Seller financing is risky. Use these mortgage programs instead

October 6, 2020 - 10 min read

Mortgage alternatives are risky — and often unneeded

Millions of homebuyers who are worried about qualifying for a mortgage turn to alternative options, like seller financing and lease-purchase agreements.

While these programs sometimes work out, they’re much riskier than mainstream home loans. And they’re often unnecessary.

Many home buyers with lower credit or income already qualify for a mortgage — or could with minimal effort — thanks to the flexible loan programs available today.

So if you don’t think you qualify for a mortgage, we urge you to check your options before using alternative financing. You might be surprised.

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Not everyone can qualify for a mortgage

Over the years, mortgages have become more and more accessible.

There are loan programs that allow you to buy a house with:

However, there’s no point pretending that everyone can qualify for a mainstream mortgage.

Certain issues can certainly prevent someone from buying a home, including:

  • A poor credit score
  • Lots of red marks on your credit report
  • Insufficient income or employment history
  • Too much existing debt
  • Not enough savings for a down payment

If you’re facing any of these roadblocks, you might want to wait and improve your finances before buying a house.

If you’re still eager to buy now, without a mortgage, you should know that some alternative financing options are much better than others.

If you do decide to go this route, here’s what you need to know.

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Seller financing: Use with caution

Seller financing lets you purchase a home and pay it off in installments, with payments directly to the seller.

There’s nothing wrong with seller financing as such.

At least you get to own the property when the loan starts. So, in that respect, it’s similar to a mortgage — and dissimilar to some other “alternative” home loans.

But homebuyers who’ve gone down this route report they sometimes encounter title issues.

If you use seller financing, get a property lawyer to check your agreement and make sure you fully understand the terms of the sale.

Somebody else might come along who has ownership or usage rights over the property. And that means the home is worth much less than the buyer originally thought — if anything at all.

So, if you want a seller-financed deal, be sure to get a title search. And you’ll be safer yet with title insurance.

As importantly, get a property lawyer to check your agreement to make sure there are no “gotcha” clauses — and that you understand completely what you’re getting into.

Lease-purchase agreements: Use with caution

Lease-purchase agreements are also known as “rent-to-own.”

That’s because, with a lease-purchase agreement, you rent your home. But the landlord gives you a right to opt to purchase the home within a set period.

If you do that, you should normally get full homeownership rights from the start.

But you’ll have to borrow the purchase price from somewhere: perhaps the seller or — if you qualify for a mortgage at that point — from a bank, credit union, or mortgage lender.

Often, the rent you’ve paid up until the purchase date reduces the purchase price.

There’s nothing wrong with these arrangements, providing you take care to understand what you’re getting into.

But, if you borrow from the seller, the caveats in “Seller financing” (above) apply.

In addition, certain issues can arise when the opportunity comes up for the renter to buy the home.

If home values have fallen, the renter may not want to buy. Or, if they still can’t qualify, they might not be able to afford it. And breaches of contract on the renter’s part can disqualify them from being allowed to buy when the time arrives.

Contract-for-deed: Avoid

Contract-for-deed works a bit like seller financing, but there’s one huge difference: You get no ownership rights over the home until you make your final payment on the loan.

If you default (probably through skipped payments, but the terms can vary by contract), you could be evicted. And every cent you’ve put into “your” new home could be forfeit.

Contract-for-deed agreements work like seller financing, except that you have no ownership or equity in the home until it’s fully paid off.

Worse, that includes all you’ve spent on repairs and maintenance, which some contract-for-deed sales specify as the buyer’s responsibility.

If someone offers you a “land contract” or an “installment sales contract,” those are actually contract-for-deed transactions. They’re just alternative names for the same thing.

Predatory contract-for-deed agreements

Pew notes with regard to contract-for-deed lenders: “Some companies have come under recent scrutiny for predatory practices.”

Remember, there are no laws to protect the buyer in these sorts of deals. Contract-for-deed is not a regulated loan type like mortgage loans are.

The worst lenders may, in effect, bank on borrowers not making it through the term of the loan without defaulting.

When that happens, the borrower may be evicted, with the lender keeping all the money that’s been paid in and returning nothing to the homebuyer.

A negative track record

There’s a well-documented history of contract-for-deed sales being used to purposely swindle home buyers — especially non-white home buyers.

As NPR reported in 2019, “Black families in Chicago lost between $3 billion and $4 billion in wealth because of predatory housing contracts during the 1950s and 1960s.”

With such a poor track record and no consumer protections in place, contract-for-deed sales are better avoided whenever possible.

Personal property loans: An option for mobile homes

Personal property loans generally apply only to manufactured homes, which are sometimes called mobile homes or trailers. You finance your purchase using a “chattel” loan.

This is a type of secured borrowing. If you fail to keep up with the monthly payments, the lender could repossess your manufactured home.

Again, there’s nothing inherently wrong with these, providing you take the time to understand your loan agreement.

But watch out for high-pressure selling of financing by park owners. Don’t sign anything until you’ve checked you can’t get a less expensive loan from a mainstream lender.

Waiting to buy a house with a mortgage

Waiting until you qualify for a mortgage — which might be easier than you think — ensures you’ll get the same low rates and consumer protections as other mainstream borrowers.

If you go the back route, with financing from a private owner, you might be able to buy a house sooner.

But it’s inherently riskier.

