Hidden Benefits of Seller Financing vs Rental Property

Already one of the lesser-known investment opportunities, seller financing has earned a poor reputation as the tactic of only the truly desperate. After all, if you are looking for monthly income and already own property, why not just use the property as a rental?

In reality, seller financing — also sometimes called “owner financing” or a “purchase-money mortgage” — offers significant benefits over owning a rental property. This method can be used to protect your income and provide security to you and your potential heirs. This is why it doesn’t come as a surprise that 80% of all small business sales include some form of seller financing.

Key takeaways

By the end of this article you will know the following:

1. How seller financing rids you of maintenance liabilities.
2. How seller financing provides you with a secure income stream.
3. How seller financing takes away some of your tax liabilities.

Benefits of seller financing

1. No maintenance

Maintenance is costly, and the property is your responsibility as a landlord. Every leaking sink, and every broken appliance falls squarely in your lap (figuratively speaking, that is). Even if you hand control of the property over to a management company, money comes out of your pocket to pay for the service.

One way or another, this venture that is supposed to make you money is not being used to its full potential while you are still paying into it.

With seller financing, you are only the beneficiary of the mortgage note, and not the owner of the property. The property’s owner, the one making the payments, is on the hook for any and all maintenance. This can turn a costly and inconvenient investment into an excellent source of passive income. And it’s why, according to an industry study, 2021 saw an increase of 7% in the total number of notes generated through seller financing.

Every landlord knows that the worst part of being a landlord is the tenants. If careless or raucous tenants destroy the property, it affects your ability to rent the property and continue to make money.

As the holder of the note, the only thing you need worry about is the paycheck showing up in your mailbox every month. What happens to the property itself is no longer your responsibility or your worry.

2. Income security

Every landlord has had to deal with a tenant who just could not or would not make their payments. With late payments come the hassle of badgering the tenant, perhaps getting the payment late, or the absolute nightmare of filing an eviction notice and even taking tenants to court over back payments.

All of this is a recipe for capital hemorrhage. As property investors, the idea is to make money, not bleed it out all over small claims court.

In the case of seller financing, you’ll find that this quirk of rental investments is no longer a problem. If the borrower defaults on the loan, everything reverts back to you, the seller, and you retain all payments, including the initial down payment.

The foreclosure process is not free, certainly, but it need not carry the same expense and uncertainty that accompanies eviction and lawsuits over back rent. The process can actually be fairly painless, depending on what state you reside in. Mortgage states have a slightly more complicated process, but if you are lucky enough to live in a Deed of Trust state like Texas, North Carolina, California or Maine, the process has a much quicker turnaround time.

3. Fluctuations in the market are no longer the master

Depending on where your property is located, you may notice that rents fluctuate. As a neighborhood becomes more desirable, the amount you can charge in rent goes up. If potential tenants begin flocking to another part of town, you have to lower the rent to lure them back.

Payments in seller financing are not subject to such turbulence, because of two factors. Firstly, homeowners tend to stay in a property a good bit longer than tenants, because simply abandoning the property has far greater consequences as an owner. Secondly, terms are determined and contracted far ahead of time, and do not carry the risk of tenants simply abandoning the property for a more attractive offer.

You need not even worry about fluctuations in the property market because you already own the note. If the buyer wishes to sell their property, it is their responsibility to find another buyer willing to pay enough to cover the full amount. Either way, you continue to build wealth without needing to worry about whether you will be able to make enough in rent to justify the cost of owning the property.

4. Sell money, not property

If you choose to sell a rental property, and especially one that is still occupied, your ability to sell is contingent on the tenant’s upkeep of the property, and it would be laughable to suggest that you only sell part of the property or the entire property for only a certain amount of time.

But this kind of flexibility is actually possible with seller-financed mortgage notes, and without the hassle of involving a Realtor or showing the property.

Notes can be sold to note buyers in part or in whole. What this means is that, for short term but pressing expenses, you can use your note as a quick source of cash by selling only part of it, and writing in the terms that the note will revert back to your ownership after a certain period of time. This creates an investment that is not only a long-term, monthly source of steady income, but a ready source of cash if the situation warrants.

5. Fewer taxes and better return

Possibly the most attractive attribute of seller financing is the ability to avoid paying excessive amounts of taxes. Fewer taxes = more money in your pocket and in your portfolio.

