Seller Financing Risks for the Seller

The biggest risk in seller financing is that the buyer stops paying and you have to take the property back, at your own cost and on your state’s timetable. Close behind it come a damaged or uninsured property, rules on home loans you may not know apply to you, tax surprises, and money that is hard to reach once it is tied up in a note. Most of these can be reduced before you sign. Few can be fixed afterwards.

Seller financing means you, the seller, lend the buyer part of the price and take payments over time, secured by the property. The basic arrangement is set out in what seller financing is. This page is about what can go wrong for the seller, and what you can do about it while you still have the leverage of an unsigned contract.

The buyer stops paying

A bank lends to thousands of people and expects a share of them to default. You are lending to one. If that one buyer loses a job, falls ill or simply decides the house is not worth the payment, your whole note is in trouble.

Your remedy is foreclosure, or forfeiture if you sold on a land contract, and either one follows state law. Some states run it through the courts and some do not, and the time it takes ranges from a few months to well over a year. During that time you usually receive nothing, may need to pay the property taxes and insurance yourself to protect the house, and pay an attorney.

Illustrative example. Round numbers, not a forecast for any particular sale.

You sell a house for $250,000, take $25,000 down and carry a $225,000 note at $1,500 a month. Two years in, the buyer stops paying. If the foreclosure takes twelve months and costs $10,000 in legal fees, and you pay $6,000 in taxes and insurance along the way, you are out $18,000 in missed payments and $16,000 in costs before you get the house back. Then it may need repairs before you can sell it again.

A larger down payment is the best single protection. It gives the buyer a stake to lose and gives you a cushion if the house has to be resold.

The property loses value or condition

Your note is only as good as the property behind it. Once the buyer owns the house, you have no say over how it is kept. Deferred repairs, unpaid property taxes and lapsed insurance all eat into the value behind your lien, even while the payments keep coming.

Unpaid property taxes are the sharpest risk, because in most places a tax lien takes priority over your mortgage. If the house burns down without insurance, you may be left holding a note against a lot. An escrow account, where the buyer pays a share of taxes and insurance with each payment, and a requirement that you be named on the insurance policy as mortgagee both reduce this risk. Market prices can also fall, which leaves you with less equity behind the note through no fault of anyone.

Rules you may not know apply

When you finance a home that the buyer will live in, federal consumer lending law can reach you. Dodd-Frank amended the Truth in Lending Act to cover loan originators, and the SAFE Act requires many of them to be licensed. Seller financers can fall within exemptions, but the exemptions have conditions on how many properties you finance and on the loan terms, and the Regulation Z ability-to-repay rule can also come into play. States add their own licensing rules and usury limits on the interest rate.

A note written outside these rules can be harder to enforce and much harder to sell, because buyers check how a note was made. Our plain-English overview of seller financing rules sets out the layers, and the effect on price is covered under Dodd-Frank, the SAFE Act and note value. Ask a real estate attorney in the property’s state before you sign, not after.

An existing mortgage on the property

If you still owe a bank on the house and sell it with seller financing anyway, often through a wraparound, the bank’s mortgage almost certainly has a due-on-sale clause. That lets the bank call the whole loan due when the property is sold. Banks do not always use it, but you cannot count on that. You also stay liable on the bank loan, so if your buyer stops paying you, you still owe the bank every month. See selling a note on a property with an underlying loan for how buyers see these deals later.

Tax surprises

Many sellers report a seller-financed sale on the installment method under IRC 453, spreading the gain over the years the payments arrive, with Form 6252 each year. Two things catch people out.

• Selling or otherwise disposing of the note can bring the remaining deferred gain into income in that year under IRC 453B. Our page on installment-sale tax when you sell a note goes into it.
• A note with a very low rate, or none, can have interest imputed under the applicable federal rate rules, which changes how much of each payment counts as interest income. See AFR and imputed interest on seller financing.

Depreciation recapture, state tax and the holder’s own situation all affect the answer as well. Talk to your tax adviser before you set the terms, because the terms are much easier to change before closing than after.

Your money is tied up

A cash sale gives you the whole price at closing. A seller-financed sale gives you the down payment and then a slow stream of payments for years, at a fixed rate that does not rise with inflation or with market rates. If you later need a lump sum, for a new home, medical bills or an estate, you either wait or sell the note.

Selling a note means accepting less than the balance, because a buyer needs a return on the cash they pay you. The discount is smaller on a note with a strong down payment, a solid payment record and clean paperwork, and larger on one without. A partial sale, where you sell only a set number of payments and keep the rest, can bring in cash with a smaller cut. How that works is laid out in our partial note purchase guide. Prepayment cuts the other way: the buyer can usually refinance and pay you off early, so the long run of interest you planned on may never arrive.

Being the bank is work

Someone has to collect the payments, track the balance, send year-end interest statements, check that taxes and insurance are current and deal with a late payment the day it happens. Sellers who do this themselves often keep poor records, and poor records lower the price of the note later. A loan servicing company takes most of the work off you for a monthly fee. If you die holding the note, your heirs inherit the job along with the income.

Ways to lower the risk before you sign

• Ask for a meaningful down payment and check the buyer’s credit, income and rental or mortgage history.
• Have an attorney draft the note and the mortgage or deed of trust, and record the security instrument.
• Use a licensed loan originator where the rules call for one, and a title company or attorney for closing.
• Set up escrow for taxes and insurance, and require you to be named on the policy.
• Use a servicer from the first payment, so the record is clean if you ever sell.

If you already hold a note

If you are carrying a note now and these risks sound closer than they did when you signed, keeping it, selling part of it and selling all of it are each sound choices depending on your plans and the note itself. Before you decide, it helps to know what it would bring. You can send us your note details for a free quote, with no obligation to sell. Every offer shows the balance, the buyer’s yield and the discount, so you can compare it with the income you would keep.

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