What is Alternative Financing?

Generally, alternative financing is considered any type of financing that doesn’t involve a bank or traditional forms of mortgage lending. There are, of course, other forms of institutional lending that may be considered non-traditional. But what I would like to concentrate on here are the common forms of owner financing.

You have no doubt heard the terms: land contract, contract for deed, purchase money mortgage, lease purchase and rent options. Each, although a form of owner financing, have significant differences and confusion, but each also has a legitimate purpose. Frequently these terms are used interchangeably, but there are real differences.

Let’s begin with the purchase money mortgage. This is the closest to the typical bank loan. In utilizing this instrument, the property owner agrees to hold the financing for the property themselves. Therefore, you provide the seller with a down payment, and then make monthly principal and interest (P&I) payments to them until the loan is repaid. Unlike a bank loan, everything is negotiable: the down payment, the rate and the term. But, like a bank loan, you still receive title to the property, and the seller retains a lien against the property. In the event you default, the seller must foreclose the loan, which is an arduous process, especially for a seller without special expertise.

This type of financing may come with a balloon payment after a predetermined number of years, simply due to the fact that although a seller may offer this type of financing as an incentive to purchase their property, they are not interested or able to hold the loan for a typical bank term of 30 years. So, they amortize the loan over a 30-year term, but the entire unpaid balance comes due at the end of 10 years (once again a negotiable matter). Why not just amortize the loan over a ten-year period? The answer is simple economics. A $100,000 loan at 6.25% interest, amortized over 30 years carries a P&I of $615 as a 10 year term makes that payment $1,123.

The confusion over owner financing really starts when we begin talking about Land Contracts, lease purchase and rent with the option to buy. Each comes with a lesser degree of commitment on the part of the buyer, although the seller is usually obligated to sell the property in each of these.

The land contract (or contract for deed) carries the most commitment. It is quite similar to the purchase money mortgage, in that both parties have agreed to a purchase transaction. However, for some reason the seller is unable or unwilling to transfer title to the real estate. Generally, this is due to insufficient down payment or credit. The seller holds the financing, often for a short time, while the buyer corrects his deficiency (saves a larger down payment or repairs credit issues), after which the buyer agrees to refinance the property and pay off the seller. The advantage to the buyer is that they get into the property under less stringent terms than those required by a bank. And, the seller has a buyer who will ultimately release him from the property. The additional advantage for the seller, since no deed is conveyed until the terms of the land contract are fulfilled, is recovery of the property being simpler in the event of a buyer’s default.

The lease purchase carries less of a commitment from the buyer. It merely says that the parties agree to the possibility of a purchase. Usually the buyer and seller enter into a lease, which states that the buyer may purchase the property at a predetermined price, at some point prior to the end of the lease term. If the buyer decides to continue with the purchase, some portion of their rent will be applied to the purchase price. Once again, all terms are negotiable, between the parties and in the event that the buyer does not purchase the property any rent credit he has accumulated is forfeited.

A rent with the option to buy situation provides the least certainty of a purchase. All that is really being said here is that the tenant has the first right of refusal on the purchase of the property. It’s a maybe. Often this looks like a lease purchase, in that some rent may be applied to a purchase, if it happens. A price may be determined, but not necessarily. In the end, the buyer can decide not to buy, and the seller can decide not to sell.

It should be understood that if the seller has an outstanding mortgage on the property, the bank could have certain rights regarding these types of transactions. Since the 1980s, most mortgages include “due on sale” clauses that have been expanded beyond the original prohibition against unauthorized assumptions. These have been expanded to include any transfer of interest to a third party, in some cases even including leases of a long-term nature. Therefore, before entering into one of these forms of “creative” financing, you would be well advised to let your attorney take a look at your current mortgage document to determine your rights.

Gary Straub is an independent real estate consultant and real estate professional for 36 years.