Buyers Are Turning to Sellers for Home Loans – An Unconventional but Practical Solution

What is alternative financing?

Typical alternative financing arrangements, such as land contracts, seller-financed mortgages, lease-purchase agreements, and personal property loans, differ from mortgages in important ways. For the purposes of this analysis, a mortgage is a real estate purchase credit agreement that typically involves a third-party lender who has no prior or other interest in the property separate from the loan and must comply with federal and state regulations. In mortgage transactions, title—that is, full legal ownership of the property as documented in a deed—transfers from seller to buyer at the same time the loan is initiated. By contrast, certain common alternative arrangements, for example land contracts, are not subject to significant regulations, and in purchases using these types of financing, the seller—and not the buyer as in a mortgage transaction—keeps the deed to the property for the duration of the financing term. And because many jurisdictions do not consider buyers to be homeowners if they do not officially hold title and have the deed in hand, this structure can create legal ambiguity and make it difficult for buyers to establish clear ownership or know with certainty who is responsible for property taxes and maintenance.

Although the rights and protections afforded to mortgage borrowers can provide useful comparisons for understanding the risks that accompany alternative financing, not all financially qualified borrowers can get a mortgage, because of the shortage of small mortgages and because some kinds of properties are not mortgage-eligible. For example, some homes may not meet required habitability standards, such as having certain utility connections or a fully finished kitchen or bathroom, and manufactured homes are often titled as personal property, which is movable property such as a car or a refrigerator, rather than real property, also called real estate, which includes land and any permanent structure on it.5 The most common alternative arrangements are:

• Land contracts. In these arrangements, also called “contracts for deed” or “installment sales contracts,” the seller extends credit directly to the buyer, who then pays regular installments on the debt often for an agreed-upon time period, without the involvement of a third-party lender. Some buyers refer to their contract payments as “rent,” though—as with a mortgage—at least some portion of the payment goes toward the purchase price for the home as dictated by the contract terms. Unlike a mortgage, however, the deed does not transfer to the buyer at the outset in most states; instead, the seller retains full legal ownership of the property until the final payment is made, leaving the buyer without clear rights to either the home or the equity that has accrued.6 Among alternative financing arrangements, land contracts have received the most attention from academics and legislators.
• Lease-purchase agreements. Under these arrangements, commonly referred to as “rent-to-own” or “lease with option to purchase,” the seller is also the landlord, and the buyer occupies the property as a tenant and typically pays an upfront fee or down payment in exchange for the option to purchase the home within a designated period. If the buyer exercises that option, a portion of the buyer’s previous monthly payments, which often exceed market rent for a comparable property, may also be applied toward the down payment for purchase. Then, either the seller or a financial institution extends credit to the buyer for the balance to be repaid over time, and usually the deed transfers at the time the loan is originated. However, if the buyer is unable or unwilling to finalize the transaction, the terms of the lease-purchase agreement may allow the seller to keep some or all of the buyer’s payments. Buyers and landlords often describe lease-purchase agreements as a way for tenants to improve their credit scores, build a credit history, and save for a down payment, but little is known about how many lease-purchase buyers ultimately achieve homeownership, continue renting, or withdraw from the deal without exercising their option to buy.
• Personal property loans. These financing products, also known as “home only” or “chattel” loans, are used to buy manufactured homes and are frequently issued by subsidiary lenders of manufactured home builders, although some banks, credit unions, and other lenders also offer this type of financing. Personal property loans typically have much higher interest rates and shorter terms than comparably sized mortgages, resulting in more expensive monthly payments and more interest paid over the life of the loan.7 In addition, personal property loan borrowers have fewer protections in default: In many states, lenders can quickly repossess homes bought with personal property loans, because they are not subject to the foreclosure process required for mortgages.8 When borrowers purchase manufactured housing with these loans, they are buying their homes as personal rather than real property, and only the structures—not the land beneath—are included in the titles and paid for with the loans. By contrast, in real property transactions, the home and land are titled together and can be financed jointly with a mortgage. Although 73% of personal property loan borrowers rent the land under their homes and face associated risks—unique among homeowners—such as sharp land rent increases and the possibility of being evicted, the remaining 27% own their land and could be eligible for mortgages, assuming they meet underwriting requirements. 9 However, to get a mortgage, these landowners would first need to have the home and land retitled together as real rather than personal property. And depending on state laws, such title changes can be difficult or impossible to accomplish, leaving some landowning homebuyers no choice but to finance their manufactured home purchase with a personal property loan.10
• Seller-financed mortgages. In these arrangements, the seller also acts as the lender, directly extending credit to the buyer to purchase the home, with no third-party lender involved. The deed to the home transfers to the buyer at the start of the agreement—just as with a traditional mortgage—giving the buyer full ownership rights while the loan is repaid over time. But almost no states have enacted laws for seller-financed mortgages, and federal rules apply only to sellers who finance more than three properties per 12-month period.11 These limited protections generally leave buyers without clear recourse if the seller has not taken steps to ensure that the home is habitable, the contract terms are fair, and the title has no competing claims.

