Most buyers follow a similar path to paying for a home purchase: decide on a lump sum down payment, talk with lenders, and secure a conventional mortgage for 15 or 30 years. Research from the Profile of Home Buyers and Sellers by the National Association of Realtors (NAR) shows that those who finance their home typically finance 88% of the home purchase.
How does a home purchase typically break down? For the down payment, 60% of the buyers relied on their savings. Another 38% use the proceeds of the sale of a primary residence. HousingWire reports, “the median down payment amount in the U.S. in 2018 was $15,490, which is 5.37% of the median price of $270,000.” According to Business Insider, the median listing price of a Texas home and June 2019 was $283,499. At last year’s median rate of 5.37 percent, that means a downpayment of $15,223.
So it's clear that most buyers seek to finance some or all of their home purchase. But you don’t have to follow the common path. Depending on your circumstances, these alternative financing options may appeal to you. Here are other ways to secure financing for a real estate transaction.
The “Conventional” Way
For the purposes of understanding what we’ll consider alternative financing, let's cover the conventional way of financing a residential home.
The conventional way most typically finances a home purchase with a down payment a loan from a financial institution. In some instances, the buyer secures 100% financing, like the VA home loan and then the USDA housing program, but those are through special programs that apply to a small percentage of home buyers.
A conventional loan is usually issued by a private lender and then sold to Fannie Mae or Freddie Mac. These loans typically require 5 to 20 percent for a down payment. Most loans with less than 20 percent down payment often require the buyer to hold private mortgage insurance (PMI). The loan terms can be for a fixed-rate mortgage or an adjustable-rate mortgage (ARM), typically over a 15 or 30 year period.
Included in this “conventional” umbrella are other loans like Federal Housing Administration (FHA) loans. This is a government-backed mortgage favored by first-time homebuyers with low credit scores but not enough for a 20 percent down payment. Another option is an FHA 203k loan, which is a home renovation loan. There's also a conventional 97 mortgage, which is a program from Fannie Mae that requires a 3 percent down payment.
So alternative lending programs covered will be ones not following the scenario of a down payment and a variation of a conventional-styled mortgage issued by a financial institution.
No-PMI Alternatives
One sticking point for some home buyers is the idea of PMI. Any home buyer not able to put 20 percent of the home purchase down is typically considered high risk. If they default on their loan, the lender is on the hook for more out-of-pocket. For protection, lenders require the buyer to hold additional insurance in case they default on their purchase.
While PMI protects the lenders, some home buyers see it as throwing money away. The fee doesn't help pay down the loan principal and has no real merit for them. Some home buyers start looking for ways to avoid paying PMI. That’s where the following alternatives come into play.
Piggyback Loan
A piggyback loan is essentially two separate loans that work to avoid paying PMI and help the buyer put 20 percent down.
In this scenario, a home buyer has 10 percent available for a down payment. They get one loan for 10 percent of the home purchase, which is used towards the down payment. They now get a second, separate loan for 80 percent of the home purchase.
The result is the buyer has two loans to pay down. This financing option might be appealing to home buyers looking to avoid paying PMI and can secure two different loans.
Retirement Loans
Some home buyers decide to leverage their retirement savings in order to help finance a home purchase. This can be done by borrowing or withdrawing from a 401(k) or an individual retirement account.
There are some specific rules about how retirement savings can help with a home purchase.
401(k) Borrowing
If you have a 401(k), you can borrow up to $50,000 or half of your vested balance. The number will depend on whichever is less. You will be required to pay back the loan with interest. Some accounts require repayment within a specific timeframe.
The advantage of using your 401(k) over the IRA is you won't have to pay taxes on the income. The disadvantage is if you end up leaving your employment and you're no longer participating in the 401(k) plan, you may be required to repay the loan in full.
Another thing to be careful of: not repaying the 401(k) within the specified timeframe. It will be reclassified as an early withdrawal. You'll end up incurring a 10 percent penalty plus income tax payments on the borrowed amount.
IRA Borrowing
With a traditional IRA, first time home buyers can borrow up to $10,000 for a down payment with no tax penalty. You will have to pay income tax on the loan. If you have a Roth IRA, the withdrawal is tax-free and penalty-free.
The problem with withdrawing from a Roth IRA account is they are capped. According to Timothy Johnson, chief investment strategist with Lincoln Financial Advisors talking to Bankrate, people with higher incomes, “may not be able to replace the money in the account with future deposits.”
Consider this when using retirement for a downpayment
The thought behind taking a loan from your retirement is it is better to pay yourself back with interest than to pay back a financial institution or pay PMI.
While you can use the savings to help purchase your home, take into consideration where you are in your career. Removing money and slowly repaying it means you will have fewer funds working towards growing your retirement nest egg.
It's important to look at your long-term financial picture and decide savings goals. You may be able to mitigate the borrowing risks depending on where you are professionally and financially.
