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Many borrowers have trouble qualifying for traditional loan programs with lenders. One option to make home-buying feasible is to seek out alternative mortgage loan financing. With purchase-money mortgages, borrowers with lower credit scores and less than ideal finances can find their ticket to purchasing a home.
What Is a Purchase-Money Mortgage?
In short: A purchase-money mortgage is a type of mortgage financing issued to the borrower by the homeowner/seller to purchase a property. This can be an option for borrowers who do not qualify for traditional mortgages because of their credit score or financial standing.
>> More: How to Apply for a Mortgage
How Do Purchase-Money Mortgages Work?
Purchase-money mortgages work similarly to traditional mortgages, i.e., making monthly payments with interest. The main difference is that the funding comes from the seller, to whom the payments will be made. The borrower and the seller will agree on the loan amount, interest, rate, down payment, and any other loan terms. The seller then draws up the security instrument, aka the loan term agreements, recorded in public records as evidence of the agreement. To ensure their own protection until the loan is paid off, sellers will hold the deed.
Different Types of Purchase-Money Mortgages
Since purchase-money mortgages are private loans, the terms and conditions can vary from transaction to transaction. Depending on their circumstances, buyers and sellers commonly use one of the following methods for purchase-money mortgages.
Hard Money Loans
This type of loan comes from investors whose focus remains more on the property itself than the borrower’s qualifications. These loans typically have higher mortgage rates and are meant to be short-term. If you plan on improving your credit in the near future but need financing to purchase a home now, this can be a great option for you.
In some cases, the seller has an existing mortgage on a property. With assumable mortgages, they could pass this mortgage along to the buyer who will take over making the monthly payments. While this may sound like a smooth transition, buyers should know that they must first qualify for the loan they are assuming.
If the buyer can satisfy this first requirement, the second step is to take out a secondary loan to cover the difference between the first mortgage and the purchase price. With the mortgage they assume from the seller, they would make the payments with the same rates and terms. The terms of the second term will be independent of the first.
A land contract is a mortgage that comes directly from the seller. With this type of agreement, the title and ownership of the home do not pass to the buyer immediately. Both parties will agree to the mortgage terms, including loan amount, interest rate, and payment schedule. Once the buyer finishes paying off the mortgage, the deed is transferred to their name.
Lease Option Agreement
In some cases, renters can enter into lease option agreements with their landlords with the goal of one day owning the property. The property transfer is done either at an agreed-upon time or when the rental lease expires. A common element of such agreements is having a portion of the renter’s monthly payment go towards the down payment. This typically comes with acontingency that the renter loses the money if they back out of the purchase.
This type of agreement is like a lease option agreement and is meant for people looking to own the property they rent. The critical difference is that the renter must buy before the end of the lease’s term. Borrowers should be sure they’re in a position toqualify for mortgage financing elsewhere if the seller does not offer to finance the purchase themselves.
What Are the Advantages of Purchase-Money Mortgages?
Not everyone qualifies for traditional mortgage lending criteria. Whatever the reason for this may be, these people may still look to purchase a property. Purchase-money mortgages offer an alternative path to home buying. Because every purchase situation is different, the terms of these mortgages vary and will depend mainly on the seller’s discretion. There is more flexibility with purchase-money mortgages because sellers do not adhere to the same financing regulations.
What Are the Disadvantages of Purchase-Money Mortgages?
Purchase-money mortgages can be an excellent option for many types of non-traditional borrowers. They do, however, come with their disadvantages. Because the seller holds leverage in the negotiating process, the terms often lean in their favor, i.e., higher interest rates and monthly payments. A huge pull for these mortgages is the lack of regulation. Borrowers should proceed with caution and still make careful financial decisions to avoid taking on payments they can’t afford.
>> More: How to Choose the Best Mortgage
Purchase-Money Mortgage Pros and Cons for Buyers
Any significant financial decision is going to come with some trade-offs. In some situations, the pros will outweigh the cons, and other times, this will not be the case. Consider the pros and cons of purchase-money mortgages before deciding to go this route.
- Flexible borrowing conditions because mortgages are not regulated. Mortgage terms can be adjusted to fit the borrower’s needs.
- Avoid paying higher closing costs – typically between 2-5% of the loan amount with traditional lenders.
- Down payment is more flexible and can be negotiated.
- Fewer hoops to jump through means not waiting for underwriting approval and getting to close faster.
- Viable financing option for borrowers who otherwise would not be able to purchase a home.
- The seller ultimately decides lending terms. This could lead to higher interest rates and monthly payments than with traditional lenders.
- Purchase-money mortgages are not federally backed loans.
- The borrower could unknowingly take on a larger loan and monthly payments than they can afford, leading to foreclosure and losing the home.
- Home is typically sold as-is, meaning the seller would not have to make any repairs they otherwise might with a traditional purchase agreement.
- If the seller defaults on their mortgage leading to foreclosure at any time during the process, the buyer is left without a home and potentially loses money put towards the transaction.
- With the seller having so much say, this could leave the borrower open to liens and other title issues that otherwise might have been addressed.
Purchase-Money Mortgage Pros and Cons for Sellers
Purchase money loans are not just for the benefit of the borrower. Sellers can also take advantage of the exchange for financial gain.
- Since the seller is the ultimate authority on the terms and conditions of the financing, they can charge above-market interest rates.
- Not having to wait for underwriting approval means closing faster and for cheaper.
- Offering seller-backed financing will attract a broader range of borrowers who otherwise may not be able to afford the home.
- Borrowers could default on their payments if the loan and monthly payments are more than they can afford.
- You need to do your due diligence in vetting borrowers to ensure a safe exchange.
- Rather than receiving the proceeds from their purchase in one lump sum, sellers will receive the payments in monthly installments or according to the agreement.
Who Gets the Title in a Purchase-Money Mortgage?
Typically, the seller gets the title. This is a way for the seller to protect themselves until they have been repaid for the mortgage.
Do Purchase-Money Mortgages Require a Home Appraisal?
Traditional lenders require home appraisals to ensure the sales price is on par with the average market value. With private lenders, this may not always be the case. This will be a condition determined by the buyers and sellers, though it is usually recommended.
Are Purchase-Money Mortgages Risky?
As with any financial exchange, there is a certain level of risk associated with purchase-money mortgages for both parties. On the seller side, they could find themselves stuck with borrowers who default on their payments. On the other hand, the buyers could fall victim to predatory lending practices or find themselves owing more than they can afford. Both buyers and sellers should do their due diligence and determine whether purchase-money mortgages are a wise decision for their situation.
Bottom Line: Purchase-Money Mortgages
Purchase-Money mortgages offer an alternative path towards home buying for people who cannot secure traditional financing.
The loan conditions are flexible; buyers and sellers will negotiate and agree on terms that work for both of them. Before deciding to take this financing route, borrowers should understand the risks associated with purchase-money mortgages and weigh the pros against the cons.