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 “creative 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’t 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.
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’t 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 “due 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’t 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 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 completely negotiable, which can turn a mediocre deal into a great deal. I’ve 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 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’t 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 “landlord” business and enters the “note 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. This issue may not be as important for homeowners, because of the IRS rule that allows homeowners to avoid paying taxes on up to $500,000 in profit from selling their primary residence – as long as it meets certain specific criteria.However, investors are not so lucky and are forced to pay taxes when they sell. 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 $100,000, 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.
This also comes back to the “ROI” concern. If an investor were to sell a property for $100,000 – they could easily lose half that amount, or more, to taxes, being left with only $50,000 to invest in something else with. Even if they could obtain 12% in the stock market – that 12% is only going to be on the $50,000 – not the $100,000 that they sold. However, if they provide seller financing at 8% , they will actually make more because the interest received is on the “pre-taxed” interest.
Can’t Sell Otherwise: As mentioned in the previous section, many properties simply are not sellable to a typical bank-financed borrower. Offering seller financing can provide a way for the seller to unload a property without needing to do the work to fix it up.
Personal Case Study of a Seller Financed Deal
A number of years ago I had just finished reading “The ABCs of Real Estate Investing” by Ken McElroy (*Publisher), which dealt heavily with the process of buying and selling mid-size apartment buildings. I was so enamored with the thought of investing in these apartment buildings and, although I didn’t know a lot, I knew it was a path I wanted to take.
The next day I was speaking with an older gentleman from my church and I casually mentioned the book and that someday I’d love to invest in mid-size apartment buildings. He looked at me funny and said “that’s ironic, because I might have an apartment complex I’m looking to sell.”
It turns out – this gentleman and his wife had owned a 24 unit apartment complex near my town for many years but had sold it using seller financing eight years previous to fund their retirement. However, the current owner (the man they sold it to) had refused to fix up any of the units as they went vacant, so one by one – they property began to lose money, causing the buyer to stop paying the monthly mortgage to the seller, the man I was speaking with. He was nearing the end of the foreclosure process and was about to take back the property but didn’t want to get back into the real estate investing game, and especially didn’t want to have to go in to fix up the units that had been neglected for so long.
The conversation couldn’t have happened at a better time. We spoke numerous times on the subject after that initial conversation, and about a year later the man and his wife officially sold the property to my wife and I for just 3% down payment (to cover the back-taxes on the property.) I still own this apartment complex today, and every month make a mortgage payment to the retired couple who travel around the country in an RV – enjoying the retirement while I own the property.
I tell this story not to brag – but to show you what’s possible with seller financing. These kind of deals exist in every market, in every price range, with every property type – but you’ll never know if you don’t start asking and talking about it. Like my story above- seller financing can create amazing win-win transactions for all parties involved. Had I not read that book, and had I not mentioned my ambitions to this man I barely knew – I would not have that apartment complex today.
Related: BiggerPockets Presents: The Best Real Estate Books Ever
Partial Seller Financing
Up until this point, I’ve discussed seller financing mostly from a “entirety” position – in that the entire property is sold using seller financing. However, as I mentioned earlier – seller financing gives you the ability to get your creative juices flowing. One such creative way to use seller financing is known as “partial seller financing.”
What if the seller didn’t own the home free-and-clear, but had some equity in the home? This kind of situation allows for you to let the seller finance just part of the deal, while a traditional lender finances the other portion. This can get a little bit confusing, so let’s look at an example.
Charlie owns his home which currently is for sale for $100,000 – but he only owes $50,000 to the bank on his mortgage. Susan is a buy and hold investor that is looking to buy Charlie’s property – but doesn’t have a large down payment to work with. So Susan works a “partial seller financed” arrangement with Charlie and her lender, in which Charlie agrees to “carry back” a second mortgage for $30,000 (in other words, Charlie “seller finances” $30,000”) as a second-mortgage *(sidebar) while the lender agrees to fund a $65,000 first mortgage. Susan is therefore able to buy the property for just $5,000 down and has two separate mortgages. The $65,000 goes to pay off the original $50,000 loan of Charlie’s, and he ends up with $15,000 in cash plus a “note” (mortgage) for $30,000, giving him some monthly income for the next X number of years.
