These days, it is tough to get a home loan with bad credit. If you are having trouble getting approved by a bank, a seller-financed mortgage may be one of your home loan options. However, it is crucial that you ask the right questions before entering into this type of arrangement.
Ideally, a seller-financed mortgage can solve problems for both parties involved in the sale of a home. It can widen the market of potential buyers available to the seller, and it can allow a would-be buyer to obtain a home loan with bad credit. However, neither party should let this solution become a bigger problem in other ways.
As a buyer, here are seven questions you should resolve thoroughly before entering into a seller-financed mortgage agreement:
- Are you comfortable with the loan language? First and foremost, just because this is a private arrangement does not mean it should be done informally. The loan terms should be nailed down in a contract that you have an attorney review. That language should not contain any provisions that would not be in a normal loan agreement between a bank and an individual, unless you fully understand those provisions and are comfortable with them.
- Have you disclosed the arrangement to other potential lenders? During the housing boom, seller-financed lease options became popular as ways for buyers with limited finances to come up with down payments necessary to qualify for loans via traditional lenders. This led to abuses, in which sellers were facilitating loans for unqualified borrowers in exchange for getting an inflated price for their homes. Lenders have cracked down on seller-financed down payments, and the Consumer Financial Protection Bureau (CFPB) recommends that you always disclose additional loan arrangements to your primary lender. Otherwise, you could run into legal problems down the road that might invalidate your mortgage.
- Are you overpaying for the house in exchange for financing? One motivation for a seller to finance a loan is to get a price for the home that a conventional lender would never approve. The CFPB recommends that you get an independent appraisal before entering into this type of arrangement, to make sure you are not overpaying.
- Is the interest rate competitive? Your loan may not be from a conventional lender, but the mortgage rate should have some basis in prevailing market rates. Be sure to compare mortgage rates with those offered by lenders in your area. The circumstances may be such that you have to pay a premium over market rates, but you should be fully aware of how big that premium is so you can make a rational decision about whether it is worthwhile.
- Does the interest rate match the term? Because sellers usually cannot wait as long as banks to get their money, seller-financed loans often have a more accelerated payback period than a traditional 30-year fixed-rate mortgage. This accelerated payback may involve a shorter-term, or a balloon payment after a few years. If either is the case, it is effectively a shorter-term loan than a 30-year fixed-rate mortgage, and should carry a lower mortgage rate. Keep that in mind when you compare mortgage rates.
- Can you meet the full payment schedule? You should look at a full amortization schedule showing what payments must be made and when they will be due. This is especially true if the loan provides for balloon payments or other increases in monthly amounts due. This was a common problem in the housing crisis -- borrowers who should not have qualified for a mortgage signed on to loans they thought they could afford, because the initial payments were easy to make. However, when monthly payments increased or a balloon payment hit, they had no prayer of meeting those obligations and often lost their homes as a result. Conventional lenders are avoiding making these loans these days, but there is no guarantee that a private lender might not.
- How will the loan be serviced? The loan agreement should clearly state where payments are to be sent, how recordkeeping will be handled, what will happen if payments are late and how any disputes will be resolved. Bear in mind that sellers who have financed a mortgage can turn around and sell the note to a finance company, so do not expect any informal understanding you have with the seller to last for the life of the loan. Essentially, if it is not in the loan agreement, it does not exist.
A seller-financed loan might be beneficial to both buyer and seller, but potential home buyers should approach this the way they would approach an agreement with any lender - with a close eye on the numbers and the fine print.