What is a purchase-money mortgage loan? With this nontraditional kind of mortgage, the seller finances part or all of the property for the buyer, who usually does not qualify for traditional financing.
Keep reading to learn more about what a purchase-money mortgage loan is and the benefits and drawbacks of using one.
Key Points
• A purchase-money mortgage is a type of financing where the seller extends credit to the buyer to purchase a property.
• A purchase-money loan may be used when buyers cannot obtain traditional financing due to various reasons, like a poor credit history or unstable income.
• Purchase-money mortgages can take several forms, including land contracts, lease-purchase agreements, lease-option agreements, and assumable mortgages.
• Benefits for buyers include flexible down payments, potentially lower closing costs, and the ability to obtain housing sooner.
• Potential drawbacks for buyers include higher interest rates, large balloon payments, and the risk of foreclosure if payments are not made.
Purchase-Money Mortgage Definition
A purchase-money mortgage is also known as owner financing. The seller extends credit to the buyer to purchase the property. This can be a portion of the sale price or the full price.
In other words, the buyer borrows from the seller instead of from a traditional lender. The seller ultimately determines the interest rate, down payment, and closing costs. Both parties sign a promissory note. They record a deed of trust or mortgage with the county. The seller usually retains title until the financed amount is paid off.
A purchase-money loan is a nontraditional financing method that may be needed when the buyer cannot obtain one of the other different mortgage types for purchasing the property.
The promise to pay is secured by the property, so if the buyer stops paying, the seller can foreclose and get the property back.
If you’re considering a purchase-money mortgage, it may be useful to use a mortgage calculator tool to help you determine what potential payments on a purchase-money mortgage might be.
Recommended: How to Buy a Foreclosed Home the Simple Way
How Does a Purchase-Money Mortgage Work?
Not all buyers are in financial situations that make it easy for them to get a conventional home loan. Even diligent shopping for a mortgage may not help them get the home loan they need.
If a buyer has a profitable business, for example, but doesn’t have two years of tax returns to prove steady cash flow, most mortgage lenders won’t take on the risk.
Enter a purchase-money mortgage. With the right property, seller, and situation, a buyer could finance the home with a purchase-money mortgage. The seller would offer terms to the buyer — usually a higher interest rate and a short repayment term, with a balloon mortgage payment at the end — and the buyer would enter into the agreement. The seller would hold title until the loan payoff.
Buyers and sellers who work with seller financing often intend for the purchase-money mortgage to be refinanced into a traditional mortgage with a lower mortgage payment at a later date.
Purchase-Money Mortgage Example
Let’s say a homebuyer wants to purchase a $450,000 house. They have a down payment of $100,000 and are making a good salary but underwent a bankruptcy two years ago and can’t qualify for a traditional mortgage. They might be able to arrange with the seller to get a purchase-money mortgage for the remaining $350,000 with a balloon payment at the end of five years. By then, they should be eligible for a traditional mortgage.
Types of Purchase-Money Mortgages
Purchase-money mortgages can come in several forms.
Land Contract
A land contract (also called a contract for deed) is simply a mortgage from the seller. The buyer takes possession of the property immediately and pays the seller in installments.
Land contracts are often for five years or less, ending with a balloon payment.
Lease-Purchase Agreement
In a lease-purchase agreement, the buyer agrees to rent the property for a specified amount of time and then enter into a contract to purchase the property at a price that’s the current market value or a bit higher.
For this and a lease-option agreement, the seller typically requires a substantial upfront fee, an above-market lease rate, or both. Part of the monthly rent payment goes toward the purchase price.
Lease-Option Agreement
A lease-option agreement is similar to a lease-purchase agreement in that the buyer agrees to first rent the property for a specified amount of time. But with this agreement, the buyer has the option to purchase the property instead of making a commitment to purchase it.
Assumable Mortgage
Sometimes the seller may have a mortgage that has more favorable terms than are common at the point they wish to sell the home. When that’s the case, the buyer may be able to simply take on that mortgage, with the same terms, and continue to make payments when the seller leaves off. This requires that the mortgage lender approves, of course, and is typically more common with government-backed loans. The buyer may need to pay the seller for their equity, as well.
