Editor's note: This article is the second part of a two-part look at seller financing. Read the first part, on what it means for the seller, here.
NEW YORK (MainStreet) -- Seller financing can make a home sale happen when it otherwise might not, but most buyers who have only used conventional mortgages are unfamiliar with the process. Borrowing from the seller requires careful consideration and a few precautions, but it can be the saving grace for some buyers.
For a rundown on how these arrangements work, read Part I of MainStreet's look at seller financing from earlier this week. As you’ll find, when you buy from the seller you make payments to the seller, or the seller’s representative (think escrow account), rather than to a standard lender like a bank.
You and the seller are therefore free to negotiate any terms you like. To attract a buyer, for example, the seller may ignore some credit blemishes or agree to little or no down payment, while most ordinary lenders currently require down payments of at least 20%.
But buyers should be wary of deals that are too casual, lest problems arise down the road. Here are some key steps to take before signing a contract.
- Get an appraisal. Though a seller/financer probably won’t demand an appraisal as an ordinary lender would, you should get one anyway to be sure the home is worth what you’re paying. Professional appraisers typically charge several hundred dollars for an assessment.
- Research interest rates. Use the BankingMyWay mortgage survey and search tool to study current loan rates. If the seller thinks you are unable to get a standard mortgage, he may try to set an above-market loan rate. Use the Mortgage Loan Calculator to see what this would cost over time. Ideally, a seller-financed deal should be a win-win situation, not an opportunity for the seller to gouge the buyer.
- Keep loan terms simple. Reject any proposal for tricky and potentially harmful terms. That includes a loan with any kind of prepayment penalty, which would prevent you from paying it off before a given date. After all, you’d want to be able to refinance if you found a better deal. Avoid an adjustable-rate loan unless you really understand how ARMs work, and know what you could end up paying if the rate rises to the maximum permitted by your deal.
- Do a title search. Unlike a regular lender, the seller/financer probably won’t require a title search and insurance, but you should insist on it. This will ensure that the seller is not encumbered by loans or liens which mean he really does not have the right to sell. You and the seller can haggle over how to pay for the search.
- Consider the worst case scenario. Many seller-financed loans involve a balloon payment when the entire loan balance must be repaid, often after five years, as a way to keep initial costs low. Many buyers plan to get a standard mortgage to make the balloon payment, assuming that appreciation will enable them to meet the 80% loan-to-value ratio required by standard lenders. But what if the property does not appreciate that much? Will you have other resources for a down payment on the new loan? What if interest rates rise or your credit rating falls? What if you can’t get a new loan and can’t sell the property? Agree to a balloon payment only if you have sound reason to think you’ll be able to make it.
- Use a lawyer. Get a real estate lawyer to go over all your paperwork, giving special attention to penalties for late payments, foreclosure proceedings and other provisions that could turn your deal into a nightmare.
—For more tips and tricks on finding a mortgage arrangement that works for you, visit MainStreet’s “Mortgages” topic page for our latest coverage!