Purchase Money Mortgage

Purchase-money mortgages can give people with less-than-perfect credit the chance to buy a home. While it may seem like a great idea to become a homeowner no matter what it takes, this process comes with some downsides that you should know about.

Let’s analyse the journey of buying a home through a purchase-money mortgage and highlight some of the risks involved.

What Is A Purchase-Money Mortgage?

Also known as seller financing, a purchase-money mortgage is a loan the property seller provides to the home buyer. This type of mortgage is common in situations when the buyer doesn’t qualify for standard bank financing, much like other non conforming loans.

As the “bank,” the seller sets the down payment, interest rate and closing fee requirements. The buyer pays the seller a down payment and signs an executed financing instrument outlining the loan details. Like a typical mortgage, the financing instrument is recorded with the county, protecting the interests of both the buyer and seller.

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Why Would Buyers Choose A Purchase-Money Mortgage Over A Traditional Bank Mortgage?

This typically happens when buyers have a bad credit score, a high debt-to-income ratio, a low down payment, and they won’t qualify for traditional bank financing. Willing sellers can provide the financing by accepting the down payment and setting the terms for the loan based on the buyer’s qualifications and the seller’s needs.

The main differences between a purchase-money mortgage and a mortgage.from a bank are the qualifying requirements and who holds the deed. In a traditional mortgage, the bank holds the deed. With a purchase-money mortgage, the seller holds the deed.

Types Of Purchase-Money Mortgages

When buyers use a purchase-money mortgage, they work out a deal with the seller. Since it’s a private mortgage, buyers and sellers have few regulations or requirements to meet. Below are the purchase-money mortgages that buyers and sellers most often use.

Land Contract

A land contract is a mortgage from the seller. The seller could own their home free and clear or have an existing mortgage, which would change the way the title reads. In either case, a land contract occurs when the buyer and seller agree on the down payment amount, interest rate and payment frequency. The buyer pays the seller the agreed-upon amounts on the agreed-upon dates. Once the buyer pays off the mortgage, the seller transfers the deed to the buyer, and the buyer owns the property.

Lease Option Agreement

A lease option agreement is a rental agreement with the option to buy the home during the lease or when it expires. The buyer and seller work out the lease details and the chance to buy when negotiating the real estate transaction.

Most lease option agreements use a portion of the monthly rent toward the down payment to purchase the home. If you don’t exercise your right to buy the house, you forfeit the extra money paid each month to put toward the purchase.

Lease-Purchase Agreement

A lease purchase agreement is also a rental agreement, but the buyer commits to purchasing the home at a later date. The buyer generally pays an option fee for the exclusive right to buy the property and secures financing at a later time in order to complete the purchase. The buyer usually pays additional money each month to apply toward a down payment. If the buyer is unable to secure financing, they typically forfeit the option fee and the additional monthly amount they have been paying toward the future purchase of the home.

Assumable Mortgage

If the seller has a mortgage on the property that has more favourable terms than are generally available for new mortgages at the time of the home’s purchase, the buyer may be able to assume the mortgages. This means the buyer takes over the loan where the seller left off, making the same payments at the same rates.

An assumable mortgage and a purchase-money mortgage usually have different interest rates and terms. It’s important to note that buyers must qualify with the lender to assume a mortgage before taking it over. Generally, the option to assume a mortgage is applicable to government-backed mortgages such as FHA, VA or USDA loans.

Hard Money Loans

Another option is a hard money loan, which is from private investors who focus on the property itself rather than the borrower’s qualifications. The only problem with hard money loans is they’re short-term and carry much higher interest rates. They are commonly used for commercial property expenses transactions.

A hard money loan can be a viable option if the buyer doesn’t have great credit but will fix it within the next couple of years, allowing them to qualify for traditional financing to pay off the hard money loan.

Pros And Cons Of Purchase-Money Loans For Borrowers

Purchase-money loans have pros and cons, just like other types of mortgages. Because each loan is at the seller’s discretion, each loan agreement will have upsides and downsides for borrowers.

