The history of seller financing.
Most people who want to buy a home start by contacting banks and lenders to apply for a mortgage. It takes considerable due diligence to determine your creditworthiness and the value of the property you want to buy.
Once you’re approved, the bank may lend you the money for a home.
It’s hard to believe, but this kind of home buying process people didn’t always exist.
Imagine living in the early 1900’s, when homes were paid for in full of savings or privately financed with a 50% down payment and a 5-year, variable-rate loan. After 5 years, the loan balance was due in full (known as a balloon payment).
Only 2 out of 5 households could afford to own a home, so everyone else rented!
The Birth of the 30-Year Mortgage
When the stock market crashed in 1929, many homeowners could not pay the balloon payments on their mortgages, so their homes went into foreclosure.
The Federal Housing Authority (FHA) was created in 1934 to insure home mortgage loans and stimulate home buying during the Great Depression.
During World War II, the Veteran’s Administration (VA) created an insurance program to back loans for military personnel. That’s when the idea of 30-year mortgages with a small down payment became common.
Home ownership rose dramatically as a result. By 2020, about 2 out of 3 U.S. households own a home.
But high inflation rates in the 1970’s and early 1980’s made home buying incredibly difficult and expensive again. In 1981, interest rates were 18%!
Think about it. If you take out a $200,000 mortgage at today’s rate of 3.8%, your monthly principal and interest payment is about $932. Over the life of the loan, you would pay about $135,500 in interest.
The same mortgage at an 18% interest rate means a monthly payment of $3000. So you’d pay about $885,000 in interest if you kept the loan 30 years. That’s 6 times more interest!
This is Where Seller Financing Comes In…
Seller financing is an agreement in which a homeowner who typically (but not always) owns a home outright, assumes the role that a bank plays with a traditional mortgage.
The owner agrees to sell their home to a buyer. The buyer agrees to make monthly principal and interest payments on the home directly to the seller.
Why do sellers offer seller financing?
- Extremely high interest rates in the 1970’s and 1980’s made it hard for buyers to buy a home.
- High rates also made it near-impossible for owners to sell homes, since no one could afford them.
- Sellers who were willing to accept monthly payments over time instead of a lump sum could offer buyers lower interest ratea than banks.
- Lower interest rates made the seller’s property much more affordable and attractive to buyers.
- Today, many home sales depend on seller financing.
Seller Financing Options
But what if a seller doesn’t own their property outright? Another seller financing option is a wraparound mortgage.
Under this option, the seller issues a new mortgage to the buyer for the purchase price, minus any down payment. The seller charges an interest rate high enough to continue making the payments on their underlying mortgage plus a profit on the new loan. The profit is possible because the original mortgage rate was lower than current bank rates.
Seller financing and other creative financing options remained popular until the early 1990’s. After that, interest rates began to fall, so getting a mortgage from conventional lenders became easier.
The only exception to this trend involved sellers who owned their homes outright and wanted to avoid a big tax bill on the sale of their home.
Since 1997, the IRS has allowed homeowners to avoid paying taxes on the first $250,000 in profit from the sale of a principal residence that meets the ownership and use test. The limit is $500,000 if your tax status is married filing jointly.
Any profit over those amounts is subject to a 15% tax rate.
In states where home prices soared (such as California), many people found that the profit they would make from the sale of their homes would easily exceed the IRS limits.
Seller financing became a way to avoid a big tax liability. Instead of paying taxes on one lump sum payment, with seller financing, sellers only needed to pay taxes on one year’s worth of payments at a time.
Seller Financing in the 2008 Financial Crisis
Enter the financial crisis of 2008. The causes of the crisis are complicated.
Most people agree that subprime lending – when banks were issued mortgages to people who didn’t qualify under traditional standards – was a big contributor. As a result:
- More people could buy homes, but not enough homes were available for everyone who wanted one.
- House prices rose rapidly because of limited supply and an increase in demand.
- As interest rates rose, subprime borrowers with adjustable rate mortgages found they couldn’t afford rising payments, so they began to default on loans.
During the resulting Great Recession, which lasted until 2012 for the housing industry, traditional lenders severely tightened lending standards. Mortgage loans became incredibly difficult to get.
Many creditworthy buyers couldn’t get traditional bank financing for home mortgages. Homes were taking much longer to sell. Instead of high interest rates stifling home sales (as in the 1970’s), now banks weren’t lending much money, even to highly qualified homebuyers.
Sellers once again turned to seller financing as a way to improve the odds of selling their homes.
In 2008, 32% of sellers owned their homes outright and seller financing transactions. Unlike the early 1980’s, when sellers offered lower interest rates than banks, in 2008 sellers could charge an interest rate as much as 4% higher than the banks.
Buyers agreed to higher rates in exchange for:
- Not having to pay for private mortgage insurance
- The money saved in traditional loan fees
- The fact that the buyer couldn’t get another loan.
How the SAFE Act and Dodd-Frank Affected Owner Financing
Two new federal laws, passed in response to the 2007 financial crisis, affected seller financing indirectly – the SAFE Act and Dodd-Frank.
- The SAFE Act (the Secure and Fair Enforcement of Mortgage Licensing) was signed in 2008 by President George Bush. It required licensing and registration of loan originators, including seller financers.
- Dodd-Frank was signed into law in 2010 by President Barack Obama. Part of Dodd-Frank requires that seller financers must make a reasonable effort to qualify their borrower for the loan that’s offered to them (i.e., due diligence).
Both laws aimed to regulate the larger mortgage industry. Individuals who wanted to provide seller financing on a one-time basis weren’t affected much.
A seller would have to sell and offer seller financing on more than 3 properties a year before becoming subject to the regulations under these laws.
Seller Financing Today
Though the reasons for seller financing changed over time, today the practice still plays a key role.
Although interest rates are low, mortgage lending is restrictive. A conventional mortgage requires a down payment of at least 3%. And private mortgage insurance is required for any down payment less than 20% of the value of the property, adding extra costs to monthly payments.
Seller financing in the current environment is an attractive option for buyers:
- Whose credit may keep them from qualifying for a conventional mortgage
- Who owns their own business and can’t easily meet proof of income requirements
- Whose property may not meet the requirements of a traditional lender, for example, non-traditional housing such as a mobile home.
- Whose property may be in “as is” condition, which means the seller is in the midst of repairs they don’t have the means to complete, with a buyer who’s willing to take over the task.
Sellers and buyers both should enter into seller financing agreements carefully. Perform full due diligence for any transaction.
For sellers, this means:
- Fully investigating the buyer’s creditworthiness.
- Setting a reasonable interest rate.
- Determining a down payment to create an advantageous equity position.
- Understanding their options later on.
For buyers, this means:
- A title search to rule out any additional owners or lienholders.
- A property inspection to identify any potentially major problems.
- Hiring an attorney to review documents and ensure no surprises down the road.
- If the seller still owes money to a lender, the buyer may be required to come up with a hefty down payment for the seller to use to pay off their loan balance.
Although we can’t predict the future, as economic conditions change and new laws pass, seller financing will likely play a key role in mortgage lending. It’s an appropriate response to economic and legal changes, and a viable option for buyers and sellers alike.
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