What do I need to know when buying on Seller Financing?

Buying a home where the seller is willing to finance the home for you is a great way to get into a home without having to be ran through the wringer like a traditional bank may put you through.   When the seller offers this there are a few things you will need to know.

As a Nevada Realtor I do these from time to time.  There are a few things you as the buyer will need to know before getting involved in one of these.  Some may be to your benefit and others may not.  This is a personal judgement call.

The most common question I get from potential buyers is about how much is their payment going to be.  Well, that is what will determine at the finish line yet it is not the actual value we are looking at from the onset.  Instead, we need to know other things like purchase price, length of the loan, and the interest rate.

Quite frequently the interest rate is the value we need to know first.  That is one of the major factors that determine the monthly payment.  The other three critical factors are the loan amount, length of loan, and type of loan.  There will be other factors yet those aren’t as critical to know upfront.

In many seller financing situations the seller may be asking for 20% as a down payment.  This is similar to the standard investor loan an investor would get when purchasing an investment property.  Plus, the seller wants to ensure you are committed and asks for values around this range for what they call having “skin in the game”.

This amount of a down payment can be quite substantial to a buyer.  However, if the buyer does not want to try to qualify via a bank and they have this type of down payment then this would be perfect for them.

The next value to know is the interest rate.  Most sellers are not going to even remotely try to compete with the banking industry and they will typically charge higher rates.  So be ready for those numbers to be higher than normal banking rates.  These rates can range from 7% up to 12% or higher.   For the owner occupied home buyer you may only want to entertain these kinds of rates for a short time.  Thereby, either refinancing into a better bank rate later when your credit improves or sell before the loan matures.

The next major item you need to know is the type of loan.  There are two main types of loans out there.  One, which is typically the one used, is a principle and interest loan.  The second is the interest only loan.  The first one means you are paying both principle payments (reducing the loan balance every month) and interest payments.  The second one is just making interest payments.  There is something you must understand in determining which is best for you.  The second interest only payments will keep your monthly payment lower however you are paying more for the home than the first method.

In the first method you are paying both principle payments and interest payment.  The principle payment is also called principle reduction.  The first month’s payment will have the most going toward interest and the least going toward principle.  The second monthly payment (which is exactly the same throughout the course of the loan) a little more goes toward principle reduction and a little less goes toward interest.  And this continues for the life of the loan.  At the end almost all is going toward principle and very little toward interest.  This will also be known as an amortization schedule which is based on the compound interest equation.

The interest only payment is less per month as there is no principle reduction portion that is added to the loan in the first type.  The reason you pay more on this type of loan is because there is no principle reduction going on.  The interest is calculated on the total amount borrowed instead of what is left to pay.  Thus, in the principle & interest type of loan that little bit less going toward interest every month lowers your interest amount continuously every month.

Therefore, after a few years that amount can become quite substantial.

Most loans are based on the principle & interest amortization schedule.

The last major aspect of determining the loan is the length of the loan.  We can assume that most loans are based on a 30 year principle & interest amortization schedule.  In the seller financing world this is often the same concept.  However, most sellers do not want to wait 30 years in order to get fully paid.  They will often put in what is known as a “balloon payment”.  This means after a certain period of time that the entire remainder portion of the principle would be due.  Typical seller financing terms have a 5 – 10 year balloon payment.

If we assume that you had a 5 year balloon then this would mean that after 5 years the remainder of the principle would be due.  That means on the 60th payment you would have to the entire loan off in full.

Now don’t let the balloon payment scare you too much.  Usually the buyer will either refinance or sell the home prior to the balloon payment date coming due.  You definitely need to be concerned and you must be aware when that date is coming up.

To recap on the main things you need to be aware when doing seller financing are:

  1. Purchase price
  2. Down payment (typically 20%)
  3. Interest rate (typically 6 – 12%)
  4. Type of loan (P&I or I.O.)
  5. Balloon payment (and amortization time frame)

If you have a good down payment then seller financing may be for you.  There are many advantages of doing one of these.

Also, seek guidance before doing this on your own.  There are other factors that need to be considered when doing these.  Other items to be considered are 1) when is the payment considered past due; 2) penalties for late payments; 3) impounds – who collects and pays for taxes and insurance; 4) what happens after 30 days late; etc.

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