A conventional mortgage is challenging to qualify for, especially if the borrower has a bad credit score. In such situations, a purchase money mortgage is helpful as it allows borrowers with a bad credit score to buy a home.
This type of mortgage has flexible eligibility requirements and is a good option if the borrower can’t qualify for a conventional mortgage. Most home buyers consider a purchase money mortgage because of the relaxed qualifications and flexible underwriting guidelines. Read on if you want to learn how purchase money mortgages work in real estate.
What Is a Purchase Money Mortgage?
A purchase money mortgage is a home loan offered by the seller to the homebuyer. In most cases, the lender issues a home loan to the buyer for purchasing the home, but with this mortgage, a seller steps in. For this reason, this mortgage is known as owner financing or seller financing.
The seller offers this mortgage as a part of the purchase transaction to the home buyer. In this mortgage, the seller is the lender, and they set the interest rate, down payment, and other loan details. Home buyers mostly get this mortgage when they are unable to obtain a loan from the bank due to bad credit or any other reason.
This mortgage differs from a conventional mortgage in which the seller doesn’t finance any part of the purchase. The buyer obtains a home loan from a bank (lender), gives the amount to the seller, and purchases the home. The seller then steps out after taking their money, and the home buyer pays the mortgage to the lender till the loan matures. In some cases, the lender uses the down payment amount to pay off the existing mortgage on the property and the closing costs. On the other hand, with a purchase money mortgage, the home buyer pays the purchase money to the seller directly, without involving a bank or a private lender.
How Does a Purchase Money Mortgage Work?
A purchase money mortgage works in different ways, which are as follows:
- If the seller owns the property without any existing mortgage, the buyer pays a down payment to the seller. The seller finances the remaining cost of the home as a purchase money mortgage. The seller also sets the monthly payments and interest rates.
- If there is an existing mortgage on the property, the buyer assumes the mortgage by taking responsibility for the remaining mortgage payments. The seller finances the difference between the remaining mortgage amount and the down payment.
- The buyer can’t qualify for a large loan enough to cover the price of the property. The buyer pays the down payment to the seller, and the seller finances the remaining amount as purchase money mortgage.
Types of Purchase Money Mortgages
Purchase money mortgages are structured in a variety of ways. Types of purchase money mortgages include land contracts, lease purchases, assuming the seller’s mortgage, and bank loans.
A purchase money mortgage may occur with a land contract. In a land contract, the seller doesn’t give the legal title to the buyer until the final payment is made. During the mortgage term, the buyer has equitable title on the piece of the land. In this type of mortgage, the buyer and the seller agree on the home price, down payment, repayment schedule, and interest rate. However, the buyer receives legal title of the land after the final payment.
In a lease-purchase agreement, the seller leases the property to the buyer and gives equitable title to the buyer. Once the lease-purchase agreement has been fulfilled, the seller gives legal title to the buyer.
Assuming the Seller’s Mortgage
If the seller is giving a mortgage on their property that already has an existing mortgage, the buyer must assume the mortgage. By assuming the mortgage, the borrower can take the mortgage from where the seller is leaving and continue to pay at the same rate for the existing mortgage. This way, the buyer will have two mortgages, the purchase money mortgage and the assumable mortgage, at different rates and terms.
Bank Loans with Purchase Money Mortgages
If the buyer can’t obtain a large loan from a bank that can cover the home price cost, the buyer can get an additional mortgage in the form of a purchase money mortgage. For example, if a house costs $400,000 and the buyer could only obtain $300,000 as a mortgage from a bank, the buyer can get an additional purchase money mortgage from the seller. The buyer can pay $20,000 as a down payment and obtain the remaining $80,000 from the seller as a mortgage to cover the home’s purchase price.
Benefits of Purchase Money Mortgages for Sellers
Sellers benefit a lot from purchasing money mortgages. Since a bank isn’t involved in this transaction, the seller can carry out faster and cheaper transactions. Besides that, the seller can also offer a loan above the market rate to benefit from the payments on the mortgage. This creates more cash flow for the seller. The seller may also pay less on installment sale taxes.
