. If the buyer and seller come to an agreement, an experienced real estate attorney probably can put the terms in writing.
On the other hand, some of the other advice on seller financing may use such words as require, catastrophic and unremarkable. Once again flexibility will often offer options to catastrophic. Unremarkable for one buyer might be a great deal for another. And if a promissory note is a standard legal document used in the sale of most real estate, don't get confused that it's required because of seller financing. Plus the flexibility I've referred to includes the construction of the promissory note. So always remember to negotiate.
Selling A Property As Is
Other viewpoints suggest that seller financing makes it easier to sell a home as is. To sell a property, whether a home a or a commercial property, as is, means that the property is sold in its existing condition without improvements. Whether a seller does a little work or clean-up first, will vary from one person to another. The particular circumstances will have a definite bearing, probably more than someone's personality.
There is a distinction here between the work involved to sell the property, and the legal term “as is” in a contract of sale. So whether the seller does some or no work to the property first, if the contract stipulates “as is,” according to the FindLaw Legal Dictionary:[3]
- An as is clause is a clause in an agreement providing that the buyer accepts the item for sale in its presently existing condition without modification or repair. NOTE: Under Uniform Commercial Code section 2-316, an as is clause releases the seller from responsibility for the quality of the item for sale.
Separate from the legal aspect, is it really easier to sell a property as is with seller financing? I mentioned that circumstances will have a bearing. Some real estate investors look for the opportunity to purchase a property for rehab, as is. Seller financing may not matter to them if they have other funds to purchase with. These investors are willing to buy properties in poor condition that most other people wouldn't. And because they are willing to deal with a contract that stipulates “as is,” they expect to buy it cheap. They may also like to get seller financing, but it may not matter. Or the seller may require a higher price because of the seller financing, and the investor won't be willing to pay it.
What about the sale of a house from one owner-occupant to another? One viewpoint suggests that preparing the house for sale could be a big deal, taking time and money, and one that could be avoided by offering seller financing. That may be true. But for the typical home seller how bad of shape is their home? If it's in really bad shape that's not typical. Otherwise, whether or not represented by a real estate agent, they probably will receive advice to prepare the property for sale. Of course that's usually a good idea.
Another opinion went further by suggesting that the seller offering owner financing, will make more money on the transaction by avoiding the preparation expenses. More often than not, it will be just the opposite. If you are a homeowner, do your homework to make wise choices on preparation expenses. Real estate investors usually have a good feel for this, and they use different approaches whether or not they are offering seller financing.
Commercial property owners have their own arena. They definitely use seller financing, especially when selling a business. In that case from the perspective of the note business, it's more ideal to use two notes, one for the business and another for the property. Each scenario can vary widely. A commercial property in its current state is best used for the current type of business. So how well it will transfer to a different use, and the level of market interest, will determine the extent necessary to prepare the property for sale. Using the “as is” clause will be more appropriate where a major rehab is necessary.
Financial Benefits For The Buyer
Higher sales price. One basic idea in negotiating a real estate deal is “price or terms.” This means that if you offer favorable terms, you should get a higher price. If you reduce the price, you should get better terms. Of course there are many other factors that impact price and terms, and the mixture will vary deal by deal. Market timing can certainly change some of the typical results. But a more lenient approach to a buyer with limited financing options tends to lead to a higher sales price. The seller offering owner financing also tends to get favorable terms, all things considered.
Higher interest rate. The marketplace for seller financing has tended to produce higher interest rates than conventional bank financing. Seller financed buyers are often not meeting the requirements that correspond to lower interest rates. While these buyers may be fine debtors, they're still in an area of finance considered subprime. Note investors will expect higher interest rates on the notes they buy. Two to four percent above the prevailing rate for conforming bank loans is common. For notes with interest rates lower than expected for the risk involved, note investors will apply a higher discount in order to purchase those notes.
Monthly income. Assuming monthly payments as part of seller financing, you will receive a new source of income. For a lot of people the higher interest rate will produce a higher rate of return than other investments. This source of cash flow is also an asset that you probably will be able to sell at some point of your choosing. A partial sale is an option that allows seller financing to produce both monthly income and a lump sum of cash, in addition to the down payment.
Tax benefits. For tax purposes, seller financing is referred to as an Installment Sale. This allows you to pay taxes on your profit as you receive it, which is spread out over time. An installment sale can be used in conjunction with a 1031 Tax Deferred Exchange for additional tax benefits. For more information please refer to my article What Are The Tax Implications Of Seller Financing?
