What is a purchase-money mortgage?

What is a purchase-money mortgage?

Often referred to as seller financing, a purchase-money mortgage is a legal arrangement between a property owner and a potential buyer to transfer ownership of the property. In most cases, there is a substantial down payment, and the remaining balance is amortized over 30 years with a five- to seven-year balloon payment. What separates this from a traditional mortgage is the absence of a traditional financial institution as the lender.

“A purchase-money mortgage is most often seen in a commercial transaction, either to purchase rental property or property that will be developed and flipped,” said Blake Shultz, a real estate agent with ARC Realty in Hoover, Alabama. “There are a number of reasons a property owner might offer this – including potential tax advantages – and a number of ways the deal can be structured. The terms of the mortgage nearly always come down to ‘my price and your terms or your price and my terms.’”

Shultz adds that other types of purchase-money mortgages may be used for residential purchases, most frequently a hard-money mortgage in which an individual pays cash for a home on behalf of the borrower who then makes monthly payments.

How does a purchase-money mortgage work?

A purchase-money mortgage bypasses a financial institution in favor of another type of lender. That may be the property owner, who might offer a lease-purchase agreement or a balloon payment. In this situation, the property owner will most often be willing to receive monthly payments for a set time — usually five to seven years — and then expect a lump-sum payoff. At that time, the buyer may be in a better financial situation to borrow the remaining balance from a traditional lender or take advantage of increased real estate values.

In other situations, a homebuyer may borrow from friends or family members who seek a favorable financial arrangement. For example, if deposit interest rates are low and mortgage rates are high, two parties may agree on a rate that splits the difference, allowing the borrower to save while the lender earns more. This arrangement may also be beneficial if the buyer is unable to qualify for traditional financing.

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Types of purchase-money mortgages

The term “purchase-money mortgage” can refer to one of a variety of potential mortgage arrangements. In each case, the lender is an individual or business other than a traditional financial institution.

Seller financing

Seller financing can refer to either commercial or residential real estate, though it is most often leveraged in commercial deals. “It’s rare for a homeowner to pay off a mortgage these days, and that’s typically a required first step in seller financing,” said Shultz. The property owner must own the property outright to finance its sale.

A commercial property owner may opt for seller financing for many reasons. They may be selling the business that occupies the building and choose to retain ownership of the building itself for ongoing income. Or they may decide to defer the income from the sale of the building to a later time by agreeing to monthly payments for months or years.

The buyer may opt for seller financing to maintain cash flow. Since most banks typically require a loan-to-value ratio at or below 70/30 – requiring significant cash upfront from the purchaser – seller financing can go as high as 100%, leaving the purchaser with cash for remodeling, repairs or additional business investment as needed.

Lease-to-own or lease-purchase agreement

With a lease-purchase agreement, the property owner may allow occupancy of the property under a lease agreement, with a certain amount of the monthly payment going toward eventual ownership. As with other arrangements, this lease can be of any term and payment, with any agreed-upon amount going toward ownership.

“This type of arrangement may be ideal for a buyer who doesn’t have cash for a down payment and doesn’t qualify for 100% financing options from a traditional source,” said Shultz.

Assumable mortgage

Most mortgages today include a “due upon sale” clause that requires the mortgage to be paid off at the time the property is sold. This eliminates the possibility of a buyer assuming an existing mortgage. While there are still some mortgages that allow it, the option is often ignored in today’s rate environment. While interest rates are up compared to just a few years ago, they remain comparatively low. “Of course, no homebuyer is going to be interested in assuming a mortgage at 8% if current rates remain at 6%,” said Shultz. “This isn’t the right rate environment for this to be a popular option.”

Hard-money loans

For residential homebuyers, the hard-money mortgage option remains the most common among purchase-money mortgages. This category includes borrowing money from family or friends to finance either all or part of the purchase price of a primary residence. In most cases, if the lender can afford to pay cash for the purchase price, they will want a relatively short term – typically five to seven years – with a balloon payment due at the end.

“By the time the balloon payment is due, most buyers will have enough equity invested to refinance with a traditional lender,” said Shultz. “In addition, the buyer will also have a more extensive credit history to demonstrate creditworthiness.”

This category also includes some finance companies that specialize in short-term loans for the purchase of investment properties to renovate and resell, or flip. The interest rates on most of these loans will not appeal to buyers who intend to occupy the home, and quick payoff is the ultimate goal.

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Pros and cons of a purchase-money mortgage

Depending upon the specific type of purchase-money mortgage you choose, there are several pros and cons for each. Because this type of mortgage is customized for a specific transaction, the terms can be adjusted to suit the needs of both parties, but you should be prepared for these general conditions:

Bottom line

A purchase-money mortgage – regardless of type – will nearly always be lender-driven, meaning that the lender must first be open to such an arrangement. Once the nonbank lender – whether property owner, family member or short-term investor – has agreed to participate, a purchase-money mortgage can be negotiated to financially benefit both borrower and lender.