DISCLAIMER: This article is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. HomeLight always encourages you to reach out to an advisor regarding your own situation.
Traditional mortgage lenders require home buyers to sign multiple rounds of endless paperwork to lay out the terms and consequences of a deal gone wrong.
But if you’re one of the less than 10% of sellers who’s agreed to personally give your buyer a mortgage in what’s called a seller-financed deal, you’re the lender now. And you should treat the process with the same level of vigilance using an airtight and enforceable seller financing contract.
Without the right terms and legal protections in place, you’ll have no recourse if the buyer falls behind on payments or defaults on the note. To avoid a worst-case scenario, follow these pointers on drafting a contract that guards your interests as the seller and financier.
- The different types of seller financing contracts (and how to find the right one for your scenario).
- Must-have contract financing terms such as loan payment amounts, interest, taxes, insurance, and additional fees.
- How to set up a payment schedule in your favor.
- Buyer responsibilities such as home maintenance and repairs.
- Enforceable terms in the event of a loan default.
- Who to consult to make sure the contract meets the requirements of your state laws.
Ready to think like a lawyer?
Start with the right type of contract
The first step to making your loan official? Find out which type of seller financing contract you’ll need to carry out the deal.
However, no matter what type of contract you use, it’s paramount that the document adheres to state laws and regulations.
“You need a contract that’s legal in your state, but the loan agreement itself is all totally negotiable,” says Edie Waters a top-selling agent in Kansas City, Missouri, who’s sold over 74% more properties than the average agent.
“With owner financing, there are any number of amendments or addendums that you can add to a contract. We always say that the contract is determined by what the buyer is willing to pay and the seller is willing to sell for—in regards to the price, house condition, and loan terms.”
It’s true that the blank seller financing contract you can get online or from a local title company can be modified to fit your specific needs. However, a blank form can’t tell you what terms and conditions are legal in your state, or how they need to be worded in order to be legally binding.
“You want your contract to include all the things that any loan officer at any loan company is going to have in their contracts,” says Waters. “So if you have any completed loan documentation you can work from, that would be a huge benefit.”
Obtaining samples of completed, legally binding seller financing contracts filed in your state is also a great resource to find ideas of terms and conditions to cover in your document.
Ultimately, to be safe, it’s always best to hire an agent or an attorney to at least look at the paperwork and make sure you’ve covered all your bases.
Spell out the big numbers: How much are you willing to lend?
First and foremost the seller financing contract is a financial document so it needs to get detailed when spelling out the financial terms—including how much the buyer owes and how they’re going to pay it back.
The three big numbers it needs to include are:
- The agreed-upon sales price
- The non-refundable deposit amount
- The remaining loan balance
“On the contract, there’s a spot for the agreed-upon sales price and the earnest deposit down, then it clearly identifies the loan balance in the line items,” explains Waters.
But these aren’t the only financial figures you need to take into account when setting up the amount of the monthly mortgage payment. Your buyer will also need to pay interest on the loan and other fees.
Pencil in other figures that impact the mortgage payment amount
Just like a traditional mortgage arrangement, in a seller-financed transaction a buyer’s monthly payment will likely include costs beyond the principal loan balance including interest, taxes, and additional fees.
“The contract must include the terms on how the loan balance will be paid back, such as at an 8% interest rate, and other monthly fees—which should include taxes and insurance.”
As this is a private loan, in most states and cases you can charge your lender any interest rate they’re willing to pay—regardless of current mortgage rates—because you aren’t a professional real estate agent or mortgage lender.
And since most buyers need seller financing because they aren’t in a financial position to obtain a traditional loan, it’s expected that the seller financing interest rate will be a bit higher than average.
But you don’t want to go overboard on the interest rate, especially if you’re planning on taking advantage of the tax breaks available with seller financing.
“If I was a seller, I’d charge the buyer 5% interest and take the deductions for any taxes I pay on the house,” says Waters. “It’s these little contract details that give the seller a cushion over the buyer’s monthly payment.”
So, along with the interest rate, the contract between the buyer and the seller also needs to spell out who’s going to take the city and state tax deductions.
Finally, the monthly payment amount needs include any other fees to cover money you’ll spend on the property throughout the duration of the loan, such as taxes and insurance.
“As the seller, you definitely want to collect enough on the monthly payment to cover taxes and insurance,” advises Waters. “You don’t want the buyer being responsible for that because you’re still technically the owner of the house until the loan is paid off.”
