A Guide to Purchase Money Mortgages: Pros, Cons, and Types
If you have below-average credit, a high debt-to-income ratio, or a small down payment, getting approved for a mortgage can be difficult. This could leave you looking for alternatives to finance a new home.
One option could be a purchase money mortgage, in which the seller finances the purchase to the buyer. But is this method of financing the best move for you? Keep reading as we explore exactly what a purchase money mortgage is, some pros and cons, and the different types available.
Key Takeaways:
Purchase money mortgages are a way to purchase a home when you can’t qualify for standard financing.
The seller receives a down payment from the buyer and then sets the interest rate and terms of the loan.
Qualifying with a purchase money mortgage is typically easier than traditional financing.
What is a Purchase Money Mortgage?
The purchase money mortgage definition is fairly straightforward: the buyer finances the purchase of a house through the seller instead of a traditional lender. This is typically done because the buyer has less-than-ideal credit and can’t receive funding through a bank.
Just like a traditional mortgage, the home is used as collateral. The sellers will take back possession if the buyer cannot keep up with their monthly payments.
How Does a Purchase Money Mortgage Work?
A purchase money mortgage works very similarly to a regular mortgage. However, instead of working with a lender, the borrower works directly with the seller. As part of the agreement, the buyer and seller agree on the down payment, the interest rate, and the loan terms. Once everything has been agreed upon, both parties file a deed of trust with the county.
Purchase Money Mortgage Example
Let's examine an example to help better understand how a purchase money mortgage works.
Let’s say Sam wants to purchase a home for $200,000. Unfortunately, her credit score suffered because of some late payments she made a couple of years ago. Because of her lower credit score, she hasn’t been able to qualify for a traditional mortgage.
Her childhood home just went on the market, and she would love to purchase it. Sam approaches the owner and asks if they would be willing to sell through a purchase money mortgage if she can provide a $80,000 down payment.
The sellers agree to finance the remaining $120,000 at a 7.5% interest rate. The loan would be for five years but amortized over a 20-year period. This means she would pay $967 per month for five years. She would also be responsible for homeowners insurance and property taxes.
Once the five-year loan term is over, Sam would make a balloon payment of $61,980. The sellers would then eliminate the mortgage lien on the home.
Pros of Financing a Purchase Money Mortgage for Borrowers
If you’re thinking about using a purchase money mortgage to buy a home, there are some advantages to consider.
Lower closing costs: When using a traditional lender to purchase a home, you must pay closing costs. This can be anywhere from 2% to 6% of the loan amount. With a purchase money mortgage, closing costs are significantly less, usually just enough to cover the seller's expenses.
Fast closing: Without working with a traditional lender, there won’t be a long underwriting process. This can help close the loan much quicker.
Flexible down payment: When you purchase a home through a lender, you need a 20% down payment, or else you’ll pay for mortgage insurance. However, by using a purchase money mortgage, you and the seller can agree on a down payment that works for both of you.
Helps non-qualified borrowers: Purchase money mortgages help borrowers who don’t qualify for traditional lending still purchase homes.
Cons of Financing a Purchase Money Mortgage for Borrowers
There are also some downsides to purchase money mortgages.
Higher interest rates: Compared to traditional lenders, you should expect to pay higher interest rates when using a purchase money mortgage.
Balloon payments: Sellers typically set a shorter loan term of approximately five years in hopes the buyer will eventually refinance the loan. After the set term period, a balloon payment is due to the seller. This amount is usually significantly higher than the normal monthly payment.
Pros of Financing a Purchase Money Mortgage for Sellers
If you’re a seller using a purchase money mortgage, there are also a number of benefits you can receive.
Higher purchase price: Because sellers set the terms of the agreement, it’s likely to get your asking price or more from the buyer.
Pay less taxes: Purchase money mortgages are considered installment loans, meaning sellers can defer the capital gains from the sale.
Increased cash flow: The monthly payment sellers receive from the borrower can help increase their monthly cash flow.
Cons of Financing a Purchase Money Mortgage for Sellers
You must consider a couple of disadvantages before selling your home using a purchase money mortgage.
Risk of default: Buyers using a purchase money mortgage typically have less-than-ideal credit, which means they are more likely to default on their payments.
Lump sum payment not available: Normally, when you sell a home, the buyer's lender writes you a check for the full purchase price. However, with a purchase money mortgage, the lump sum payment is the agreed-upon down payment, and then you receive monthly payments instead.
Different Types of Purchase Money Mortgages
You should be aware of several different types of purchase money mortgages before moving forward.
Land Contract
A land contract is a mortgage between the seller and buyer. The seller sets the interest rate and terms of the loan, and the buyer takes possession of the home and makes monthly payments. Land contracts are usually for terms of five years or less and include a balloon payment at the end of the term. After the buyer pays off the entirety of the loan, the seller transfers the deed to the buyer.
Lease-Purchase Agreement
Lease-purchase agreements are a type of rental contract that includes an agreement to purchase the home at a later date. Before entering into a lease-purchase contract, the buyer typically makes a lump sum payment to the seller as a good-faith gesture about their intention to buy in the future. Plus, a portion of the monthly rent goes toward the future purchase price.
Lease-Option Agreement
A lease-option agreement is very similar to a lease-purchase agreement. The most significant difference is that instead of giving your commitment to purchase the home at a later date, you have an option to buy.
A portion of the rent goes toward the purchase price each month, but if you choose not to buy, this money is forfeited.
Assumable Mortgages
If the current homeowner has a mortgage with more favorable terms than are available, the buyer could assume their mortgage. The buyer continues with the same payments as the sellers were previously making.
One thing to keep in mind about assumable mortgages is that the buyer needs to qualify with the current lender before being able to take over the mortgage.
The Bottom Line
Purchase money mortgages give buyers with flaws on their credit report the opportunity to purchase a home. However, it’s important to understand that they typically have higher interest rates than traditional financing and include a balloon payment at the end of the mortgage term.
