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Purchase Money Mortgage: Definition – Explanation – Example

What Is a Purchase Money Mortgage?

Purchase Money MortgageA purchase money mortgage is seller or owner financing granted by the seller of a home to the borrower as part of the purchase transaction. This type of financing is typically used when a buyer cannot qualify for a mortgage through standard banking methods. A purchase money mortgage can be employed when the buyer assumes the seller’s mortgage and the difference between the balance on the assumed mortgage and the property’s sales price is made up of seller financing. A purchase money mortgage might allow purchasers with less-than-perfect credit to purchase a property. This may appear to be a good idea to become a homeowner no matter what. However, there are some drawbacks to this procedure.

As part of the purchase agreement, a person purchasing real estate may grant the seller a mortgage on the property. This form of financing replaces some or all of the cash the buyer would have paid the seller otherwise. A buyer could, for example, pay for a $600,000 house with a $400,000 bank mortgage, $100,000 in cash, and a $100,000 purchase money mortgage. The interest rates for purchase money mortgages are greater than those on typical bank mortgages. They are frequently utilized by buyers who do not have enough savings to cover a traditional down payment.  Or, buyers who are unable to obtain a large enough bank mortgage due to poor credit.

Purchase Money Mortgage – A Closer Look

A purchase money mortgage is not the same as a standard mortgage. Rather than getting a mortgage through a bank, the buyer makes a down payment to the seller.  The buyer then submits a financing document as proof of the loan. Typically, the security instrument is recorded in public records, shielding both parties from future disputes. Any existing mortgage on the property is only significant if the lender accelerates the loan upon sale.  This could be due to an alienation provision. If the seller has a clear title, the buyer and seller simply agree on an interest rate, monthly payment, and loan period. In either case, the buyer pays the seller in installments for the seller’s equity.

Types of Purchase Money Mortgages

Buyers can utilize a purchase-money mortgage to negotiate a bargain directly with the seller. There aren’t many restrictions or standards that buyers or sellers must fulfill because it’s a private mortgage. It varies from agreement to agreement.  However, most buyers and sellers employ one of the following transaction types.

Land Contract

A land contract does not provide the buyer with legal ownership when the mortgage is issued by the seller. Rather, the buyer is given an equitable title. The buyer and seller reach an agreement on the down payment, interest rate, and payment frequency. The buyer makes the agreed-upon payments to the seller on the agreed-upon dates. When the buyer has paid off the mortgage or refinances, the seller transfers the deed to the buyer.  At that point, the buyer becomes the owner of the property.

Lease Option Agreement

A lease option agreement is a rental agreement.  However, it includes the option to purchase the property at the end of the lease or when it expires. When negotiating the transaction, the buyer and seller hash out the lease details and the opportunity to buy. The majority of lease option agreements apply a percentage of the monthly rent toward the down payment for the home. The potential buyer can choose not to exercise the right to buy the house.  However, they then forfeit the extra money paid each month to put toward the purchase.

Lease-Purchase Agreement

A lease-purchase agreement is similar to a rental arrangement.  However, there is an obligation to purchase the home before the lease period expires. In a lease-purchase deal, the seller grants the buyer equitable title and leases the property to the buyer. Following the completion of the lease-purchase arrangement, the buyer receives title and credit for some or all of the rental payments toward the purchase price.  At this point, the buyer often obtains a loan to pay the seller.  If the buyer is unable to obtain typical mortgage financing at this time, it may prove difficult.  Unless, of course, the seller steps in to offer seller financing.

Assuming The Seller’s Mortgage

Sometimes, the seller has a mortgage on the property that will not be paid off before the buyer takes possession. In this case, the buyer must assume the mortgage.  In other words, the buyer picks up where the seller left off on the loan.  The buyer assumes the same payments at the same rates from the same lender. Buyers often have two mortgage options because most homes sell for more than the existing mortgage amount.  They can assume the existing mortgage and carry a purchase money mortgage for the difference. These typically have varying interest rates and terms. Buyers must understand that before assuming a mortgage, buyers must qualify with the lender.

Hard Money Loans

A hard money loan is a loan from private investors who focus on the property itself rather than the borrower’s qualifications. If the borrower defaults, the hard money lender takes over the property.  Hard money loans are usually for a brief period of time and carry substantially higher interest rates.  Consider this type of loan as a short-term bridge loan. They may be a reasonable choice if the buyer does not have excellent credit.  It allows a fixed period of time during which the borrower can improve his credit score.  Ultimately, it can buy the necessary time to qualify for standard financing to pay off the hard money loan.

Purchase Money Mortgage Benefits for Buyers

Even if the seller gets a credit report on the buyer, the seller’s eligibility criteria are often more flexible than those of traditional lenders. Buyers can choose between interest-only, fixed-rate amortization, less-than-interest, and a balloon payment. Payments can mix and match, and interest rates can fluctuate or remain constant based on a borrower’s needs and the seller’s judgment.

Down payments are flexible. If a seller demands a greater down payment than the buyer has, the seller may allow the buyer to make periodic lump-sum installments toward the down payment. Closing costs are also cheaper. There are no loan or discount points, nor are there any fees for origination, processing, administration, or other categories that lenders frequently impose. Buyers may also close faster and gain possession sooner than with a conventional loan because they are not waiting on lenders for financing.

Purchase Money Mortgage Benefits for Sellers

When offering a purchase-money mortgage, the seller may receive the full list price or more for a home. On an installment transaction, the seller may also pay less in taxes.  Buyer payments may improve the seller’s monthly cash flow, resulting in spendable revenue. Sellers may also receive better interest rates than money market accounts or other low-risk investments.

FHA’s Purchase Money Loan Guarantee Program

The Federal Housing Administration (FHA) oversees various homeownership initiatives. These programs are popular because they allow borrowers to purchase a property with a lesser down payment.  They also have less stringent underwriting standards than traditional loans.

The FHA 203(b) program provides mortgage insurance to protect lenders against the risk of default on mortgages to qualified buyers. Banks originate the mortgages, and the FHA provides the mortgage insurance. If a borrower defaults, once the lender completes foreclosure, the lender may file a claim with the FHA for payment of the remaining principal balance on the mortgage and certain other expenses. (Source: occ.gov)

Up Next: What Is the Income Approach for Real Estate Valuation?

Income ApproachThe income approach is a real estate valuation method where investors estimate the worth of a property based on the revenue it generates. This method is also known as the income capitalization technique.  It is a real estate valuation process that allows investors to estimate the worth of a property based on the revenue generated by the property. It is calculated by dividing the net operating income (NOI) of the rent collected by the capitalization rate. The income approach is used by real estate investors to evaluate a property based on its net operating income.  This is the money a property generates less running expenses.

The income approach is arguably the simplest and most direct way of valuation. An investor simply considers the money generated by the property, regardless of sales comparisons or building depreciation. The property’s income is the most essential indicator of its value.

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