Buyers who use options like seller financing, contract-for-deed, and lease-purchase agreements can be more vulnerable to problems with their housing later on. And they have fewer means for recourse.

So, what should you do if you want to wait and buy a house with a mainstream home loan?

Mortgage qualifying might be easier than you think

The truth is that many of those who get into trouble with these alternative forms of borrowing could probably have got a traditional mortgage.

And, if they couldn’t have done so immediately, they might have been able to qualify for a mortgage within a few months or two or three years.

Many who get in trouble with alternative forms of borrowing could probably have got a traditional mortgage. Or, they might have been able to qualify for one within a few months or two or three years.

Those four obstacles we mentioned above (damaged credit, insufficient income, too much other debt, and not enough savings for a down payment) are often much easier to get past than many assume.

Let’s run through some ways around them.

Buying a home with poor credit

Did you know that some lenders will approve your mortgage when your credit score’s as low as 580?

The main loan program for buyers with low credit is the FHA loan, which allows:

  • Credit scores starting at 500 with a 10% down payment
  • Credit scores starting at 580 with a 3.5% down payment

But what if yours is below that?

We recommend waiting to apply until you’ve given yourself time to build your credit score up to 580 — or even better, 620 or higher.

Even if home prices are rising sharply where you want to buy, you may well find yourself better off waiting than with alternative forms of borrowing.

In the meantime, check out our Guide to improving your credit score for some tips.

Buying a home with low income

There’s no ‘income rule’ for mortgage qualifying. Homebuyers qualify for all sorts of mortgage loans, even with low income.

See our list of 8 low-income mortgage programs for more info.

Of course, lenders want to be sure you can comfortably afford to pay the loan back. But they don’t really have income-related scales that say you can borrow x if you earn y.

Your earnings and spending should show you can easily accommodate the payments on a new mortgage.

But what if you can’t show that?

One option to consider is Fannie Mae’s HomeReady mortgage. Those with a current roommate can invite him or her to share the new residence you plan to buy.

Up to 30% of your qualifying income can come from their rent payments.

You just have to provide documentation that your roommate has shared a residence with you for at least 9 of the most recent 12 months. You may also need a letter that they intend to continue living with you at the newly purchased home.

Debt-to-income ratio (DTI) is important

Mortgage lenders examine income much more closely as it relates to your existing debt payments.

This is called your debt-to-income ratio (DTI), and it plays a big role in getting your mortgage application approved.

True, there’s no short cut to this one. You just have to pay down your existing debts — credit cards, auto loans, student loans, personal loans, and other unavoidable commitments such as child support — until your DTI reaches an acceptable level.

But your DTI doesn’t need to be extremely low, either.

Most mortgage loans allow a DTI as high as 43% — meaning your debts (including mortgage) take up 43% of your gross monthly income.

Some programs, like FHA loans, even allow a DTI as high as 50%. But you have to find a lender willing to be so flexible.

Buying a home without a big down payment

Saving for a down payment is cited most often as the main barrier to homeownership. And yet it’s often the easiest to clear.

To start with, you need only put down 3% of the purchase price if you opt for a conventional loan (which most homebuyers do). But you’ll need a decent credit score to get one of those.

If that’s a problem, FHA loans give more leeway over credit. And you only have to put down 3.5% of the purchase price.

A couple of types of mortgages require no down payment at all, including:

  • VA loans (almost exclusively for veterans and those currently serving)
  • USDA loans (for those with modest incomes buying in designated less-densely-populated areas)

If you qualify for either of these programs, you might not need any money for a down payment.

Down payment assistance

Better yet, there are thousands of down payment assistance (DPA) programs across the country — including where you want to buy.

These vary hugely.

You may be offered a low-interest loan to help cover the down payment that you pay back in parallel with your main mortgage.

Other DPAs provide interest-free loans that are forgiven after you’ve stayed in residence for a set number of years.

Some even offer down payment grants — essentially free money that you do not have to repay at all.

Most lenders are willing to partner with down payment assistance programs, and some are even willing to help you find and apply for one.

Using a co-borrower

There’s one more option that can help you buy a home if you don’t qualify for a mortgage.

A co-borrower — someone with creat credit or income to supplement your own — can sign for the mortgage with you. This lets you qualify based on someone else’s strong financials.

A co-borrower or ‘co-signer’ is most often a family member or friend.

This option might sound like the easiest, but there are risks to consider too.

If you fail to make payments or default on the loan, the lender will come after the co-signer or co-borrower for all the money you owe.

This can deplete that person’s savings and also have a serious negative effect on their credit score.

So, if you go this route, you’ll want to be very certain your lower income or credit score won’t stop you from making mortgage payments. And you and your co-signer should be very clear on the terms of the agreements and the potential risks.

The bottom line

Mortgage alternatives aren’t always a bad thing. Especially with seller financing, some find these a fast route to homeownership.

But borrowers lack the legal and regulatory protections every mainstream mortgage brings. So you must proceed with the greatest caution.

Better yet, work toward becoming a qualified mortgage borrower in your own right.

It may not be as hard as you think. In fact, you might be one already without even knowing it.

Time to make a move? Let us find the right mortgage for you

Peter Warden
Authored By: Peter Warden
The Mortgage Reports Editor
Peter Warden has been writing for a decade about mortgages, personal finance, credit cards, and insurance. His work has appeared across a wide range of media. He lives in a small town with his partner of 25 years.