Hard Money Loan
A hard money loan is generally a short-term high-interest loan made by private investors, often for buyers who want to purchase commercial property. It may make sense if the buyers anticipate that they will be able to refinance within a few years, for example, if their credit will improve significantly.
Pros and Cons of Purchase-Money Mortgages for Buyers
Like any kind of loan, a purchase-money mortgage may have benefits and drawbacks for potential buyers.
thumb_up
Pros:
• Buyers, including first-time homebuyers, may be able to obtain housing sooner than if they were to wait to qualify for a traditional mortgage through a lender.
• The down payment may be more flexible for a purchase-money mortgage.
• Requirements may be more flexible.
• There may be no or low closing costs.
thumb_down
Cons:
• Interest rates are typically higher than they are for other mortgage options
• Large balloon payments may be required at the end of the loan term.
• Homebuyers don’t have the home’s title until they have paid off the entire loan.
• As with any mortgage, there is the potential for foreclosure if you don’t make your payments.
Pros and Cons of Purchase-Money Mortgages for Sellers
Sellers will also want to consider carefully the plusses and minusses of purchase-money mortgages.
thumb_up
Pros:
• The seller may be able to get the full list price or even more from a buyer who needs the seller’s help to obtain a mortgage.
• The seller may be able to make some money by acting as the lender, including asking for a down payment and a higher interest rate.
• Taxes may be lower, since the amount is financed over time.
thumb_down
Cons:
• Responsibility for the property often remains the seller’s, so they may need to pay for repairs, for instance.
• There’s no lump-sum payment at the closing the way you would get with a more traditional sale.
• There may be a higher risk level since buyers are more likely to have high DTI ratios and/or lower credit scores.
Recommended: How to Navigate the Mortgage Preapproval Process
The Takeaway
If you’re able to secure financing from a seller, a purchase-money mortgage may be a good fit — assuming you have an exit plan for a few years down the road. It’s smart for both buyers and sellers to know the risks and rewards of a purchase-money mortgage.
Looking for an affordable option for a home mortgage loan? SoFi can help: We offer low down payments (as little as 3% - 5%*) with our competitive and flexible home mortgage loans. Plus, applying is extra convenient: It's online, with access to one-on-one help.
FAQ
Who holds the title in a purchase-money mortgage?
The seller controls the legal title; the buyer gains equitable title by making payments.
Can a bank issue a purchase-money mortgage?
Yes, but it is not common. A buyer might pay for a house with a bank mortgage, cash, and a property seller mortgage. Both the mortgage issued by the third-party lender and the seller financing are considered purchase-money mortgages.
Does a purchase-money mortgage require an appraisal?
Not if the seller does not require one. With owner financing, the seller sets the terms, which may not include an appraisal.
Is a purchase-money mortgage the same as seller financing?
A purchase-money mortgage is essentially the same as seller financing, though there are several kinds of purchase-money mortgage, including land contracts and lease-purchase options, among others.
Should you buy with a purchase-money mortgage?
In general, if you can get a traditional mortgage, you may be better off with that, since typically you’ll get a lower interest rate and a longer term. However, if you can’t qualify for a traditional mortgage but can afford to make the necessary payments, a purchase=money mortgage can be a way to get a home sooner. Just be sure you understand the terms and have a plan to make sure you can refinance when the term is up.
Photo credit: iStock/MicroStockHub
*SoFi requires Private Mortgage Insurance (PMI) for conforming home loans with a loan-to-value (LTV) ratio greater than 80%. As little as 3% down payments are for qualifying first-time homebuyers only. 5% minimum applies to other borrowers. Other loan types may require different fees or insurance (e.g., VA funding fee, FHA Mortgage Insurance Premiums, etc.). Loan requirements may vary depending on your down payment amount, and minimum down payment varies by loan type.
SoFi Loan Products
SoFi loans are originated by SoFi Bank, N.A., NMLS #696891 (Member FDIC). For additional product-specific legal and licensing information, see SoFi.com/legal. Equal Housing Lender.
SoFi Mortgages
Terms, conditions, and state restrictions apply. Not all products are available in all states. See SoFi.com/eligibility-criteria for more information.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Third Party Trademarks: Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP®, CERTIFIED FINANCIAL PLANNER®
SOHL-Q325-032