Seller financing, also called “owner financing” or a “land contract,” is when the home seller provides a loan to the buyer.
Seller financing can help a buyer move from renter to homeowner without meeting standard mortgage guidelines. It’s a popular option for borrowers who struggle to get a mortgage through a traditional lender. Though seller financing will help borrowers at the time of their purchase, they may be able to get more favorable loan terms and interest rates by refinancing after earning home equity.
Here’s everything you need to know about refinancing a seller-financed home.
Can You Refinance a Seller-Financed Home?
After the borrower has accumulated some equity in their home by making payments on the seller-financed loan, they can use a lender to refinance into a traditional mortgage. However, depending on the original promissory note between the seller and buyer, there may be drawbacks.
When you buy a house through seller financing, both parties agree on the loan conditions through a promissory note. The note serves as your loan agreement. And if the seller includes something like a prepayment penalty for refinancing early, you’re subject to the conditions set at the sale.
It’s pretty standard to refinance a seller-financed home. Many seller-financing agreements have a short loan term, usually five to ten years. The loan terms end with a balloon payment, also known as a lump sum payment, of the remaining balance on the mortgage.
The seller receives a few years of payments with interest, and the buyer builds some equity in the home before eventually making their balloon payment through a refinance. A new lien-holder (typically, a traditional lender) gets the loan when the buyer refinances, and they make the balloon payment promised to the original seller.
Typically, the buyer’s refinance options are limited to the standard refinance. The buyer usually can’t do a cash-out refinance. If you’re unsure about your options per your loan agreement, review the promissory note or hire a real estate attorney to help.
Here are the steps for refinancing the seller-financed home.
How to Refinance a Seller-Financed Home
Refinancing a seller-financed house is similar to refinancing any other mortgage. You need to set your expectations, apply with several lenders, and make sure you can pay any closing costs and fees. Here’s a step-by-step process.
Step 1: Review your current financing terms
Before diving into the refinancing process, carefully review the terms of your existing seller financing agreement. Take note of the repayment terms and any other conditions that may impact your decision to refinance. A savvy seller would have set a prepayment penalty in the loan agreement to ensure they still make a profit if the buyer decides to refinance early.
If you’re unsure about your loan agreement, consider hiring a real estate attorney. The intricacies of a seller-financed mortgage can take time to understand. Real estate attorneys will determine the necessary steps for you to take to properly refinance and identify any pitfalls along the way, such as prepayment penalties and any other special conditions.
If you’re following the terms of the original loan agreement closely, you could forgo this step altogether. For example, if the original loan agreement was a five-year mortgage with a balloon payment at the end and you’re refinancing at the end of the loan, you likely won’t need an attorney.
Step 2: Apply with several lenders
There will be a slight decrease in your credit score when you apply with the first lender, but subsequent inquiries won’t negatively affect your credit further.
Talk with each lender and make sure your goals align with what they can offer. Each lender should give you a Loan Estimate document with their loan details. Pay special attention to the closing costs and fees, as you’ll have to fit those into your budget. It’s time to move forward when you’re satisfied with a lender.
Step 3: Gather the necessary documents
Prepare the required documentation for the refinancing application. Refinance documents typically include proof of income, tax returns, bank statements, and details about the property.
Your lender will let you know which documents you need, and additional documentation may be needed compared to a traditional mortgage-to-mortgage refinance.
For example, since non-traditional financing isn’t always reported to credit agencies, your credit report may not include your history of on-time mortgage payments for your seller-financed loan. Therefore, you may need an additional bank statement as proof that payments were made regularly for the most recent 12 months.
Step 4: Appraisal and property valuation
The lender will typically conduct an appraisal or property valuation as part of the refinancing process. This step helps determine the home’s current market value, influencing the new loan terms.
The appraisal helps determine the Loan-to-Value Ratio (LTV), which is the ratio of the loan amount to the property’s appraised value. A higher appraised value can result in a lower LTV, potentially allowing you to qualify for a more favorable interest rate or terms.
Step 5: Underwriting and approval
Once the lender has all the necessary information, the application goes through the underwriting process, where they thoroughly review your financial history and the property’s value.
Your lender might contact you to ask for additional financial documents during this step. Respond promptly, as they can’t approve you before finishing the underwriting process.
Once everything meets the lender’s criteria, you’ll receive loan approval.
Step 6: Closing the refinance
Coordinate with the lender to schedule the closing. You’ll sign the new loan documents during the closing, and the new lender’s funds will pay off the existing seller financing. Make sure to notify the original seller-financer about the changes.
You’ll need to pay closing costs and fees in this step. After the closing, congratulations—you’ve refinanced your seller-financed home.