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Buying a home with bad credit can be challenging, especially when the housing competition is so fierce.
There is an option that could help close the gap. It means skipping the bank altogether or supplementing a bank loan with a purchase money mortgage.
But just because it’s an option doesn’t mean it’s a good one. Purchase money mortgages come with huge risks for the seller and higher prices for the buyer.
Here’s what you need to know.
What Is a Purchase Money Mortgage and How Does it Work?
Purchase money loans, also known as seller financing or owner financing, allow buyers to avoid banks altogether by having the seller step in as the lender. It’s used mainly for buyers who might have difficulty qualifying for a bank loan.
This is different from a traditional home sale with a bank. With a bank-lender sale, funds from the buyer’s down payment and loan are used to pay off the seller’s existing mortgage and closing costs. The sellers keep any leftover funds as profit.
With a purchase money mortgage, though, the bank is not involved. Instead, the seller takes the place of the bank as the lender. There are many ways this could be structured, but in essence, the buyer of a home makes payments directly to the seller as if they were a bank. The buyer would sign a loan agreement with the seller outlining the loan terms, such as the interest rate, loan amount, and the amount of the monthly payments.
Types of Purchase Money Mortgage Situations
Purchase money mortgages can be structured in a number of ways.
Bank loan with a money mortgage. A purchase money mortgage can be used in addition to a bank loan if the buyer is not able to get a loan large enough to cover the home costs. For example, a buyer can purchase a $300,000 house with a $200,000 bank loan, $50,000 in upfront cash, and a $50,000 purchase money mortgage.
Land contract. The seller and buyer agree on the amount of the down payment, home price, payment frequency, and interest rate. The buyer of the home does not gain full legal ownership of the property until the last payment on the loan has been made.
Assumable mortgages with a purchase money mortgage. With the approval of the seller’s mortgage lender, the buyer takes over the seller’s existing mortgage terms. The difference between the balance on the assumed mortgage and the home’s sale price could be financed through a purchase money mortgage. For example, a buyer assumes a seller’s $250,000 mortgage, payment terms, and interest rate. But the home is listed for $300,000. The buyer could use a $50,000 purchase money mortgage to cover the rest.
Purchase Money Mortgage Pros and Cons for Buyers
Since compliance regulations require banks to adhere to strict lending requirements, there are a number of factors that could make a person or a property ineligible for financing. “Purchase money loans offer buyers easy financing [because there are] no restrictions on your debt ratio, credit score, or down payment,” says Huy Nguyen, a former lending supervisor at Wescom Credit Union in California.
While seller-financing may be easier for a buyer to purchase a home, that doesn’t mean it comes without downsides. If you are a homebuyer with credit issues and can’t qualify for a traditional mortgage loan, you’ll likely pay a higher overall price for the house with a purchase money mortgage. This accounts for the risk the owner is now assuming that the bank normally would take on. The home will likely be listed for a higher price, and the interest rate will also be higher.
Here are a few other pros and cons buyers should consider:
More flexibility in negotiating loan terms
Fewer overall fees
Lower closing costs
Ability to close more quickly by forgoing bank approval process
Option for bad credit buyers
Difficult to find sellers offering purchase money loans
Interest rates might be higher than a mortgage loan from a bank
Difficult to compare rates across different lenders
Pay a higher price for the house
Higher monthly payments
The seller can default on their mortgage causing a foreclosure, leaving the buyer without recourse or a home
If the seller has a lien on the property it could complicate the deed transfer
Potential for unexpected repairs since typically sold as-is
Without title insurance, there is no guarantee the seller owns the property leaving the buyer vulnerable to scams
Purchase Money Mortgage Pros and Cons for Sellers
For sellers, bypassing the requirements of a bank means that the transaction can be completed faster and cheaper. You could also attract a wider variety of borrowers, including those who do not qualify for a mortgage loan from a bank.
But the buyer could default on payments, and the house could go into foreclosure. “Sellers sometimes lack the means to effectively enforce loan payments, at least when compared to a financial institution,” says Jason Zarraga, a California real estate agent at Homequest. Eviction or foreclosure processes can be very lengthy and expensive, making this a huge risk for the seller if the buyer defaults on payments.
Ability to attract more offers, such as those unable to qualify for financing from a bank
Closing the transaction can be done faster and cheaper
Can charge above-market interest rate on the loan
Higher risk of loan default
Payment made in monthly installments, instead of one lump-sum
Due diligence needed to assess ability of buyer to repay the loan
At risk of defaulted payments, foreclosure, or eviction process
What You Need to Know
Purchase money mortgages offer some advantages and an additional path to homeownership for those who can’t qualify for a bank loan. But there are significant trade-offs.
By eliminating the need for a bank, sellers can benefit financially because the house could sell faster and cost less to close without the bank fees and inspections.
”Seller financing should only be used in some cases where the seller absolutely trusts the buyer’s ability to repay the loan,” says Zarraga. This is because sellers no longer have the assurance that a bank has gone through a borrower’s finances to make sure the buyer can afford the house payments.
Potential homebuyers with bad credit should consider other options before getting involved in a purchase money mortgage. You can look into a government-backed loan such as an FHA, USDA, or VA loan. There are also options for low-income families and programs for lower down payments that could offer better financial terms. You can always reach out to a HUD-approved housing counselor.
Take careful consideration with a purchase money mortgage. Unless you are willing to take on all the financial risks associated, it’s best to avoid them completely.