Other Pros And Cons
“No bank fees or appraisal costs.” Yes closing costs will be less than with a bank. But seller financing does not rule out a bank for part of the purchase funds. Either way, is it really a good idea to buy and sell property without an appraisal? Usually not. Further, if the owner providing seller financing wants to sell the note or part of it, a note investor will prefer a deal where the value was determined by an appraisal. At least a drive-by appraisal or broker price opinion will be used for an update. But a full appraisal at the time the property is sold, will provide the note investor with more confidence in the offer they make to purchase the note.
“Needs seller approval” has been referred to as a con. Is it possible that the Dodd-Frank Wall Street Reform and Consumer Protection Act was referenced in the same article? Is it actually a con that someone has to approve the sale? Normally it will be easier to get approval for seller financing than bank financing. But of course the seller has to approve the transaction, and should take steps to qualify the purchaser for seller financing.
If the Dodd-Frank Act applies to you, then this rule may apply to you: “The seller determines in good faith and documents that the buyer has a reasonable ability to repay the loan.”[4] To get a better clue you might start with this PDF Flowchart on my website.
“Pros and Cons Lists.” I you are in a hurry, be careful if you read a list of pros and cons without any explanation. The article itself might have some helpful information on the topic. But if you just read the basic list taken out of context, you may make some faulty assumptions.
Seller Financing Drawbacks
Looking at other articles that list the cons of seller financing, I think of those cons more like drawbacks. Even that might be harsh. Much of this is a matter of opinion. Part of the issue here is how much do you consider work a con? And given your circumstances along with the potential benefits of seller financing, what should you expect?
If you are a real estate investor who offers seller financing, it can be a great tool. Being a real estate investor doesn't guarantee that your business will be profitable, just like any other. And seller financing could produce a series of problems. Some of those will be due to bad luck, others to poor business choices. Yet if those investors can hang in there, what is a con for a one time home seller using owner financing, can be an opportunity for the investor.
For the home owner, selling their residence can be a lot of work even when things go well. While the seller can hire a real estate agent and also offer seller financing, often seller financing is offered in conjunction with a “for sale by owner.” If that is you, then you should be properly prepared for the entire process including the ups and downs.
Perhaps you have inherited the property. This could be good news or bad news. Seller financing might be the ideal tool for your circumstances.
If you choose to offer seller financing you should be aware of these potential drawbacks referred to as cons by other websites:
Monthly or regular need to keep track of payments. I hope you don't feel too sorry for yourself about this. The recommended approach by those who do this seriously is to hire a loan servicing company. Possible services include collecting payments, depositing funds wherever you direct, providing monthly statements and year-end financial accounting required for the IRS, online access to your account and managing escrow accounts. Here are two companies that provide such services:
Besides being a worthwhile service while you own the note, it will make it easier to document payment history if you try to sell a note. A documented payment history is important to note investors.
Possible need to foreclose. Proper due diligence will minimize the risk of foreclosure. Keep in mind that most banks that provide mortgages operate very profitable businesses, despite dealing with foreclosures. If you need to foreclose hire a well qualified attorney.
Need to pay off existing mortgage in full. If you have an existing mortgage on your property, at some point you will pay it off whether or not you ever provide seller financing.
Most mortgages have a due on sale clause. This clause gives the lender the right, but not the obligation, to ask for payment in full upon the sale or transfer of the property securing the mortgage.
There are other relevant considerations on this matter, but the point I'm making here is simple. Of course the mortgage is supposed to be paid in full at some point in time. So this issue is not a con just because someone provides seller financing.
Before taking any pros or cons too seriously, take some time and figure out what works for you.
I think that my comment above gets at the heart of the pros and cons of seller financing. Most sellers won't be interested in seller financing. When selling a business, that is often the case. Yet most small businesses are sold with some amount of seller financing. For residential property seller financing is a tool that may provide you with really helpful options. So be willing to spend some time learning about it. Your circumstances will dictate what's good for you.
References
- Photo by Q K from Pixabay
- Funk & Wagnalls Standard Dictionary, 1966
- Source: Merriam-Webster's Dictionary of Law ©1996. Merriam-Webster, Incorporated. Published under license with Merriam-Webster, Incorporated.
- Ability-to-Repay/Qualified Mortgage Rule