All of these arrangements fall under the rubric of alternative financing, but the required contractual provisions and applicable consumer protections for each vary widely from state to state. In general, research has shown that alternative arrangements are associated with higher long-term costs, less favorable contract terms, and an increased risk of losing home equity compared with commensurate mortgages.12

Approximately 36 million home borrowers have used alternative financing

Pew’s survey found that, although most of the roughly 171 million U.S. adults who have ever borrowed to buy a home have used traditional mortgages, about 36 million Americans, or 1 in 5 home borrowers, have used alternative financing at least once—and many have used both at different times.13 (See Figure 1.)

Personal property loans are the most common type of alternative arrangement; about 11% of home borrowers have used them to buy a home.14 Much more is known about these loans than other alternative arrangements, because the Home Mortgage Disclosure Act requires lenders who make personal property loans to report details for each loan application to the Consumer Financial Protection Bureau (CFPB). That data shows that, compared with manufactured home buyers who obtain mortgages, personal property loan borrowers have similar financial characteristics but pay much higher interest rates.15 For example, over the life of a $100,000 home loan, a personal property loan borrower would pay a 7.75% interest rate, twice that of a mortgage borrower’s 3.75% and costing almost $48,000 more.16

After personal property loans, the survey found that other common types of alternative financing are lease-purchase agreements (6%), seller-financed mortgages (6%), and land contracts (5%). Most research into the prevalence, terms, and outcomes of these alternative arrangements has focused on land contracts, because some state and local governments require public recording of land contract transactions while almost none do for seller-financed mortgages or lease-purchase agreements.17

Additionally, and in part because of a lack of consistent national regulatory or statutory conventions defining these three types of alternative arrangements, such as exists for mortgages, the language used to describe them varies across the U.S., and unscrupulous sellers can use the resulting lack of clarity to their advantage, referring to arrangements by other names to circumvent laws. For example, in states with strong land contract laws but weak renter protections, land contract sellers could skirt the consumer protections by marketing their financing to buyers as rent-to-own arrangements, while still structuring the financing as land contracts.18

Further, the available evidence indicates that lease-purchase agreements, seller-financed mortgages, and land contracts often share risky features that lead buyers to pay higher costs and can result in default and potentially loss of the home and all funds paid. For example, sellers may inflate their asking prices for a property because third-party appraisals are not required; they may insist that buyers pay for repairs to properties for which the buyers do not hold clear title; or they may evict buyers without first offering buyers the opportunity to catch up on missed payments.19 Because seller-financed mortgages and lease-purchase agreements are about as common as the better-studied land contracts and can lead to similarly harmful outcomes, they merit more research attention.

Among borrowers who have used alternative financing, 22% have used more than one of the arrangements that Pew studied. (See Figure 2.) And although the available evidence is insufficient to explain why borrowers use these alternatives, it does indicate that even financially capable borrowers face systemic barriers to accessing mortgages.

The increased costs and risks associated with alternative financing raise concerns about their recurring use by the same households. For example, legal aid advocates and researchers have called attention to profit-driven “churning,” which occurs when an owner initiates the sale of the same house repeatedly, receiving deposits or other unsecured payments from successive buyers under alternative agreements that, because of the lack of regulatory controls on such arrangements, never result in any of the buyers achieving full ownership or recouping their investments.20 However, little is known about how often this occurs and at what point these agreements typically collapse, so more research is warranted.

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