Don’t worry if that was confusing to you – this is pretty advanced stuff! The point is, seller financing allows for some creativity and using a seller’s equity to partially fund a real estate deal is a potential path you may want to take some day. Keep in mind, however, that many banks and lending institutions do not allow seller carry-back second mortgages anymore (they were much more common in the past) and may require you to still put a certain down payment into the deal, no matter how much the seller agrees to carry. However, you won’t know until you pick up the phone and start asking different lenders what their rules are!
Five Ways to Find Seller Financed Deals
So, you now have a pretty good idea of how seller financing works and how you can use it in your real estate investing to get more deals. But how do you find owners who are willing to carry the contract and provide seller financing? Here are three simple ways to find these sellers:
Ask – it may seem obvious, but sometimes all it takes is a simple question. When talking with sellers – whether directly or through your real estate agent – simply ask the question “do you need to be 100% cashed out or are you able to provide any seller financing?” As hopefully I’ve made clear – seller financing is about creating a win-win situation, not trying to take advantage of someone. Therefore, never be afraid to ask – because they may be ecstatic to provide seller financing but never thought about it before. Besides – it never hurts to ask. What’s the worse they can say?
Look for Keywords – When scanning the MLS, Craigslist, or other sources of finding properties keep an eye out for phrases like “owner will carry,” “owc,” “flexible terms” “seller financing,” “motivated” or other indications that the seller is open to the conversation.
Direct Mail – Although direct mail practices are far beyond the scope of this post (check out the BiggerPockets Forums for some awesome discussions on Direct Mail best practices) understand that you have the ability to purchase lists of homeowners and can specify how much “equity” the homeowner has in the property. Significant equity is a good sign that seller financing may be a possibility – so when sending out direct mail, keep an eye out for high equity and again – don’t be afraid to ask.
Although seller financing can provide some excellent options for you as a buyer, the strategy is not without some risks and dangers to be aware of. This section is going to look at 3 of the most common concerns when dealing with seller financing and offer some tips on overcoming those potential problems.
The Due on Sale Clause – We covered this already quite a bit, but I can’t help but rehash it here. It’s vitally important that you understand what the due on sale clause is – and why it matters. You don’t want to endanger the credit or the relationship with a seller by trying to circumvent this clause. Understand that if you buy a home using seller financing, and the home has a mortgage with a due on sale clause- the bank may foreclose on the seller, leaving both of you in a financial mess.Again, the simplest solution is to only use seller financing on properties owned free and clear. The only exception I have to this rule is through short term financing. There are investors out there who user seller financing with existing mortgages (often called a “wrap” because you wrap one mortgage over another) despite the due on sale clause – because they believe they can quickly fix the property up and either sell or refinance before the bank finds out and has an issue with it. I won’t tell you this is a great idea to do- I’ll leave that to you and your risk tolerance level.
Higher Interest Rates – Although seller financing allows for incredible creativity, generally speaking you will pay a higher than normal rate with seller financing. This has not always been the case, but in today’s lending environment with under 4% loans, it’s difficult to get a seller to accept interest as low as that (though, some investors do negotiate 0% interest seller financed loans.) Just be sure to run the numbers with the interest rates you plan on obtaining, and make sure they work for the deal.
Fewer Potential Properties – Let’s face it – although seller financing can be a great win-win for both parties, the vast majority of homeowners are either unable (due to existing mortgages) or unwilling to carry a contract and provide seller financing. Therefore, the pool of potential deals is significantly smaller when looking to work with seller financing.
Seller Financing Doesn’t Mean “Go Buy a Bad Deal”
Before we head out, I want to make something very clear: although seller financing allows you to obtain properties without using a bank, this does not give you an excuse to overpay for a property. Leverage is only leverage when used responsibly – or else it simply becomes a liability.
Seller financing is a tool in your tool box – not your whole game plan. Use it when it works, but don’t try to force it when it doesn’t. So go out there, add the “seller financing” tool to your toolbox, and go make some magic happen.
Thoughts? Have you purchased real estate using seller financing? Would you? Let me know in the comments section and let’s chat about it!