What is a Purchase Money Mortgage?

Real estate has many complex terms and “purchase money mortgage” is one of them. If you’ve asked yourself “what is a purchase money mortgage?” read on below. We’ll tell you what this term means, how it works, and what the benefits are of using this type of financing in a real estate transaction.

Key takeaways

By the end of this article, you will know that:

1. The two forms of purchase money mortgages are sale land contracts, where ownership of the property transfers only after the mortgage has been paid, and lease purchase agreements, in which the buyer leases the property for a period of time before buying it.
2. Purchase money mortgage give buyers greater ability to purchase a property, and sellers the opportunity to gain a regular, passive income from the sale of the property.
3. Purchase money mortgages can be sold on to investors, giving the note-holder an immediate lump sum of money.

What is a purchase money mortgage?

At its core, the purchase money mortgage definition is simple. This type of loan is an alternative to a traditional mortgage. In this case, rather than receiving the funds needed to purchase the home from a bank or lender, buyers who are using a purchase money loan enter directly into a contract with the seller to buy the home.

Also known as “seller financing” or “owner financing,” this arrangement involves the buyers making a down payment to the sellers and making regular installment payments in exchange for equity in the home. It’s typically used in the event that the buyers cannot qualify for a traditional bank loan.

Types of purchase-money mortgages

Installment sale land contracts

Most purchase money mortgages are installment sale land contracts. These documents spell out details like the amount of the down payment, the interest rate, and the amount of the installment payments. They also cover details such as who will be responsible for the upkeep of the home and what happens in the event that the buyers decide to stop making payments.

Notably, installment sale land contracts do not pass legal title to the buyers right away. The buyers are only given the deed once they have made their final payment on the home.

Lease-purchase agreements

Lease-purchase agreements are rarer, but they generally work similarly to a traditional lease. However, the tenants may be required to buy the home at the end of the lease term. In this scenario, a portion of the rent that you pay during your lease term may be applied to the purchase price at the end of the lease term.

That said, the tenants may be required to get a smaller mortgage to account for the portion of the purchase price that wasn’t covered by their rent payments at the end of their lease term.

FHA loan

An FHA loan is ideal for first-time homebuyers or those who haven’t owned a home in the past three years. Because it’s insured by the Federal Housing Administration, lenders are more willing to offer loans to individuals with lower credit scores and smaller down payments. The minimum down payment for an FHA loan is 3.5% if your credit score is 580 or higher. Borrowers with credit scores between 500 and 579 are required to put down at least 10%. Additionally, borrowers must pay for mortgage insurance, which will slightly increase the monthly payments.

VA loan

VA loans provide exceptional terms to eligible military service members, veterans, and some members of the National Guard and Reserves. One of the most significant benefits is the ability to purchase a home with no down payment and no requirement for private mortgage insurance (PMI). VA loans also come with limited closing costs, and the VA limits the fees lenders can charge, making this a cost-effective option. These loans are provided by private lenders but guaranteed by the Department of Veterans Affairs.

USDA loan

USDA loans are targeted at assisting rural homebuyers, which can include some suburban areas that meet the USDA’s criteria. To qualify, you must purchase a property in an eligible area and meet certain income limits, which vary by region. Like VA loans, USDA loans offer 100% financing, which means no down payment is required. These loans also typically offer lower interest rates and mortgage insurance costs than many conventional loans.

Adjustable-rate mortgage (ARM)

An ARM can be an excellent choice for someone who plans to stay in their home for only a few years, or who expects their income to rise in the future. The initial interest rate on an ARM is lower than that of a fixed-rate mortgage, which can make a home more affordable in the short term. However, the interest rate can increase or decrease over time based on market trends, which introduces a degree of uncertainty. Borrowers should be prepared for potential rate increases and ensure they can handle possible payment fluctuations.

Balloon mortgage

This type of mortgage might appeal to someone who has a specific plan for securing a lump sum of money before the balloon payment is due. It typically offers low interest rates and low monthly payments for a set period (usually 5-7 years). At the end of this period, the remaining balance of the mortgage is due in a single, large payment. Balloon mortgages are best suited for people who plan to sell their home or refinance before the balloon payment comes due, as failing to pay the balloon payment can lead to foreclosure.

