Seller Financing

Seller financing is a sale in which the seller of the property supplies the credit that pays for it. Rather than the buyer borrowing from a bank and handing the seller cash, the buyer signs a promissory note payable to the seller and gives the seller a mortgage or deed of trust on the property as security. The seller collects payments over the agreed term, and the buyer owns the property from closing, exactly as with a bank loan.

The regulator's word for this is "seller financing." Regulation Z, the rule implementing the Truth in Lending Act, carries two provisions headed "Seller financers" at 12 CFR 1026.36(a)(4) and (a)(5), and excludes a qualifying seller financer from the definition of "loan originator" at 1026.36(a)(1)(i)(D). In everyday use the same arrangement is called owner financing, and a seller who carries part of the price while a bank supplies the rest is said to take a seller carryback or to carry paper. The names are interchangeable; the federal one is worth knowing because the rules that matter are written under it.

Three neighboring arrangements are frequently confused with it and are not the same thing. Taking over the seller's existing bank loan on its existing terms is an assumable mortgage. A lease that gives the tenant the right to buy later is rent-to-own. And an installment purchase in which the seller keeps legal title until the last payment is a contract for deed, which is a species of seller financing rather than a separate idea, distinguished by who holds the deed while the payments run.

The threshold question is whether the seller is a "creditor," and for most sellers the answer is no. Regulation Z at 12 CFR 1026.2(a)(17)(v) says a person "regularly extends consumer credit only if it extended credit (other than credit subject to the requirements of § 1026.32) more than 25 times (or more than 5 times for transactions secured by a dwelling) in the preceding calendar year." A homeowner selling one house and carrying the note is nowhere near five dwelling-secured extensions, so the bulk of Regulation Z's creditor obligations, including the ability-to-repay rules written for creditors, do not attach.

The same sentence contains a trigger nobody expects, and it works on a count of one. It continues: "A person regularly extends consumer credit if, in any 12-month period, the person originates more than one credit extension that is subject to the requirements of § 1026.32 or one or more such credit extensions through a mortgage broker." Section 1026.32 is the high-cost mortgage rule. So two high-cost seller-financed deals in twelve months, or a single one arranged through a broker, makes the seller a creditor with no volume test at all.

The loan-originator exclusions are two different tests, and the difference is the balloon. A seller financer who meets 12 CFR 1026.36(a)(4) or (a)(5) is not a loan originator. Paragraph (a)(4) is open to any "person," including a company, covers the sale of three or fewer properties in any 12-month period, and requires that the financing be "fully amortizing," that the seller make a good-faith determination that the buyer has a reasonable ability to repay, and that the rate be fixed or adjustable only after five or more years with reasonable annual and lifetime caps against a widely available index. Paragraph (a)(5) is open only to "a natural person, estate, or trust," covers one property in any 12-month period, and requires only "a repayment schedule that does not result in negative amortization," plus the same rate condition.

Read those two lists side by side and one practical rule falls out. A balloon payment is not fully amortizing, so it fails (a)(4); but a balloon does not cause the balance to grow, so it satisfies (a)(5). An individual selling one house may carry a note with a balloon and stay outside the loan-originator definition. A company selling three cannot. Both exclusions bar a seller who built the house in the ordinary course of business.

A seller who still owes a mortgage is making a transfer the lender can act on. The federal rule preempting state due-on-sale laws defines the trigger broadly. Under 12 CFR 191.2(b), a sale or transfer "means the conveyance of real property of any right, title or interest therein, whether legal or equitable, whether voluntary or involuntary, by outright sale, deed, installment sale contract, land contract, contract for deed, leasehold interest with a term greater than three years, lease-option contract or any other method of conveyance of real property interests." The protected transfers at 12 CFR 191.5(b)(1), which cover things like a transfer on the death of a joint tenant, a divorce decree or a move into a living trust, do not include a sale to a buyer. So the seller's own lender may call the loan due. The mechanics of that clause and the transfers Congress carved out are covered on the assumable mortgage page.

The interest rate is not entirely the parties' to choose. Where a deferred-payment sale charges no interest or too little of it, Internal Revenue Code section 483 treats part of each payment as interest anyway. It defines "total unstated interest" by discounting the deferred payments at "the applicable Federal rate determined under section 1274(d)," which means a seller cannot convert interest income into sale price simply by writing a low rate into the note. The rules apply to payments due more than six months after the sale under a contract with payments due more than a year out.

The transaction closes like any other sale. The deed transfers to the buyer, and at the same closing the buyer signs a promissory note for the financed portion and a mortgage or deed of trust securing it, which is recorded against the property. The buyer pays the seller on the schedule in the note. If the buyer defaults, the seller enforces the security interest through the same foreclosure process a bank would use, under the law of the state where the property sits.

Four terms carry most of the negotiation: the down payment, the interest rate, the amortization schedule, and whether there is a balloon, meaning a date on which the whole remaining balance falls due. A balloon is common because few sellers want to wait thirty years to be paid, and it is the term that most often decides whether the deal works, since the buyer has to be able to refinance or sell by that date.

A hypothetical example. A seller lists a house at $400,000 and agrees to carry the financing. The buyer pays $60,000 down and signs a note for $340,000 at 7 percent, amortized as though it ran for 30 years but with the full balance due in five. The monthly payment is $2,262.03. Of the first payment, $1,983.33 is interest ($340,000 times 7 percent, divided by 12) and $278.70 reduces the balance.

Over five years the buyer pays $135,721.71 in total, of which $19,952.59 goes to principal and $115,769.11 is interest. At the balloon date the remaining balance is $320,047.41, and the buyer must refinance it, sell, or renegotiate. Because the seller here is one individual selling one property in a 12-month period, the balloon is compatible with the exclusion at 12 CFR 1026.36(a)(5), which asks only that the schedule not produce negative amortization. Had the seller been a company selling three houses that year, the same note would have failed 1026.36(a)(4)'s "fully amortizing" condition.

Pros

• It can close a sale that no lender would fund, whether because of the buyer's income documentation, the property's condition, or an unusual property type.
• The terms are negotiated between two people rather than dictated by an underwriting matrix, so the down payment, rate and schedule can be shaped around the deal.
• Closing is usually faster and cheaper, because there is no lender underwriting, and several third-party costs that a mortgage requires either disappear or shrink.
• The seller receives interest on money that would otherwise have been returned in a lump sum, and may spread the gain under the installment method.

Cons

• The seller carries the buyer's credit risk with none of a bank's infrastructure for collecting, escrowing taxes and insurance, or working out a default.
• If the seller has a mortgage, the sale is a transfer that can trigger the due-on-sale clause, and nothing in the federal rule protects a sale to a buyer.
• Balloon dates arrive. A buyer who cannot refinance by then loses the property, and a seller who wanted to be paid gets it back instead.
• Buyers pay for the flexibility. Rates on seller-carried notes are set by negotiation rather than by a competitive lending market, and there is no shopping process behind them.
• Foreclosing is the seller's problem, and it runs on state law, takes months or longer, and costs money the seller has to advance.