Possible foreclosure. If the buyer stops making payments and won't leave the property, you might need to start the foreclosure process, which could take months or even years.
For the buyer, utilizing seller financing means they do not have to pay the points and fees and go through the "red tape" at the bank. Buyers will also consider this because a privately held mortgage does not show up on a credit report or a balance sheet.
One of the primary advantages of seller financing is the ability to defer capital gains taxes by recognizing the gain over several years through installment payments, rather than paying the entire tax in the year of the sale.
The expectation is usually that the initial seller-financed purchase will improve the buyer's creditworthiness and allow them to accumulate equity in the home. Once that happens, they can then refinance their payment to the seller with a traditional lender. Seller financing is sometimes called owner financing.
The buyer may default, delaying payments and putting the seller at risk of not capturing all payments agreed to in the sale. If the buyer defaults on the loan, the seller may need to go through the foreclosure process to reclaim the property.
If the buyer defaults, the seller can repossess the property, as outlined in the finance agreement. This method benefits both parties by providing flexible terms and potentially faster transactions.
When using seller financing, the seller does not have to pay taxes on principal repayments made by the buyer. Taxes are only paid on interest income that the seller earns from this type of arrangement. The interest will be taxed by the IRS as ordinary income.
Who Holds the Deed in an Owner-Financed Deal? It depends on how the deal is structured, but often, the owner holds the deed until they are paid in full—which happens when the buyer either makes the final payment or refinances with a mortgage from another lender.
Owner financing may not affect your credit in the same way a traditional mortgage might, but it can still have an effect. For example, if the seller decides not to report your payments to the credit bureaus, paying on time won't help build your credit score and missing a payment here or there won't harm it either.
Deal Doesn't Value or Has Poor Documentation
It either gets a valuation from the SBA that doesn't justify a full loan or the financial documentation might be so poor that the SBA won't fund the deal. In either case, these are red flags that the business might not be as valuable as it looks on the surface.
Most seller notes are characterized by a maturity term of around 3 to 7 years, with an interest rate ranging from 6% to 10%. Because of the fact that seller notes are unsecured debt instruments, the interest rate tends to be higher to reflect the greater risk.
Per IRS Publication 523 Selling Your Home, starting page 16: Report any interest you receive from the buyer. . If the buyer is making payments to you over time (as when you provide seller financing), then you must generally report part of each payment as interest on your tax return.
You may end up paying higher rates.
So that the dealer can make money from the loan, they will likely offer higher rates than a financial institution. The dealer may be happy to set up a longer-term loan, but the longer you pay, the more money you pay.
As a benchmark, if current conventional mortgage rates are around 6-7%, a seller financing interest rate might range between 3-5% on average. This range typically still benefits the seller by accounting for tax advantages, ensuring long-term passive income, and reducing default risk through manageable monthly payments.
Risks and Downsides of Seller Financing
Default Risk: The top risk is that the buyer defaults on making payments as agreed. The seller must be confident in the buyer's ability to repay the loan. If they default, the seller can repossess the business but a disruption is likely.
From the buyer's perspective, the interest paid on seller financing may be deductible as business interest, subject to certain limitations and conditions. The buyer should consult with a tax professional to determine the deductibility of interest payments.
The buyer does not need to qualify for a loan with a financial institution. Moreover, the seller can receive a higher return on the “investment” through receiving equity with added interest. The seller can also negotiate a higher interest rate or higher selling price.
Conventional mortgage vs seller financing
One final major difference is the structure and duration of the loan itself. Conventional home loans usually have repayment periods of 15 or 30 years. With seller-financed mortgages, five years is a more common term, although every arrangement is different.
In such cases, seller financing emerges as a viable option, enabling buyers to negotiate terms directly with the seller. The most critical aspects of these negotiations are interest rates and repayment periods, which must strike a balance that suits both parties involved.
A mortgage contingency usually provides 30 to 60 days for buyers to secure loan approvals — which means that if buyers don't obtain financing within that period, they risk losing their earnest money deposits, and sellers are legally allowed to cancel the contract.
Many seller financing agreements use a deed of trust. With a deed of trust, the buyer and seller agree to have a neutral third party hold the title. The trustee holds the title until the buyer meets their obligations under the agreement. Once that occurs, the trustee can transfer the title to the buyer.
Seller financing typically runs for a relatively short term that is amortized for a longer period of time. At the end of the term, a balloon payment is due. This balloon payment is a lump sum representing the remaining balance on the principal.