Because of the way seller financed mortgages are structured, you don’t incur capital gains tax until you start collecting on the principal of the loan, which, in a 30-year loan, allows you to defer capital gains tax for many years. This assumes, of course, that you fall into certain categories under the Dodd-Frank legislation.

As the beneficiary and not the property owner, you also avoid both the burden of property tax and property insurance, which are both the responsibility of the property owner themselves.

In addition, you are looking at a much better return on your dollar than you can get with a rental agreement. For instance, you could take all your rental earnings and put them away in high-interest savings or money market account, which these days pays at best 3% or 4%. You’ll grow your money, sure.

But let’s say you seller-finance that same property at 8%. You’re now bringing in a solid monthly income at an interest rate of more than double what you could have gotten out of investing your rental proceeds in the bank.

There are, of course, things to consider. If you don’t own the property free and clear, the bank could invoke what is known as the “due-on-sale” clause, requiring you to pay off the entirety of what is owed on the property or face foreclosure. They are not required to do this, but it is a risk. Like with any financial decision, Selling versus renting should be approached with care and an eye toward your particular circumstances.

As an investment property owner, deciding to convert a rental property into a seller-financed mortgage note is one not to be taken lightly. That said, seller financing offers the benefit of keeping cash in your pocket with the elimination of management companies, rental maintenance and the inevitable taxes that come with property ownership, and the opportunity for long-term passive income.

Types of seller financing

Seller financing can take several forms, each with its unique structure and benefits, depending on the needs and agreements between the buyer and seller. Here are some common types:

• All-inclusive Mortgage (AIM): Also known as an all-inclusive trust deed (AITD), this type of seller financing involves the seller carrying the entire mortgage. The buyer makes payments to the seller under the terms agreed upon, which typically cover the balance of any existing mortgages plus the amount of equity the seller has in the property. This can be beneficial when buyers cannot qualify for a traditional mortgage for the full purchase price.
• Junior Mortgage: In this arrangement, the seller provides financing for just part of the loan, usually the down payment or a portion of the purchase price, while the buyer secures a primary mortgage from a traditional lender for the remaining amount. The seller’s loan is then subordinate to the primary mortgage. This is useful for buyers who can almost, but not fully, meet the lending criteria of traditional banks.
• Land Contract: Also known as a contract for deed, the buyer makes payments directly to the seller for a predetermined period after which the legal title of the property is transferred once the full price has been paid. During the contract term, the buyer holds equitable title and gains full ownership only upon the final payment.
• Lease Option: This type allows the buyer to rent the property with the option to buy at a later date. Part of each rental payment can go towards the purchase price. This setup helps buyers build equity in the home and save for a down payment while locking in a purchase price.
• Lease Purchase: Similar to a lease option, a lease purchase obligates the buyer to purchase the property at the end of the lease term, unlike an option, which is just that—an option. This arrangement can be appealing to sellers who want a guaranteed sale and to buyers who need time to improve their credit score.

What buyers and sellers should know about seller financing

For buyers:

• Negotiation Leverage: You have the unique opportunity to negotiate directly with the seller on terms like the interest rate, down payment, and repayment period. Use this opportunity to align the terms favorably with your financial situation.
• Professional Advice: Engage real estate attorneys and financial advisors who can offer guidance, help negotiate terms, and ensure that contracts are legally sound and protect your interests.
• Due Diligence: Conduct thorough due diligence, including property inspections, appraisals, and title searches. Ensuring the property is free of liens and disputes is crucial before entering into any financing agreements.
• Understanding Seller Motives: Analyze why the seller is offering financing. This could indicate their need for a quicker sale or could suggest issues with the property that have made traditional financing difficult for previous interested parties.
• Legal Protections: Ensure all agreements are formalized and recorded properly. This protects your ownership rights and prevents potential legal disputes in the future.
• Long-term Financial Planning: Consider how this purchase fits into your long-term financial goals. Be cautious of arrangements that could strain your finances over time, such as balloon payments or high interest rates.

