What Is Purchase-Money Mortgage?

A purchase-money mortgage or seller financing is a mortgage issued by the home seller as part of the purchase transaction. This can be an excellent solution for buyers who don’t qualify for a traditional mortgage. In some cases, the buyer may assume the seller's mortgage, and the difference is made up with seller financing.

A purchase-money mortgage offers people with less-than-perfect credit the chance to buy a home with financing. But this option has pros and cons. Understanding the risks and advantages before entering a purchase-money mortgage is important. Read on for details of the types of mortgages you can consider. 

Understanding Purchase-Money Mortgage

A purchase-money mortgage is a type of seller financing. This differs from a traditional mortgage in that the buyer won't apply for the mortgage with the bank. In some cases, the buyer will assume the seller's mortgage and the seller will finance the difference between the outstanding mortgage balance and the home sale price. This differs from a traditional mortgage.

How Does Purchase-Money Mortgage Work?

A purchase-money mortgage allows more buyers to purchase a home. The usual barriers to entry, including a low credit score, no credit score or an insufficient down payment, may not be obstacles for this type of mortgage. 

Instead of obtaining a mortgage through a bank, the buyer makes a down payment to the seller and gives a financing instrument as evidence of the loan. A purchase-money mortgage security instrument is recorded in public records to protect both parties from disputes in the future.

The simplest form of a purchase-money mortgage happens when the seller has a clear title. Then, the buyer and seller agree on an interest rate, monthly payment and other loan terms. 

After the agreement, the buyer will pay the seller monthly installments at the agreed-upon rate until the home is paid for in full. If the property has an existing mortgage, the lender may agree to transfer the mortgage to the buyer. But if the lender has an alienation clause, the mortgage balance will be due on sale, paid by the seller or the buyer.  

Here's an example: Fred and Jane are selling their ranch home to move into a retirement property. The home's market value is $400,000. They have paid off the mortgage and own the home outright. Lila puts in an offer on the home for $400,000 but requests a purchase-money mortgage. She has $20,000 saved for the down payment. Fred and Jane accept the offer with an interest rate of 9%. They agree to a 20-year repayment period. 

That means Lila agrees to pay $3,843.96 monthly for the principal plus interest. Of course, if interest rates on mortgages go down in the future, she can choose to get a mortgage and repay Fred and Jane in a lump sum. 

Who Should Apply for Purchase-Money Mortgage?

Generally, borrowers with difficulty qualifying for a regular mortgage can look at a purchase-money mortgage. That includes borrowers with low or bad credit, a high debt-to-income ratio (DTI) or a low down payment.

Types of Purchase-Money Mortgages

You can choose from various types of purchase-money mortgages. These include everything from an assumable mortgage to hard money loans. Here's an overview of how each option works. 

1. Assumable Mortgage

With an assumable mortgage, the buyer takes over the seller's mortgage loan to purchase a home. Assumable mortgages are especially attractive to buyers who can take advantage of a seller's locked-in lower interest rate. If the full sale price isn't mortgaged, the buyer may need to take a second mortgage or consider seller financing to cover the difference. 

To assume a mortgage, the buyer must qualify with the lender and meet lender criteria. Generally, government-backed mortgages such as Federal Housing Administration (FHA), Veterans Affairs (VA) or U.S. Department of Agriculture (USDA) loans offer the option to assume the mortgage and usually have some of the most favorable interest rates, making them an attractive option for buyers. 

2. Land Contract

A land contract is the most common type of seller financing. The seller can offer this type of purchase money mortgage whether they own the home free and clear or have an existing mortgage. If they have a mortgage, it would change how the title reads. 

The buyer and seller agree on the down payment amount, interest rate and payment frequency with a land contract. The buyer pays the seller, instead of a mortgage lender, the agreed-upon amount on the agreed-upon dates. The seller only transfers the deed of the property to the buyer once the buyer has paid off the mortgage. This requires excellent documentation to protect both the buyer and the seller. 

3. Lease-Purchase Agreement

A lease-purchase agreement is a type of rental agreement in which the buyer commits to purchasing the home at a later date. Generally, the rental payments or a portion of the rental payments count toward a downpayment on the home. The buyer may pay more each month toward a down payment.

In lease-purchase agreements, the buyer generally pays an option fee for the exclusive right to buy the property and secures financing later to complete the purchase. If the buyer cannot secure financing, they will forfeit the option fee and the additional monthly amount they were paying toward the future purchase of the home.

4. Lease Option Agreement

A lease option agreement is similar to a lease-purchase agreement, except that the buyer can purchase the home when the lease expires. When negotiating the rental contract, the buyer and seller decide on the lease details and the option to buy.

Like a lease-purchase agreement, with a lease option agreement, a portion of the monthly rent may go toward the down payment to purchase the home if the buyer purchases the home. If you don’t exercise the right to buy the house, you will generally forfeit the extra money paid toward the purchase.

5. Hard Money Loans

A hard money loan is private financing offered by private investors who focus on the value of the property rather than the borrower’s qualifications. Hard money loans are generally short-term and carry much higher interest rates. While they are commonly used for commercial property transactions, they're not usually the best option for a private home purchase.

A hard money loan can be a solution if the buyer doesn’t have great credit but works to improve it within the next few years. In that way, the buyer could secure short-term financing before qualifying for a traditional mortgage with better terms. 

Advantages and Disadvantages of Purchase-Money Mortgages for the Buyers

Purchase-money mortgages have both pros and cons for buyers. Here's what you should be aware of. 

Pros

• Unqualified borrowers have options to buy a home
• Lower closing costs
• Flexible down payments
• Flexible guidelines 
• Higher debt-to-income ratio accepted
• Faster closing

Cons

• Higher interest rates
• Foreclosure risk if you miss monthly payments
• Higher monthly payments
• Balloon payment requirements can be high

Should You Use a Purchase-Money Mortgage?

A purchase-money mortgage offers the option for more homebuyers to secure a property. However, it comes with the risk of higher interest rates, the expectation of a balloon payment and the risk of losing the home if you miss a payment. For many borrowers, a purchase-money mortgage offers the option to purchase a home when they might not qualify for a traditional mortgage. Ready to explore other options? Find the best VA loans and FHA loans or compare the best mortgage lenders to find an option that fits your needs.

Frequently Asked Questions