What is a purchase money mortgage? How does it work? We’ll answer these questions and explain six potential advantages and disadvantages of using this kind of financing to buy a home.
Depending on who you talk to, you may hear different explanations of what a purchase money mortgage is. The most accurate purchase money mortgage definition is that it’s simply a form of seller financing. Purchase money seller financing is commonly structured in a few different ways, which we’ll cover in a moment.
However, some mortgage professionals also use the term more broadly to refer to any mortgage used to purchase real estate, including FHA, VA, and conventional home purchase financing. This is technically incorrect, but it’s common in the mortgage lending industry. We’ll stick to the more precise definition for our purposes here.
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What is a Purchase Money Mortgage?
A purchase money loan is basically just seller financing. In other words, the seller serves as the bank and holds a mortgage for the buyer in a real estate purchase transaction. This kind of financing is commonly structured in several ways:
- Land contract: A land contract (or contract for deed), is a legal agreement between a buyer and seller for the purchase of real estate. The seller acts as the lender and the buyer makes payments to the seller for a set period of time. The buyer receives possession of the property (called equitable title), but the seller retains legal title ownership until the purchase price is paid in full. Once the payments are complete, the buyer receives full legal title to the property. Land contracts can be a great option for home buyers who have difficulty qualifying for traditional bank financing.
- Lease-to-purchase: A lease-to-purchase agreement (or rent-to-own agreement), is a contract between a landlord and tenant that allows the tenant to lease a property with the option to buy it at a future date. These types of agreements usually include a lease period during which the tenant pays rent and has the right to live in the property. The agreement also includes the option to purchase the property at a predetermined price within a specified time frame. Lease-to-purchase agreements can be attractive for home buyers who have limited funds for a down payment or otherwise have difficulty getting a traditional mortgage.
- Seller financing: In a seller financing arrangement, the seller of real estate provides financing to the buyer for all or part of the purchase price. The seller basically acts as a lender and the buyer makes payments directly to the seller for an agreed-upon interest rate and period of time. The loan is secured by a mortgage on the property, and the buyer is typically required to make a down payment and pay interest on the loan. This kind of financing is sometimes used in combination with a traditional bank mortgage.
As you can see, purchase money transactions can be structured in a variety of ways. In fact, it’s this flexibility that makes them attractive. You’re working directly with a seller instead of a rigid lending institution.
A purchase money mortgage can be structured as the only form of financing (land contract, lease-to-purchase, or seller financing), or it could be a secondary form of financing in addition to a traditional bank mortgage (seller financing).
Advantages of Purchase Money Financing
Purchase money mortgages are advantageous for several reasons:
- Flexibility: Purchase money financing can be advantageous because it’s so flexible. Everything is negotiable because you’re working with the seller instead of a bank with rigid lending standards. You can work with the seller to structure a purchase that works for you both.
- Easier to qualify: Many creditworthy home buyers have difficulty getting a traditional bank mortgage. For example, many self-employed home buyers have excellent qualifications, but they can’t document their income because of how much they write off on their income taxes. A purchase money loan can be a great solution that helps them get into a home.
- Smaller down payments: Purchase money financing can help you get into a home with a smaller down payment (or no down payment at all) than would be possible with a regular bank mortgage.
Disadvantages of Purchase Money Financing
Though purchase money loans can make it easier to get into a home, they’re not without potential disadvantages:
- Higher risk: A purchase money loan can be risky if it’s used to compensate for weak home buying qualifications. If a homebuyer has poor credit, a high debt-to-income ratio, or a shaky job history, they will likely have trouble getting a traditional bank mortgage. A purchase money loan could get the deal done, but should they really be buying a home in the first place? Such buyers put themselves at risk of foreclosure by purchasing a home when they have shaky finances.
- Difficult to qualify for a traditional bank loan: Another disadvantage of a purchase money mortgage is that it can sometimes make it difficult to qualify for traditional bank financing when used in combination with a traditional bank mortgage. Many mortgage lenders don’t like writing home purchase mortgages with secondary financing provided by a seller.
- Difficult to refinance later: It can be difficult to refinance or cash out equity in the future if you have seller financing. If you have a land contract or lease-to-own, you don’t technically own the home, so you won’t be able to refinance. If you have a seller carryback mortgage, you own the home, but it may be difficult to refinance if you have another mortgage on the home and owe a large combined balance.
Alternatives to Purchase Money Financing
If a purchase money mortgage doesn’t work for you, the best alternative is to use a regular purchase mortgage. There are a few potential options depending on your credit profile and available down payment funds:
- VA: If you’re a veteran, you can purchase a home with a VA loan for as little as 0% down with no private mortgage insurance (PMI). VA financing tends to have the lowest rates of any mainstream mortgage product.
- Conventional: If you have excellent credit and you’re not a veteran, a conventional loan might make sense. You can put down as little as 3% (with excellent credit and qualifications), but you’ll have to pay private mortgage insurance for any down payment less than 20%.
- FHA: If you have lightly bruised credit, an FHA loan might make sense. You can put down as little as 3.5% of the purchase price. FHA technically allows credit scores as low as 580, but most banks require at least a 600 or 620.
If you’d like to check out current purchase mortgage rates, go to our purchase mortgage rates page. You can shop multiple loan options and lenders all in one place.