Sellers, however, enjoy several benefits. Most sellers secure a higher purchase price because buyers must agree to the sellers’ terms for their financing. Sellers also have access to monthly cash flow and sometimes earn a higher interest rate than they’d earn investing the money in other low-risk investment options.

Pros

• Lower closing costs: By not using a traditional lender, borrowers often save on closing costs. Sellers usually charge closing costs to cover any expenses they incur while putting the loan together, but these expenses are generally lower than standard closing costs which are around 2% – 6% of the loan amount.

• Flexible down payments: Sellers can be as flexible as they want with the down payment requirement. They typically want some money down, but they understand that a large down payment might be preventing a buyer from qualifying for bank financing.

• Flexible guidelines: Most borrowers use purchase-money mortgages when they don’t have good credit or they have a high DTI. Sellers provide the financing because they want to sell the home and possibly help borrowers out, which usually means less restrictive underwriting

• Faster closing: Since there’s no bank to deal with, sellers can often close the loan in a matter of a week or two, depending on the loan requirements.

• Unqualified borrowers being able to buy a home: Borrowers who don’t qualify for bank financing may think they’re stuck with renting forever, but seller financing makes it possible to buy a home sooner than they perhaps otherwise would be able to.

Cons

• Foreclosure risk: If borrowers get in over their head in a mortgage loan they can’t afford, they run the risk of losing the home because the seller has the right to foreclose to property, just like a bank would.

• Higher monthly payments: Your monthly payments could be much higher than if you went with traditional financing. This is because purchase-money mortgage qualification standards can be less strict.

• Higher interest rates: Sellers take a large risk loaning you money and selling you the home. They don’t walk away with a lump sum like they would if you used bank financing. To make up for the risk, they usually charge higher interest rates than banks.

• Balloon payments: Many seller-financing loans include a provision for a balloon payment. This is a payment that can be much larger than your typical monthly loan payment, and it is usually due at the end of your loan term. Sellers may lend buyers money for the short term, hoping they’ll refinance the loan with a traditional bank in a year or so after they fix their credit and/or have the money to afford it.

Should You Buy With A Purchase-Money Mortgage?

A purchase-money loan is a considerable risk. You use the home as collateral and if you miss your payments, you could lose the home. The main difference between a purchase-money mortgage and a traditional mortgage is how you qualify.

For almost all people, it’s recommended to opt for traditional financing from a bank. You’ll likely get better interest rates and lower fees, and you won’t have to worry about a balloon payment in a few years that you may not be able to afford.

If you don’t qualify for traditional financing yet, learn how to strengthen your mortgage application so you can qualify with a mortgage lender for VA, USDA, FHA and conventional finance.

FAQs About Purchase-Money Mortgages

Review some frequently asked questions about purchase-money mortgages below.

Do purchase-money mortgages require an appraisal?

Lenders will typically require an appraisal on the home being purchased, but since the transaction is between the buyer and seller, it may not be necessary. Regardless, an appraisal is still recommended to be sure of the home’s value.

Who holds the title in a purchase-money mortgage?

With a purchase-money mortgage, the seller will generally hold onto the house title until the loan is fully paid off. The seller does this to protect themselves in the event that the buyer is unable to fulfil the terms of the purchase-money mortgage.

How does a wrap-around mortgage work?

Similar to a purchase-money mortgage, a wrap around mortgage is an opportunity for buyers who can’t qualify for a home loan to purchase a home from a seller. The seller finances the buyer’s home purchase but keeps the existing mortgage on the home and “wraps” the buyer’s loan into it.

The seller will continue making monthly payments on their mortgage while collecting monthly payments from the buyer.

The Bottom Line

A purchase-money mortgage is a good alternative when you can’t secure traditional bank financing but know you can afford a home. Explore your options with the seller, including rent-to-own or lease-option agreements, to determine which one is best for your situation since this isn’t a one-size-fits-all approach.