If you do intend to pay the property taxes, title insurance, or other housing expenses for the duration of the loan, you may need to set up an escrow account—which should also be explained in the contract.
Once all the numbers that’ll impact the amount owed by the buyer are lined up, the contract needs to detail exactly when and how much you’ll get paid each month.
Set up the payment schedule for your seller-financed loan
“The contract should include a plan to buy down the loan that states how much the buyer is agreeing to pay each month, and for how long. This is called the amortization schedule,” explains Waters.
Again, since this is a private loan, the seller is pretty much free to set any repayment schedule that the buyer is willing to accept.
Most seller financing arrangements are a short-term solution to the buyer’s inability to get a traditional loan—with the expectation that the buyer will find alternative financing within a few years.
The repayment schedule often reflects this short-term approach with terms meant to financially motivate the buyer to find alternative financing as soon as possible.
For example, the contract might include an interest rate that increases annually, or a sizable balloon payment scheduled to be paid just a few years into the loan.
While this financial incentivizing has long been the practice in seller financing contracts, it’s no longer so cut and dried, legally speaking.
The dubious mortgage lending practices that led to the housing market crash during the 2008 financial crisis, resulted in the federal government instituting the Dodd-Frank Financial Regulatory Reform Bill.
And while these regulations were designed for traditional companies, some do impact private loans—which means you may not be able to include that incentivizing balloon payment after all.
The smart play is to run your repayment plan by a real estate contract expert (like an agent or an attorney) to make sure it meets all legal standards.
List out all of the buyer responsibilities—no term is too obvious
Beyond the financial obligations, the seller financing contract also needs to detail all other buyer responsibilities, like maintaining the property and paying expenses that could put the property in jeopardy.
“You have to be careful with the details and guidelines in the loan contract. It needs to state that the seller is just the bank, not the landlord,” advises Waters.
Be perfectly clear that the buyer is responsible for things like the home maintenance, because sometimes the buyer thinks that the seller is responsible.
For example, if the dishwasher breaks, the buyer needs to replace it, not the seller.
It may seem silly to detail common sense responsibilities like keeping the landscaping healthy or replacing broken appliances, but just remember that it’s still technically your home until the loan is paid in full.
So you need to clearly state that the buyer must maintain the condition and value of the property for the duration of the contract.
If spelling out your home maintenance expectations for the buyer seems outlandish, then stating that they must pay other bills on time may sound like you’re overreaching.
However, any buyer-paid housing expenses that can put the home at risk if left unpaid need to be detailed in the contract—so you have legal recourse to protect your property.
For example, if your buyer falls behind on the HOA fees, that can lead to a property lien or foreclosure on your property. This can prevent you from selling the house if the buyer also defaults on the loan—and could even leave you on the hook for those unpaid bills.
That’s why the contract needs to detail these buyer responsibilities, so that you can take steps to protect yourself before it reaches this stage.
Include loan default terms and consequences
Once all the terms and expectations are laid out, the contract needs to state the consequences that’ll happen if those terms and expectations aren’t met. This ensures that you have legal recourse to protect your property and evict your buyer if necessary.
In fact, the possibility of your buyer defaulting on the loan is exactly why the contract needs to name the home features and assets that the buyer is expected to maintain, repair, or replace.
“With seller financing, the challenge is when the buyer defaults on the loan. In desperate times, good people become desperate. They will strip down the house and sell the stuff for money,” warns Waters.
“So anything they could sell—like the appliances, the hot tub, the light fixtures, even the doors—that all needs to be detailed in the contract to spell out what’s all included in the loan. Otherwise, you don’t have any recourse if they sell them out from under you.”
Protecting the condition of the house is necessary so that you can turn around and sell the house again without having to invest a lot of money to repair or replace items. However, you can only sell the house once the defaulting buyer has been evicted.
So one of the most important details of the contract is the statement of your right to evict and foreclose. Eviction and foreclosure vary by state, so it’s essential that your seller financing contract states these rights in language that meet the requirements and language of the state where the property is located.
If not, you may run into trouble if you do find yourself in a situation where you need to evict your buyer.
The bottom line on seller financing contracts: There’s a lot riding on this paperwork
Writing any legally binding contract on your own is tricky business in the best of circumstances—and when it’s a real estate contract, the contract is only part of the process. There are tons of other forms and details to address, like title insurance, transfer of property rights, and more.
If you don’t get it all done correctly, you may be putting your finances at risk.
Header Image Source: (Maresa Smith/ Death to the Stock Photo)