Creative Financing: Thinking Outside the Bank

“Creative financing” is a phrase that is becoming more common in the financial sphere, especially given the current interest rates. But what exactly is creative financing? It simply means financing methods which are alternative to borrowing from traditional money lenders (i.e., banks and credit unions). There are a few options for creative financing and each has its own pros and cons. A major category of creative financing is known as “seller financing.” This means a buyer would be working with the seller to obtain a loan rather than a traditional money lender. The methods outlined below are examples of some of the most prevalent forms of seller financing.

Contract For Deed

A contract for deed (which is sometimes called a land installment contract) is a financing option where the buyer and seller enter into a contract that requires the buyer to pay the purchase price for real estate through installments over a fixed period of time. Unlike a traditional mortgage, the buyer makes these payments directly to the seller and the seller remains the legal owner of the property until the full purchase price—along with any interest—is repaid. Once that is achieved, title to the real estate passes to the buyer.

A contract for deed is beneficial for buyers who cannot obtain traditional financing, or those who want more flexibility in their contracts. It allows the buyer and seller to agree to terms like the down payment, interest rate, monthly installment amount, and timeframe required to complete the purchase. It is important to note that the interest rate must meet the Applicable Federal Rate (AFR) which is the minimum rate for private loans allowed by the IRS. A contract for deed can be put in place quicker than a traditional loan closing and it is particularly useful if the buyer and seller know each other and have a good working relationship.

This method is not without its drawbacks, however. A contract for deed does not have the same legal protections as a traditional mortgage and there are fewer laws governing them and the seller’s foreclosure rights if the buyer does not timely pay. Additionally, the buyer is generally responsible for property maintenance and taxes even though he does not technically own the property. Finally, many contracts for deeds contain “balloon payments” which are larger, single sum payments due at the end of a loan period. If the buyer is unaware or unprepared, this payment could come as a surprise.

Promissory Note and Mortgage

A promissory note with a mortgage is an additional method that is commonly used in seller financing. A promissory note is a written promise between parties where one party promises to pay the other a certain sum of money at a future date. A promissory note typically includes the principal amount, interest rate, payment schedule, and maturity date. A mortgage is a legal document in which the borrower grants the lender a lien on real estate as collateral for a loan. Generally, a mortgage granted by a buyer to a seller of real estate is referred to as a “purchase-money mortgage.”

The biggest drawback to this method of financing is it cuts out the financial institution as a middleman. Like a contract for deed, a promissory note and mortgage can be a quicker way to close on a real estate deal and it also offers more flexibility between the two parties. It can also provide homeownership opportunities to those with low credit scores who would normally have difficulty securing a loan from a traditional money lender. Unlike a contract for deed though, title to the property passes at closing, so the buyer is the owner right from the start.

The promissory note and mortgage method has its criticisms too. There are fewer laws protecting a buyer in a private transaction than with a traditional money lender. The buyer may also have an interest rate which is higher than the market rate, as sellers are not as able to take on risks like a larger financial institution could. If the buyer fails to make payments and defaults, the seller is also faced with the costly process of foreclosing the mortgage.

Conclusion

The contract for deed and the promissory note and mortgage are two of the more popular methods of creative financing. They both offer options to buyers who might otherwise have difficulty obtaining a bank loan, but it is important to note that in these seller financing situations, a healthy relationship between the two parties goes a long way in making the transaction worthwhile. 

There are many options for creative financing and navigating the intricacies of real estate law can be cumbersome. If you require assistance in your property endeavors, Woods Fuller’s dedicated team of attorneys is here to assist.