You may have recently found yourself wanting to get into the rental property business, only to find out you cannot qualify for a traditional mortgage.
Perhaps you have poor credit, not enough saved up for the typical 20% down payment required on investment properties, or maybe you have a previous foreclosure or short sale on your record that won’t allow you to qualify for a loan.
Whatever the case may be, know that there are several creative ways to finance a rental property catering to those in situations such as yours.
In fact, one of the best ways you can become a rental property owner, without following the orthodox mortgage route, is to opt for seller financing.
Though not for everyone, seller financing offers prospective property owners a unique way of financing rental property, if done the right way.
If this sounds like something you might be interested in, keep reading to find out exactly what seller financing is, and what the pros and cons to seller financing brings to the process of investing in real estate.
What is Seller Financing?
Seller financing is exactly what it sounds like – the seller of a piece of property provides the financing to an interested buyer of the property.
Used as a way for sellers to help buyers purchase their property, seller financing assigns the role of “bank” to the seller. From there, the buyer will make agreed upon payments directly to the seller of the property until the mortgage has been satisfied.
Banks must follow a whole host of rules and regulations when it comes to approving someone for a loan to purchase a rental property. However, when it comes to seller financing, the bank is not involved, and the seller and buyer can negotiate their own terms so the deal can close.
Seller financing agreements are usually constructed as a promissory note that includes the interest rate, repayment schedule, and default consequences.
That said, some experts in seller financing make the point that since these agreements are not bound by the rules and regulations the banks hold you to, the terms of the agreement can be adjusted for the benefit of both seller and buyer.
For example, consider the following unorthodox terms:
- The buyer offers a 10% down payment this year, with a fixed repayment schedule for the year, and another 10% down payment next year, with the promise to continue the repayment schedule until the mortgage is satisfied
- The seller accepts a mortgage repayment schedule with zero interest with the agreement that the purchase price will exceed the going market price
- The repayment schedule will last anywhere from 3-30 years, depending on how much the mortgage is for, what the interest rate is, and what the overall goals of both parties are
- A no recourse clause is included in the agreement meaning the seller cannot go after the buyer in the case the buyer cannot fulfill his repayment obligations
As you can see, these are just some examples of how both parties can tweak the financing agreement to meet the needs of both sides.
Why Consider Seller Financing?
There are several reasons why property owners and interested investors may be open to a seller financing agreement.
In fact, Paul Kelley, author of Swapping Real Estate for Fun and Profit, has the following to say about why people may consider seller financing:
The owner of a property may be interested in seller financing because they do not need the cash right away. This means accepting payments from an investor, structured under their own terms, is a viable option.
In addition, sellers may want to sell their property for more than the market will allow, the property may be unconventional and banks are refusing to finance it, or possibly the owner wants to sell the property quickly, which, under the traditional mortgage process, is not always possible.
Investors may consider seller financing because they do not have the typical 20% down payment required for investment properties. Moreover, they may have poor credit, a previous foreclosure or short sale on their record, or may not otherwise qualify for conventional financing.
As you can see, seller financing offers both property owners and investors a legitimate solution when it comes to buying and selling property.
The Benefits of Seller Financing
Here is a breakdown of how both the seller and investor benefit from a seller financing agreement.
The seller is going to benefit from a seller financing agreement in many ways:
- Equity continues to build in the property as the mortgage is paid by the investor
- A consistent stream of income is received each month until the mortgage is satisfied
- There are no long vacancies to contend with (which is possible should you lease the property instead of sell)
- You can receive a large, non-refundable down payment that exceeds the amount of profit you would make by selling the property the traditional way
- You avoid paying taxes on the property you own until the mortgage is paid off
- You can get out of a property you don’t want to be in anymore, and still have the mortgage satisfied
- Your property is sold quicker and for a higher purchases price since you set the terms
- You can sell a property in need of TLC easier
- If the buyer stops making payments, you receive the property back
On the other hand, there are also some significant advantages to investing in a property, using seller financing:
- You can secure a rental property even if you are having trouble getting approved for a loan through the bank
- You may be able to negotiate terms that save you money on the overall purchase price (think lower down payment, purchase price, or interest rate)
- The closing process is quick and inexpensive
- You may be able to negotiate a large discount (sometimes as much as 20% off) on the overall purchase price with an early payoff
The point of getting involved in seller financing, according to Kelley, is to make the deal work for both parties.
Once the investor figures out what the seller needs, both parties can work together towards a middle goal.
The Disadvantages of Seller Financing
If seller financing had nothing but pros attached to it, everyone would be doing it. However, seller financing still remains a rarely used method for selling and investing in property.
In fact, there were far fewer seller financed notes created in 2016, compared to 2015, and the trend seems to continue a slow but steady decline.
This is in some part because interest rates are still at all-time lows so traditional financing is still a viable option for most investors.
That said, let’s look at some of the disadvantages facing both sellers and investors when it comes to seller financing agreements:
If you do not own the property free and clear (meaning it is not paid in full yet), you typically need approval from your mortgage lender to construct a seller financing agreement with an investor.
In addition, the buyer can stop making payments at any time, meaning you will now have your property back (and possible mortgage payments due). And, if you do receive the property back after a seller financing agreement goes sour, you may find yourself with significant maintenance and repair costs, depending on the condition of your property.
Investors also risk something when they partake in seller financing. For example, you may not be able to generate a high enough rent rate to cover the mortgage payment.
While this can happen to anyone, even someone that mortgaged a property through a bank lender, with seller financing you risk losing the property altogether without the option to sell it and move on.
Additionally, your interest may be higher than a traditional bank loan and you may be required to pay a balloon payment at the end of the note term.
Again, any business transaction, especially one as large as this one, will come with a certain level of risk.
This is especially true if you do not educate yourself about the pros and cons of seller financing and jump into a deal that is solid.
In the end, seller financing is a great strategy for investors looking to purchase rental property. It has the potential to be a profitable transaction for both parties involved, lends itself to flexible terms, and makes investing in rental property a reality for those having trouble with traditional financing options.
If you are considering getting involved with a seller financing agreement in order to add a rental to your portfolio, take the time to educate yourself about the pros and cons of seller financing, as well as seller financing strategies.
While seller financing can be beneficial to you in your quest for success as a rental property owner, it is important you understand what you are getting yourself into before closing a deal.