Most rental loans come from a bank. Seller financing skips the bank: the person selling the house becomes the lender, and your payment goes to them.
That changes three numbers at once, and the interest rate is only one of them.
How does seller financing work?
You and the seller agree on a price, a down payment, an interest rate and a term. It goes into a promissory note secured by the property. You take the deed at closing, and the seller collects a payment from you every month the way a bank would.
Two things usually look different from a bank loan. The down payment is often smaller, because the seller is not working through an underwriting manual. And the note usually comes due early: the payment is stretched over 30 years, but the whole remaining balance falls due in year 5 or year 7.
On the seller’s side the IRS calls this an installment sale, and its definition is short. An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. A qualifying seller reports the gain as the payments arrive rather than all in the year of the sale, and must report interest as ordinary income. That spread is usually the seller’s reason to consider it. What it is worth to a particular seller is a question for their tax professional, and the note and the deed are work for an attorney on both sides.
One house, a bank loan and a seller’s note
Here is the same house twice, with only the loan changed. It costs $250,000, rents for $2,750 a month, and pays $3,000 of property tax and $1,400 of insurance a year. Five percent of the rent covers empty months, 5% goes to repairs, 5% to replacements and 8% to a manager. The bank lends at 20% down and 7% over 30 years. The seller’s note is 10% down at 6% over 30 years, with the balance due in year 5. Both rates are the example’s assumption.
| Bank loan, 20% down at 7% | Seller’s note, 10% down at 6% | |
|---|---|---|
| Rent | $2,750 | $2,750 |
| Empty months (5% of rent) | −$138 | −$138 |
| Property taxes | −$250 | −$250 |
| Insurance | −$116 | −$116 |
| Repairs and replacements (10% of rent) | −$275 | −$275 |
| Property management (8% of rent) | −$220 | −$220 |
| Loan payment | −$1,331 | −$1,349 |
| Cash flow each month | +$420 | +$402 |
These are example figures, not a quote.
The bank loan leaves $18 a month more. Stop there and the seller’s note looks like the weaker deal.
Why does a smaller down payment raise the return?
Because the cash you did not hand over still belongs to you.
| Bank loan, 20% down | Seller’s note, 10% down | |
|---|---|---|
| Down payment | $50,000 | $25,000 |
| Closing costs (3% of price) | $7,500 | $7,500 |
| Cash in | $57,500 | $32,500 |
$420 a month on $57,500 is 8.8% a year on your cash. $402 a month on $32,500 is 14.8%. Same house, same rent, same bills. Asking for $25,000 less up front nearly doubles the return on what you put in.
The $25,000 you kept is also the furnace you can replace without borrowing, or the deposit on the next house. For what a bank expects up front on a rental, see how much money you need to buy a rental property.
What happens when the note comes due?
Year 5 is where this deal is won or lost.
The payment is calculated as if the loan ran 30 years, so very little principal is gone by then. On this house $209,372 is still owed in the month the note comes due. You refinance it or you sell, at whatever rates exist that year. The CFPB puts the mechanism plainly: a balloon payment on a mortgage is a large, one-time payment at the end of the loan term.
In the calculator, the years go in the “Note comes due in” box and the balance appears as “Still owed when the note comes due”. For the arithmetic on a balloon, and what refinancing one costs, see the balloon payment example.
Refinancing in year 5 also means a lender’s rules apply then, even though none applied when you bought. Most of them size the loan against what the property earns, not what you earn, so what a DSCR loan will lend is the test to run on this house before you agree to a five-year note.
Do mortgage rules cover a seller-financed rental loan?
Mostly not, because a rental loan is a business loan.
Regulation Z sits behind most of the disclosures and protections people associate with a mortgage. Its official commentary says that credit extended to acquire, improve, or maintain rental property (regardless of the number of housing units) that is not owner-occupied is deemed to be for business purposes, and business-purpose credit is outside the rule. The same comment draws the occupancy line: if the owner expects to occupy the property for more than 14 days during the coming year, the property cannot be treated as non-owner-occupied and the special rule does not apply.
Two things follow. A seller writing a note on a pure rental is not handing you a consumer mortgage, so the familiar paperwork and the familiar limits are not automatic. And if you plan to live in the property, even for part of the year, that 14-day line changes which rules are in play, which is a question for an attorney before you sign.
What should you pin down before you sign?
The rate is the easy part. These are the terms that move the money:
- When the note comes due, and the balance owed that month. Run it in the calculator before you agree to the year.
- Whether you can pay it off early without a penalty, so a refinance in year 3 is possible if rates fall.
- Who holds the deed. Taking title at closing with the seller holding a lien is a different position from a land contract where the deed comes later.
- What happens if you are late, and how many days you get.
- Whether the seller already has a mortgage on the property, and whether that loan requires payoff on a sale.
Run the house with the seller’s terms, then again at 20% down and today’s bank rate. If the seller’s version only works because the payment is small, year 5 will find that out.