Benefits of Purchase Money Mortgages for Buyers
The main benefit of a purchase money mortgage for the buyer is that it is easier to qualify. The qualification requirements are more flexible for a purchase money mortgage as compared to a conventional mortgage. The seller may also allow the borrower to choose from various payment options, which include fixed-rate amortization, interest-only payments, balloon payment, or less-than-interest payments. Besides that, the buyer can also negotiate the down payment if they can’t afford a high upfront amount. The closing costs are also lower in purchase-money agreement mortgages. Lastly, the borrower can make the payments faster and get the title easily in a purchase money mortgage.
Purchase Money Mortgage vs. Hard Money Mortgage
A hard money mortgage is also used by buyers with bad credit who face difficulties in qualifying for a conventional mortgage. In a hard money loan, the purchased property is used as collateral for the mortgage. A purchase money mortgage differs from a hard money mortgage in the following ways:
|Purchase Money Mortgage||Hard Money Mortgage|
|Financer||Seller||Bank or traditional lender|
|Mortgage terms and conditions||Based on the buyer’s credit report or seller’s existing mortgage||Based on the property used as a collateral|
|Loan approval||Slow process||Fast process|
|Buyer type||Buyers who can’t qualify for traditional mortgages||Buyers who can’t qualify for traditional mortgages|
Purchase Money Mortgage Examples
Example: Suppose Luke couldn’t qualify for a traditional mortgage that is enough to purchase a property that is worth $250,000. Luke could qualify for only $150,000 from a conventional lender because he doesn’t have a high monthly income. He discusses his situation with the property seller and expresses his wish to buy his property. The seller wants to sell the property too, and he proposes that he can become the lender and offer him a purchase money mortgage to cover the remaining price of the property. The following is a breakdown of the mortgage:
- Home price: $250,000
- Mortgage approved by the bank: $150,000
- Down payment: $30,000
- Purchase money mortgage: $70,000
Luke has to make monthly payments for two mortgages: the purchase money mortgage and the conventional mortgage. However, with the help of the purchase money mortgage, he was able to buy the house of his dreams.
Frequently Asked Questions
What are the Risks Associated with a Purchase Money Mortgage?
A few risks are associated with a purchase money mortgage for the buyers and sellers. Due to high monthly payments, the buyer has to pay a higher price for the house with this mortgage. Plus, the deed transfer will be complicated if the seller has a lien on the buyer’s property. If the borrower defaults on the loan, the seller can foreclose the property just as a bank does when the borrower defaults. Lastly, since fewer regulations are involved in the process, the eviction or foreclosure process in case of default can be lengthy and complicated.
Why Would a Buyer Choose a Purchase Money Mortgage?
A buyer will choose a purchase money mortgage if they don’t qualify for a conventional mortgage. This happens when the buyer has a bad credit score or a high debt-to-income ratio. Moreover, a buyer also chooses this mortgage when they aren’t able to obtain a mortgage large enough to cover the cost of the property. In this case, they can take an additional mortgage from the seller, a purchase money mortgage. These mortgages have flexible requirements, and there are very few regulations and conditions to meet.
Who Holds Title in a Purchase Money Mortgage?
In a purchase money mortgage, the seller holds the property title. Title of the property is transferred to the buyer once the loan is completely paid off.
What to Know for the Real Estate Exam
A purchase money mortgage is a type of seller financing in which the property seller provides a loan to the buyer. In this type of mortgage, the seller holds the deed, while in a traditional mortgage, the bank holds the deed. There are fewer requirements and regulations, and the seller sets most of the loan details. Like any other mortgage, this mortgage also requires recording of the financing instrument with the county to protect the interests of the buyer and the seller. These types of mortgages benefit buyers who can’t qualify for conventional mortgages. If you want to learn about more such terms, go through these real estate definitions.