One of the biggest considerations when negotiating an owner-financed home sale is determining a fair interest rate. The seller needs to make certain that she is charging enough not only to cover her own mortgage, if applicable, but also to make a fair return on her investment. Charging too much interest, however, may cause the buyer to walk away.
Think Like a Bank
Chances are you're considering a seller-financed deal for one of two reasons: You're either looking to make a return on your real estate investment by charging interest on an installment loan, or you want to buy a house but can't qualify for traditional financing. A seller who has his own mortgage to worry about should charge a higher rate than he's paying; in other words, if you're paying 6 percent, consider charging 8 or 9 percent. Just like traditional financing, in seller financing, riskier buyers pay higher rates.
Sellers who charge too much, however, may cause their buyers to balk. A buyer who has a large down payment, perhaps 20 percent or more, and good credit should be given a better interest rate because she is less of a risk. The buyer may also agree to paying more than fair market value for the home in exchange for a reduced interest rate; although the seller won't see the income immediately, she will be paid in full at term-end. A seller may also consider the amount of the monthly payment that's used to pay down the principal; a buyer may agree to a higher interest rate if more of the payment goes toward paying down the balance. There may be tax advantages for the seller in this approach, too.
The biggest risk for both parties is default. If the buyer reneges or the seller is forced to sell the note to a secondary market, there is significant potential for a big financial hit. If interest rates have dropped enough that the buyer refinances -- assuming he has improved his credit during the term -- the seller will lose his income stream. Although he will then be paid in full, he'll also have to declare any profit on his income taxes.
Due Diligence and Your State's Laws
Both parties should be sure to complete a thorough due diligence process before determining the deal's interest rate. Hiring competent representation to review state usury laws protects both parties. Reviewing income, asset, and credit history information will alert the seller to the level of risk the buyer has. Many deals have prepayment penalties; buyers must pay attention to the deal's fine print to ensure they aren't being taken advantage of, as unscrupulous sellers sometimes make terms so expensive and strict that the deals seem doomed to fail. When it does, the seller forecloses and repurchases the property, cheaper than before. However, sellers need to assure themselves that their buyers can truly afford the home; agreeing on a fair interest rate is a good way to help.
- Nolo; Seller Financing: How it Works in Home Sales; Broderick Perkins
- Real Town; What Interest Rate Should a Seller Charge for Seller Financing?; August 2009
- Owner-Financing: Interest Rate Risks of Owner Financing
- Century 21: Seller Financing
- Jawnies; Seller Carry Back Mortgages: Financing Solutions for Real Estate Buyers and Sellers; April 2011