For sellers:

• Attracting Buyers: Offering seller financing can make your property more attractive to a broader pool of buyers, especially those who might not qualify for traditional loans immediately.
• Increased Sale Price: You might be able to command a higher price for the property as you are providing a financing solution which can be seen as an added value to the buyer.
• Tax Benefits: Spreading out the receipt of the payment over several years through seller financing can potentially lead to tax benefits by spreading out income recognition and possibly staying in a lower tax bracket.
• Risk Assessment: Evaluate the buyer’s creditworthiness as thoroughly as possible. Unlike traditional lenders, you may not have access to as many tools to vet buyers, so consider requiring detailed financial information.
• Securing the Loan: Ensure that the financing agreement includes a promissory note and mortgage or deed of trust. This secures the loan with the property itself, offering you protection if the buyer defaults.
• Legal and Financial Consultation: Work with professionals to draft the financing agreement, ensuring that all legal bases are covered and that the deal does not expose you to unexpected financial risks.

Disadvantages of seller financing

For sellers:

• Risk of Default: One of the biggest risks for sellers is the buyer defaulting on the loan. Unlike traditional lenders, sellers may not have as rigorous tools for assessing a buyer’s creditworthiness and financial stability, which can increase the risk of non-payment.
• Tied-up Capital: By offering financing, sellers tie up capital in the property rather than receiving a lump sum from a traditional sale. This can be problematic if the seller needs cash for other investments or personal use.
• Complex Foreclosure Process: If the buyer defaults, the seller may need to go through the foreclosure process to reclaim the property. This process can be lengthy, costly, and stressful, particularly for those who are not familiar with the legal aspects of property repossession.
• Management Responsibilities: Seller financing can sometimes require ongoing management, such as collecting payments, handling taxes, and maintaining records, which might be more administrative work than the seller anticipated.

For buyers:

• Higher Interest Rates: Buyers might face higher interest rates compared to those available through traditional mortgage lenders. Since offering financing is riskier for sellers, they often charge higher rates to mitigate this risk.
• Shorter Loan Terms: Seller-financed loans typically have shorter durations than conventional mortgages, often requiring a balloon payment at the end of the term. This can pressure buyers to refinance or sell the property sooner than they might prefer.
• Limited Equity Building: With terms that might involve interest-only payments or balloon payments, buyers may find that they are building equity at a slower pace, which can affect their long-term financial health and investment returns.
• Legal and Financial Complexity: Navigating the terms and ensuring the legality of seller financing agreements can be complex and typically require the assistance of legal and financial professionals, adding to the cost of purchasing.

Charging Prepayment Penalties

When you’re dealing with prepayment penalties in a seller financing agreement, it’s crucial to thoroughly understand the specifics. Start by reviewing the details: how long the penalty period lasts, how the penalty is calculated, and the circumstances under which it applies. Knowing these terms will help you plan accordingly, especially if you’re considering refinancing or selling the property earlier than initially planned.

If the prepayment penalty seems too restrictive, don’t hesitate to bring it up in negotiations with the seller. Sometimes, you can work out terms that are more favorable, like reducing the penalty or shortening the period during which it applies. Sellers often appreciate the straightforwardness and might be open to adjustments if it means moving forward smoothly. Also, consider seeking advice from a real estate attorney or a financial advisor. They can offer a professional perspective on whether the terms are reasonable and how they might impact your financial future. If you decide to proceed, having a clear strategy in place for managing or avoiding the prepayment penalty can help keep your larger financial goals on track.

Frequently Asked Questions

What is a due-on-sale clause?

The due-on-sale clause protects the lender’s interest in the property by prohibiting the sale or transfer of ownership without the lender’s permission.

Is it still possible to sell my home if it has a due-on-sale clause?

It is still possible to sell your home if it has a due-on-sale clause, but you will need to get your lender’s permission first. You can do this by requesting a release of the due-on-sale clause from your lender.

How do I know if my property is eligible for seller financing?

To qualify for seller financing, your property must be free and clear of any existing mortgages or liens. You will also need to provide a loan agreement that outlines the terms of the sale, including the interest rate, repayment schedule, and other relevant details.

How do I get started with seller financing?

If you’re interested in seller financing, the first step is to contact a real estate attorney to draw up the necessary paperwork. You will also need to work with a mortgage broker or loan officer to get pre-approved for a loan. Once everything is in place, you can start marketing your property as a seller-financed home.

Cited Article Sources

1. Statistics retrieved from https://noteinvestor.com/notes-101/owner-financing-2021/
2. Statistics retrieved from https://morganandwestfield.com/knowledge/ma-seller-financing/
3. Data retrieved from https://www.companiesinc.com/grow-your-business/mortgage-states-and-deed-of-trust-states/