Benefits of purchase-money mortgages for buyers and sellers

For the buyer

1. It affords you the opportunity to become a homeowner: If you are unable to get a traditional bank loan, your options for buying a home are likely going to be more limited.  Purchase money loans offer a viable path to purchasing your own home.
2. There’s less red tape: Often, when you apply for a bank loan, you’re subject to certain requirements in terms of the down payment, interest rate, and loan term. Since purchasing loans are not held to the same standards, there is often more flexibility available.
3. You may save money on closing costs: Since there’s no mortgage company involved in an owner financing scenario, you won’t be required to pay any of their fees.

For the seller

1. It can be a source of passive income: In particular, sellers who are looking for an ongoing source of monthly income may benefit from this option because it gives them the chance to receive regular monthly payments.
2. That said, there’s still an option to receive a lump-sum payment: If you’re not interested in receiving smaller monthly payments, it’s also possible to get paid in a lump-sum. We’ll get into more detail about the process later, but it’s possible to sell your purchase money mortgage note to an investor and receive payment right away.
3. There are often fewer contingency requirements: With bank loans, mortgage companies often impose certain contingency requirements — like getting a satisfactory appraisal or making certain repairs — that must be met in order to receive financing. However, with purchasing loans, you’re not necessarily subject to requirements like this.
4. You may be able to close more quickly: Since the buyer doesn’t have to go through the underwriting process as they would with a traditional mortgage, you should be able to close on the home more quickly than you would normally.

Cons of a purchase money mortgage

For the buyer

1. Higher interest rates: Often, purchase money mortgages might come with higher interest rates compared to conventional bank financing. This is because the seller, acting as the lender, may view the arrangement as riskier, especially if the buyer has less-than-ideal credit.
2. Limited equity building: If the terms of the purchase money mortgage include a balloon payment or are structured in a way that emphasizes interest over principal, buyers might find that they are building equity in the home more slowly. This can be a significant disadvantage if the market fluctuates downward, potentially leaving them with less home equity than expected.
3. Dependence on seller’s conditions: Since the seller is providing the financing, they might impose stricter conditions or less flexible terms than a traditional lender would. This can include a shorter amortization period, unusual payment schedules, or early payoff penalties, which could make it challenging for buyers to refinance or sell the property later.

For the seller

1. Delayed full payment: Sellers offering a purchase money mortgage won’t receive the full sale price upfront. This arrangement might not be ideal if the seller needs immediate liquidity for other investments or to purchase another property. Instead, they receive payments over time, which involves a certain degree of risk and uncertainty.
2. Risk of buyer default: If the buyer defaults on the mortgage, the seller has to manage the foreclosure process, which can be lengthy and costly. The seller then must either find a new buyer for the property or manage it as a rental until they can sell it, which might not be in their original plans.
3. Overhead management: Acting as a lender means the seller must handle tasks usually reserved for a bank, such as managing account statements, tracking payments, and dealing with potential late fees or collection issues. This administrative burden can be significant, especially if the seller is not accustomed to managing financial instruments.

What to consider before entering into a purchase money mortgage

The terms of the contract

With a purchase loan, buyers and sellers need to work together to hammer out the terms of the contract and come up with an agreement that works for both parties. With that in mind, you’ll want to consider the following:

1. Loan term: The length of time that it will take the buyer to repay the loan.
2. Down payment: A deposit that the buyer makes to indicate their interest in purchasing the property, which goes towards the sale of the property.
3. The interest rate: The rate that the sellers charge for the privilege of allowing you to pay for the loan over time.
4. Balloon payment: A large, final lump-sum payment at the end of a loan. A mortgage can be structured such that the borrower has lower monthly payments (for instance, paying only the interest) than they otherwise would, and then owe the balance of the mortgage at the end of the term.

The structure of the contract

There are two separate ways you can structure your owner financing contract. The most common way is by drawing up a mortgage or purchase money deed of trust and a mortgage note. The mortgage note outlines the repayment terms for the loan and the mortgage or deed of trust holds the home up as collateral in the event that the buyer decides to default on the loan.

This is typically the method most preferred by buyers because it’s the most secure. In this case, the buyer will be put on the title and given a deed while the mortgage gets recorded in public records.

The other method is known as a “contract for deed” or “agreement for deed.” It’s structured in the same way as a mortgage and purchase money mortgage note, except that the seller remains on the deed until the loan is paid off in full.

For their part, sellers usually prefer this method because, since they remain on the title,  the foreclosure process is often easier. It’s also a cheaper and easier method than the alternative.

Purchase-money mortgage examples

There’s a first-time homebuyer, Susan, with a stable job but modest savings and a credit score of 600. She’s interested in a $200,000 home. An FHA loan is perfect for Susan because it allows for a lower down payment and is accommodating to her credit score. She puts down 3.5% ($7,000), securing an FHA loan for the remaining amount. 

