Home Seller Financing Pitfalls in a Credit-Tight Market

In a still-tight credit market, if the seller finances the buyer, home sales can happen faster. But in the long term, it is unlikely to be to your advantage as a seller.

Selling a home is nearly always stressful. When you add the goal of selling it quickly in a sluggish market, 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 1980s, but waned as interest rates declined and buyers found obtaining conventional fixed- and adjustable-rate mortgages easier. Seller financing now enjoys 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 for the loan. Then the buyer sends the seller a check every month until the buyer pays off the house or secures other financing to retire your loan.

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 also potentially reduces 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 have to complete various tasks before the sale, such as running credit checks on prospective buyers and hiring an attorney to draw up an enforceable loan agreement. You also need to determine the length, interest rate and terms of the loan.

After the sale, you have to take care of the mortgage payments and all of the recordkeeping that comes along with it, or hire a loan servicer. All this involves a lot of expense, a lot of work or both. In a traditional sale, the seller need not worry about such hassles.

Also, note that buyers interested in a seller-financed home generally can’t obtain a regular bank loan, at least under favorable terms. While not all of them have bad credit ratings, you should find out why the bank declined their applications. If the eventual buyer is unable to meet the terms of the loan, you have to foreclose and take the property back and perhaps sell it again, which is costly and time-consuming.

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 buyer pays all debts. 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, the house may be worth substantially less than the price you sold it for. If the government seizes the house for failure to pay taxes, you may end up with nothing at all.

Even if the buyer pays reliably, it takes years for you to collect the entire selling price. 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 structured the loan to meet industry standards.

Further, bear in mind 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 through yearend 2013, the average annual return on the Standard and Poor’s 500 Index is slightly over 10%.

Getting a house off the market and into a buyer’s hands can seem appealing at any price when you are selling under pressure. But the truth is that seller financing ultimately extends your risk.

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Written by Eric Meermann, CFP, CVA, EA, who is client service manager and a member of the investment committee of Palisades Hudson Financial Group LLC in Scarsdale, N.Y.

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