The Definitive Guide to Using Seller Financing to Buy Real Estate
One of the most popular methods of using low or no money down when investing in real estate is using “seller financing.” Perhaps one of the oldest of financing methods we talk about here on BiggerPockets, seller financing seems to have become less and less popular in recent years largely for reasons we will look at in this section. However, knowing how to effectively use seller financing in your business can help you get more deals done, faster, for less money so don simply toss the idea of seller financing out the window. This post is going to show you exactly what seller financing is, how you can get use it in your investing business, and the dangers to look out for.
What is Seller Financing
Seller financing is just what it sounds like: the seller provides the financing. In other words, the owner of the property acts as the bank and, although legal ownership is changed hands, the payment is sent directly to the previous owner rather than a bank.
I want to purchase a particular rental house but do not want, or lack the ability, to get traditional bank financing. The seller would like $100,000 for the property, but is willing to “carry the contract” which is investor jargon for someone who agrees to finance a property they own. The owner asks for $5,000 down and a 7% interest rate on the remaining $95,000 amortized over 30 years for a monthly payment of $632.03. I agree to his terms and after doing my due diligence, I close on the property through my local title company. I then look for a tenant who rents the home for $1400 per month and collect the cash flow difference each month.
In the scenario above, the seller gets a good, fixed interest rate on their money, I get to buy the house for just $5,000 down, and I don’t have to deal with a bank at all. Seller financing can be another great win win for all parties involved. But what’s the catch? Why aren’t these more popular?
Why Doesn Everyone Buy with Seller Financing?
There is one major problem with seller financing that puts a wrench in the whole strategy: the “due on sale clause.” The on sale clause is a legal part of nearly every mortgage that gives the bank the right to demand that the loan be paid back, in full, immediately if the property is sold (hence the name “due on sale.”)
So you can see the problem with seller financing: the property is being sold, so it doesn work real well when you have an existing mortgage on the property. In other words, if you have a mortgage on a property, and you sell it using seller financing, then the bank could come to you and demand to be paid back right now or foreclose on you.
Well, remember that the “due on sale clause” gives the bank the RIGHT to demand full payment, it doesn’t require the bank to do so. The bank may be perfectly fine with the arrangement tommy hilfiger uk and never say a word or they may never find out. However, the risk you carry is great any time you sell a property with a due on sale clause. When I invest in real estate, I want to decrease the amount of risk I am taking, so I personally don’t flirt with the due on sale clause. So how do I use seller financing?
So how do you get around the Due on Sale Clause?
As I mentioned above, the danger of using seller financing when the seller already has a mortgage is that it may trigger the “due on sale clause.” If this happens, and you can’t pay the bank back the entire loan balance, the property may be foreclosed on. If you are buying from a homeowner, the homeowner may get foreclosed on and both of you would lose the property. Obviously this is not a situation you want to find yourself in, so there is one simple solution:
Only use seller financing when the home is owned free and clear.(There are some exceptions, which we will cover later.)
In other words, if the owner of the home currently has a mortgage on the property, don’t use seller financing to buy it from them unless you pay off the existing loan first. Your goal when buying using seller financing is to find sellers who don’t have a mortgage. This way, they can provide the financing without the risk of them being foreclosed upon.
The Benefits of Using Seller Financing
There can be numerous benefits to using seller financing, so let’s take a look at a few of the most common:
Ease of Financing: As mentioned earlier, when you use pure seller financing to purchase a property, you avoid the need to use a bank which can mean the difference between a deal and no deal for many people. If you are “tapped out” on the number of mortgages you can get, seller financing can be a great tool in your toolbox to obtain additional rental property.
Possible No or Low Down Payments: Because you are dealing directly with a homeowner seller, there are no “cut and dry” rules when it comes to the down payment. You aren’t dealing with rigid rules from Fannie Mae or Freddie Mac which require 20% 30% down on an investment property. Instead, you get what you negotiate with the seller. The seller may want nothing down, or they may want 50% you won’t know until you ask and negotiate.
Option for Creativity in Structuring the Deal: As I mentioned above the rules when dealing with banks can be extremely rigid but not so with seller financing. Seller financing gives you the ability to get creative to solve a problem. Rate, term, payment amount, payment dates, and everything else is completel tommy hilfiger uk y negotiable, which can turn a mediocre deal into a great deal. I known investors to negotiate a 0% seller financing situation with the seller talk about being creative!
Purchase “Un Financable” Properties: Sometimes, the condition of a property may be too poor to use traditional financing. In these cases, seller financing can give the buyer a chance to own the property, begin fixing it up, and possibly refinance into a more traditional form of financing later on.
Doesn’t Show On Your Credit Report: Unless the seller of the home signs up with one of the credit reporting agencies to report the debt (very unlikely) chances are tommy hilfiger uk your seller financed deal will not end up on your credit report, which can make it easier to obtain other loans and mortgages in the future.
There are no doubt numerous other reasons why you may want to use seller financing, so don’t be afraid to seek out opportunities where you can use it. It truly can be a great way to finance properties of any size. However, if it’s so good for the buyer are there also good reasons for a seller to agree to it?
Why Would Sellers Sell Via Seller Financing? (Say that Five Times Fast!)
If I gave you the choice of getting $100 today or $1 per month for the next 30 years, which would you take?
Most of you would want the $100 right now, but if you do the math $1 per month for 30 years is $360, which is more than 3x more than the lump sum! How about now? Did you change your mind? Doubtful. Chances are you still would want the $100.00 because of your current position in life you would rather have $100 now than $360 spread out over many years. However, others may choose to take the $1 per month, because they don need the cash now and would rather have the security of a monthly dollar.
The same principle is true for home sellers. If a home owner owns their home free and clear, many of them would rather just get the cash and move on. However, for a large number of sellers, the value of getting monthly payments outweighs the need for a large check. Let’s take a closer look at why owners would choose to sell via seller financing as opposed to just getting cashed out.
Monthly Income: Perhaps the most common reason sellers would prefer to sell via seller financing is to get monthly income. Just like in the example I used above, with the $100 or $1 per month there are a lot of individuals who would simply prefer to get steady checks each month instead of one lump sum. This is especially true for older sellers, who need monthly income to survive and pay the bills. A $100,000 chunk of money would only last so long for an older seller, but if that income is financed over 30 years, the money will last them a lot further into retirement.
Better ROI: Many homeowners and investors choose to sell with seller financing because the interest they get from the financing is greater than they will likely get elsewhere. For example, if the homeowner were to sell a home for $100,000, they could put that money into a Certificate of Deposit at the bank to get 1.5% APY or they could seller finance their home and get 8%. Which is better?Many seasoned real estate investors understand this concept and eventually move their portfolio from a “holding” phase to a “selling phase” where they use seller financing to unload the hassle of being an owner but still collect monthly income by carrying the contract and providing seller financing. At that point, the investor leaves the business and enters the buying business. For more tips on buying and selling notes, check out Five Advantages of Note Investing.
Spread Out Taxes: Anytime you make money the government wants it’s share, and when you sell real estate it’s no different. For example, if an investor spends 30 years paying off a rental property mortgage, and now owns the home free and clear and decides to sell the property for $100,000 the investor would need to pay taxes on that $10 tommy hilfiger uk 0,000, which could result in a nearly $50,000 tax bill. Additionally, the investor will also need to pay a “recapture of depreciation” tax that could add much more to that tax bill.
Therefore, many investors choose to seller using seller financing rather than getting a lump sum, in order to defer most of those tax payments. You see, the IRS has special tax rules for installment sales, such as using seller financing, so the seller may only need to pay a small portion of that tax bill each year while the loan is being paid off.