Susan’s decision to use an FHA loan to purchase a $200,000 home comes with several financial obligations that she needs to prepare for, both upfront and over the course of her mortgage. These include: 

1. Down Payment: Susan’s first financial commitment is the down payment. For an FHA loan, the minimum down payment is usually 3.5% if the applicant has a credit score of 580 or above. With a credit score of 600, Susan qualifies for this minimum down payment rate, so she needs to pay $7,000 upfront to secure the mortgage.
2. Mortgage Insurance Premiums (MIP): FHA loans require two types of mortgage insurance. First, there’s the upfront mortgage insurance premium (UFMIP), which is typically 1.75% of the loan amount. For Susan, this would be 1.75% of $193,000 (the loan amount after the down payment), which equals approximately $3,377.50. This amount can be rolled into the mortgage if Susan chooses not to pay it upfront. Secondly, there’s the annual MIP, which is usually between 0.45% and 1.05% of the loan balance per year, depending on the loan term, the amount borrowed, and the initial loan-to-value ratio (LTV). This cost is divided into monthly payments and paid as part of her mortgage.
3. Closing Costs: These are fees and expenses that Susan must pay to finalize the mortgage aside from the actual property cost. They typically range from 2% to 5% of the loan amount. In Susan’s case, these could be anywhere between $3,860 to $9,650. These costs can include appraisal fees, attorney fees, title insurance, and more.
4. Monthly Mortgage Payments: Susan’s monthly payments will depend on the final negotiated interest rate, but they will consist of principal, interest, and her portion of the annual MIP. Given the added MIP, her monthly payments might be higher compared to conventional loans.
5. Property Taxes and Homeowners Insurance: These are not specific to FHA loans but are typical homeownership costs. Property taxes can vary greatly depending on location, and homeowners insurance rates depend on factors such as the value of the home and the area’s risk profile.
6. Maintenance and Unexpected Costs: As a homeowner, Susan will also need to account for ongoing property maintenance and potential unexpected repair costs, which are now her responsibility.

When she understands these financial obligations, Susan can better prepare for the total cost of buying a home with an FHA loan and plan her budget accordingly. 

What happens after selling a purchase money loan?

As discussed above, it’s possible to sell a purchase money loan. Many home sellers choose to go this route because, rather than waiting years to receive full repayment on the purchase money loan, it allows you to be paid for your asset in a lump sum. It also allows institutional investors and banks to recycle their capital without creating any new debt.

After buying your mortgage note, the note buyer will ultimately introduce the loan into the secondary mortgage market.  In this case, whole loan acquisition firms like Amerinote Xchange will purchase the whole mortgage loan and service it through maturity.

Frequently Asked Questions

Should I buy a home with a purchase money mortgage?

Deciding to buy a home with a purchase money mortgage should be based on your unique financial needs and circumstances. This type of financing can be particularly useful if you find it challenging to secure traditional financing from banks due to credit issues or if you’re self-employed and face difficulties in meeting standard income verification processes. 

Ensure that you carefully review the terms and conditions of the mortgage agreement, as these can vary significantly from standard bank loans. Before taking a purchase money loan, try consulting with a financial advisor or a real estate attorney for a clearer understanding of how it fits into your financial strategy.

What are the risks associated with a purchase money mortgage?

The risks associated with a purchase money mortgage are its cons for the buyer and the seller. As mentioned above, these cons include high interest rates, risk of buyer default, limited equity building, foreclosure risk, the dependence of the agreement on the seller’s financial stability, and many others. 

Is it still possible to sell my home if my lender requires me to pay my mortgage in the event of a sale?

Yes, it’s still possible to sell your home if the mortgage you’re paying has a due-on-sale clause that requires you to pay it all off in the event of a sale. However, you will need to get your lender’s permission first. You can do this by requesting a release of the due-on-sale clause from your lender.

How do I know if my property is eligible for seller financing?

Your property must be free and clear of any existing mortgages or liens in order tu qualify for seller financing. However, you may be able to negotiate a wraparound mortgage that includes the outstanding balance of the existing mortgage within the new mortgage to be paid by the buyer. You will need to provide a loan agreement that outlines the terms of the sale, including the interest rate, repayment schedule, and other relevant details.

How do I get started with seller financing?

