photo by Mark Moz, courtesy pallspera.com
Selling a home is nearly always stressful. When you add the goal of selling it quickly in a sluggish market that resists all efforts to do so, it can become a nightmare.
In the post-housing bubble environment, prospective buyers may have trouble getting approved for a mortgage, or the process may go much more slowly than sellers want. Distressed sellers tend to consider all sorts of ways to help a transaction along.
Enter seller financing.
Seller financing is not a new concept; it was popular in the 1970s and ‘80s, but waned as interest rates declined and buyers found it easier to obtain conventional fixed- and adjustable-rate mortgages. Seller financing is now enjoying renewed attention in the wake of the housing crisis of a few years ago, though it remains a small component of the housing market overall.
The idea is this: Instead of waiting for a buyer to secure a loan from the bank, the seller steps in to serve in the bank’s place. Buyer and seller negotiate terms and draw up legal agreements to that effect. Then the buyer sends the seller a check every month until the house is paid off or the loan is refinanced.
It is easy to see why seller financing has gained new popularity. If you need to sell a home quickly in a down market, seller financing can broaden your pool of prospective buyers. It could also theoretically offer the opportunity to recognize income as it is received in each calendar year, potentially reducing the tax on the sale by splitting it into installments. And sellers can charge a relatively high interest rate, should they wish to treat the sale as an investment. But seller financing involves a number of major drawbacks.
First, financing the sale of your home can be very complex. You will have to complete various tasks, such as running credit checks on prospective buyers, hiring an attorney or other service provider to draw up an enforceable loan agreement, getting the mortgage recorded after the sale, and paying any recording or property transfer taxes connected with the sale. You will also need to determine the length, interest rate and terms of the loan. After the sale is closed, you will either have to hire a loan servicer or take care of the mortgage payments and all of the recordkeeping that comes along with it on your own. It will involve a lot of expense, a lot of work or both, none of which would personally involve the seller in a traditional sale.
Also, it is worth remembering that the types of buyers who are interested in buying a seller-financed home are generally those who are not able to obtain a regular bank loan under their preferred terms. While some buyers may have trouble getting a loan for reasons that don’t make them bad credit risks, you should want to know why the bank declined their applications. If the eventual buyer is unable to meet the terms of the loan, you will have to foreclose and take the property back, which is costly and time-consuming. Then, presumably, you will need to sell it again.
Even if the buyer pays reliably, it will be years before you collect the entire selling price. Seller financing is often set up to have a relatively short term, with a balloon payment - a lump sum of the balance - to be paid at the end of the loan’s term, commonly five years or so. You will be tying up a large amount of capital in what is essentially a concentrated investment during that time. There are companies that purchase such mortgages if you wish to get your cash (less a discount, in many cases) before the buyer finishes repayment, but you must make sure you have structured the loan to meet industry standards if you want to find a buyer on the secondary market.
You should also realize that, while the home you sold with seller financing is no longer technically yours, you retain a financial interest in the property until the debt is satisfied. It is in your interest to make sure that the buyer has proper insurance, pays the property taxes on the home, and sees to maintenance and upkeep. Otherwise, if the buyer defaults, you might end up stuck with house worth substantially less than when you sold it. If the house is seized for failure to pay taxes, you may end up with nothing at all.
From a financial point of view, seller financing is unlikely to be to the seller’s advantage in the long term. While the installment sale tax treatment will allow you to pay tax only on the portion of the gain you collect each year, you must also pay tax on the interest your receive. Further, you must bear the opportunity cost of not taking a lump-sum payment for your house and investing it elsewhere, such as in the stock market. Based on data going back to 1926, the average annual expected return of the aggregate bond market is greater than 4 percent, and the Standard & Poor 500 index’s expected annual rate of return is over 11 percent. A lump sum invested in a diversified portfolio at the outset may beat the tax benefits of the installment sale.
Getting a house off the market and into a buyer’s hands can seem appealing at any price when you are in the midst of trying to sell, especially if you are selling under pressure. But the truth is that seller financing ultimately extends your risk.