Buying a home is a major personal finance decision, and the large sum of money involved makes this one of if not the biggest transactions most of us will ever be party to. Few individuals possess the means required to cover the entire cost of the house and will therefore take a mortgage. Purchase mortgages are one type of arrangement that can help facilitate home buying. So, what is a purchase mortgage?
Because the financing comes from the seller, a purchase mortgage is also known as seller financing. There are some key differences between this type of mortgage and those offered by a financial institution.
Understanding Purchase Mortgages
A purchase mortgage is a direct arrangement between a buyer and seller. These often take place when there is a pre-existing relationship between the two parties, though this is not a requirement.
In practice, the buyer and seller will enter into a contract. Because a bank is not involved, the two parties have a large amount of leeway to decide upon the contours of the down payment and subsequent mortgage agreement, such as the size, length, and interest rate.
Similar to a more traditional mortgage, the buyer will pay regular mortgage (both principal and interest) payments to the seller over time, gradually building up more and more equity in their asset.
To protect both the seller and buyer, the contract will be entered into a governmental registry. This is a legal document that will serve as a basis to arbitrate any disputes that may arise during the life of the arrangement.
Who Benefits from a Purchase Mortgage?
There are benefits for both the seller and the buyer from a purchase mortgage. For the buyer, these consist of the following:
(1) Pathway to homeownership: Because a purchase mortgage does not include bank financing, it is often suitable for those with lower credit scores or higher debt-to-income ratios. This additional flexibility can be the difference between homeownership for those who might not be able to acquire a traditional mortgage.
(2) Streamlined process: Especially in an instance when two parties have a pre-existing relationship, the process takes place directly between buyer and seller. This prevents bidding wars between multiple prospective buyers, and can also allow for a quicker closing process. Also, with no bank in the picture, buyers can potentially save on closing costs and other fees that financial institutions charge.
(3) Flexible terms: Providing a down payment of 20% tends to be the minimum that many lenders and buyers are looking for. With purchase mortgages, the seller has the flexibility to modify this number and consider other factors.
There are also advantages for sellers, which include the following:
(1) Direct negotiation: If the seller and buyer know each other, there is no need to engage in open houses and other work presenting the property to a wide audience. The seller can directly negotiate with their intended buyer.
(2) Choice of pricing: The seller will also have the ability to define the house price as well as the other terms of the financial arrangement. This can give the seller a high degree of autonomy.
(3) Regular cash flow: Instead of getting a lump sum at the outset, sellers will have access to a guaranteed stream of income. Depending on the agreed-upon interest rate, this could be higher than the returns from other investment opportunities.
(4) Tax benefits: Depending on the particular situation, there might be tax advantages from pursuing a purchase mortgage arrangement.
What Are the Drawbacks of a Purchase Mortgage?
There are, however, some disadvantages inherent with a purchase mortgage. For the buyer, these consist of:
(1) Higher rates: Because the seller is taking on more risk than with a traditional mortgage, they may charge higher interest rates. This can impact the overall cost of the loan during the lifetime of the mortgage.
(2) Inability to pay: There might be a fully valid reason that the prospective buyer is unable to secure traditional financing. The purchaser might not be able to remain current with the regular payments and thus runs the risk of being foreclosed upon.
(3) Balloon payments: Purchase mortgages may include balloon payments at the end of the arrangement, which are higher than earlier payments. This is because buyers often do not have the means to pay more at the beginning of the process. The two sides anticipate that the buyer’s financial situation will improve over the course of the mortgage, and will thus be able to make higher payments towards the end of the arrangement.
For sellers, there are some drawbacks as well, such as:
(1) More risk: Unlike when a bank provides a lump sum of cash at the outset, the risk of a default is ever-present. This is especially true when the prospective buyer has a poor credit score.
(2) Additional responsibility: In addition to parting with the property, the seller is also effectively functioning as the bank. They must monitor the loan progress, keeping tabs on payments made (and any that are missed) throughout the life of the loan.
(3) Emotional burden: Just like providing a loan to friends and family, there are emotional risks of entering into a financial arrangement with someone you care about. Hopefully, the arrangement will go smoothly and the seller will have helped a relation achieve homeownership. However, if things go south, it would be especially painful to foreclose upon a loved one.
The Takeaway
There are some clear benefits of working within the confines of a purchase mortgage. The flexibility and freedom for buyers and sellers to work directly with their counterparty can streamline the process.
However, there are reasons that financial institutions are involved in most mortgages. Financial arrangements are complex and fraught with peril, and a third-party can diminish the risks on both sides of the ledger.
Therefore, before proceeding with a purchase mortgage, it is crucial that both sellers and buyers fully understand the pros and cons of this financial arrangement.
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