If you’re interested in seller financing, the first step is to contact a real estate attorney to draw up the necessary paperwork. You will also need to work with a mortgage broker or loan officer to get pre-approved for a loan. Once everything is in place, you can start marketing your property as a seller-financed home.

How is a purchase-money mortgage different from other seller financing methods?

A purchase-money mortgage is a loan secured by the property itself and legally recorded, unlike informal seller arrangements. The mortgage is executed through a formal financing instrument (typically a deed of trust and promissory note), making it enforceable and transferable. If the buyer defaults, the seller may need to foreclose, just like a bank would.

Can a purchase-money mortgage be used with a traditional lender?

No. By definition, a purchase-money mortgage replaces the need for a traditional mortgage lender or bank mortgage. It’s a form of nontraditional financing where the seller provides the financing directly. Buyers use it when they cannot qualify for a mortgage from a bank or need more flexible terms.

Can you refinance a purchase-money mortgage?

Yes. A buyer may refinance into a traditional loan once they improve their credit or build equity. This often helps them replace a high-interest seller loan with a lower-cost option from a mortgage lender, and may allow them to remove any lien that had been filed during the original financing.

How is a purchase-money mortgage recorded and enforced?

A purchase-money mortgage must be recorded with the county like any other lien. This protects the seller’s interest if the buyer defaults. If the buyer fails to make payments, the seller may need to foreclose to regain control of the property.

What happens if the seller holds the deed during repayment?

In some structures—such as a contract for deed—the seller holds the deed or keeps title until the loan is paid in full. This gives the seller leverage and makes reclaiming the property easier if the buyer defaults. But it can also limit the buyer’s rights until they fully own the home.

What’s the benefit of a purchase-money mortgage for sellers?

Purchase-money mortgages for sellers allow them to receive full list price or higher, avoid commissions, and either collect monthly income or sell the note for a lump sum. The seller also gets to set the terms and choose who qualifies—often faster than banks.

Can the buyer negotiate the terms of a purchase-money loan?

Yes. Since the buyer and seller agree on the loan without a bank, they can customize everything from interest rate to balloon structure. The seller sets the terms, but flexibility is part of the appeal. This can help the buyer better secure financing when they can’t qualify for traditional financing.

How does a purchase-money mortgage impact the title?

In a standard structure, the deed to the property is transferred to the buyer, and a mortgage on the property is recorded as a lien in favor of the seller. This protects both parties: the buyer becomes the legal owner, and the seller holds recourse if payments stop.

Can purchase-money loans help buyers who lack cash?

Yes. A purchase-money mortgage may allow buyers to move forward with less upfront cash. The seller provides financing, and the buyer often contributes part of the purchase money toward a down payment instead of paying the full purchase price at closing.

What role does the promissory note play?

The buyer must sign a promissory note stating they’ll repay the loan. This document outlines the payment schedule, interest, and penalties. It’s legally binding and, along with the deed of trust, forms the backbone of the purchase-money mortgage structure.

Is a purchase-money mortgage always a full financing solution?

Not always. In some cases, the seller only finances part of the purchase and the buyer uses a primary mortgage lender for the rest. This creates a purchase money second mortgage behind the first, allowing buyers to stretch their financing without relying solely on banks.

Can a buyer use a purchase-money loan to buy back their own home?

Yes, especially in off-market deals like divorce settlements or family transfers. In these cases, the buyer pays the seller directly, often using funds from a money market account, retirement account, or even proceeds from another property sale.

What is a purchase money second mortgage?

A purchase money second mortgage is a secondary home loan provided at the time the buyer purchases the property. It’s usually to cover a portion of the price not financed by the first loan. It’s often used when the buyer cannot qualify for a traditional mortgage large enough to cover the full price. In these cases, a lien has been filed behind the first mortgage, and the mortgage is executed between the buyer and a second lender or sometimes the seller.

What does it mean to purchase a mortgage?

To purchase a mortgage means acquiring an existing loan—either as an investor buying a note, or as a buyer taking over a seller-held loan. If the mortgage from the seller is structured properly, the money from the mortgage goes toward the purchase price of the home, and the new owner assumes responsibility. In private sales, this allows two parties to structure financing without a traditional bank.

What is the meaning of purchase money?

In real estate, purchase money refers to funds a buyer puts toward the purchase of property. It often includes a down payment plus any financing used to purchase the real estate. A seller can extend a mortgage from the seller to cover the remainder. In some lease-purchase deals, the buyer may also have an option to buy the home, with rent credits applied toward the purchase price.