If you do finance some of the home purchase from retirement, know the rules before you dive into borrowing. Estimate your repayment requirements to make sure you can afford this in addition to the mortgage payment. Carefully document the withdrawal.
It will take time to get the funds available for your down payment. Arrange to have the retirement funds deposited several weeks before closing on your home purchase. The timing is important. If you end up withdrawing funds from a traditional IRA, you could end up with a penalty if you don't use it towards a home purchase within 120 days.
Remember, reducing your retirement savings an alternative to financing a down payment is an option. Still, you'll miss out on some tax advantages, perhaps an employer match program, and the financial gains that cash would have made if it had been left alone.
Borrowing from the retirement can be most appealing for homebuyers who have substantial retirement savings, are still in the earlier phases of their career, and are using the loan in addition to the savings they already have for the down payment. These buyers should feel stable in their career and earning power.
Insurance Policy Borrowing
Similar to borrowing from your retirement, some whole or variable life insurance policies allow policyholders to take a loan out against the principal. The future premiums go back to paying the loan. Rates vary widely.
Usually, there’s no approval process to take out a policy loan. There’s no payback schedule or repayment policy.
The downside is your heirs end up with less money from the life insurance policy. If you don’t pay the loan back, the insurance company can reduce the amount by what is owed, which cuts into the death benefit. Additionally, if the amount owed exceeds the insurance policy’s value, the policy could be terminated, and the loan becomes taxable income.
Other financing routes
Sometimes, homebuyers aren’t able to secure a conventional mortgage. This happens with poor credit or a high debt-to-income ratio. In these cases, buyers can look to other lender types.
Owner financing
Alternatively known as seller financing, the buyer is essentially borrowing money from the home seller. The current property owner or seller will put up part or all of the money required to purchase the property.
Asking for owner financing is not very common, but it can work in certain circumstances.
With owner financing, the buyer and the seller will agree upon an interest rate, a monthly payment, a repayment schedule, and other details of the loan. The buyer gives the seller a promissory note that agrees to these terms. The promissory note should be entered into the public record to protect both parties.
The seller will keep the title to the home until the buyer repays the loan in full.
Why would someone opt for owner financing?
For the buyer, the requirements to qualify for owner financing are less stringent and more flexible. If they have poor credit or are struggling to qualify for a conventional loan, asking for owner financing can be an option. The financing can be tailored to their specific needs. They'll have more flexibility with the down payment, pay lower closing costs because there are no institutional imposed fees, and possess the property faster than waiting for a bank appraisal and underwriting.
For the seller, they may be able to negotiate a higher sale price. They'll gain monthly income from the mortgage repayments. Sellers can negotiate a higher interest rate than what is available conventionally and will end up with a quicker sale. One source even suggests that there are potential tax breaks from doing owner financing.
But owner financing is a tricky and complex process. It's important to follow state laws, and Texas has some stringent regulations when it comes to owner financing.
The SAFE Act, which can be found in “Texas Finance Code, Chapter 180,” heavily restricted owner financing.
In order to do owner financing, the current code requires the owner to have a residential mortgage loan originator license (RMLO) from the Texas Savings and Mortgage Lending Department. There are some exceptions to needing this license. The rules do not apply if:
- The mortgage is made between “immediate family members," including a spouse, child, sibling, parent, grandparent, or grandchild (by adoption, marriage or natural birth).
- The sale of a home in which the seller resides. “Your primary homestead property may be owner-financed without a license — even to a non-family buyer,” writes Daniel Ray in the Herald-Danner.
- And, “The Commissioner of the TDSML has ruled that the SAFE Act will not be applied to non-pros - persons who make five or fewer owner-financed loans in a year, thus preserving the so-called "de minimus exemption" under Finance Code Section 156.202(a)(3).” Source
Additional restrictions come into play thanks to the Dodd-Frank Act, or Title XIV of the "Mortgage Reform and Anti Predatory Lending Act.” Under these regulations, the seller and lender in a residential owner financed transaction must determine if the borrower can repay their loan at the time that they extend the credit.
This means that the owner-financer must make a good-faith effort to determine the borrower is able to repay the loan according to its terms by looking at their credit history, current income and assets, employment status, other debts, and debt-to-income ratio.
All these regulations may result in more paperwork but were made to protect consumers from predatory lending practices as seen in the past.
The Texas property code also has some rules and restrictions in real estate transactions where the property is not immediately conveyed to the buyer. For example, a financial disclosure must be given to the buyer at closing, and the seller must give an accounting statement every January. Read about all the requirements here.
The best advice when considering owner financing is to consult with an expert real estate law professional about your circumstances.
Rent-to-own
In this financing scenario, the buyer agrees to rent the property for a specified time with the option to buy it before the lease agreement expires. These agreements have a standard lease agreement plus include the purchase option.
In a rent-to-own agreement, the buyer pays a one-time upfront fee called the option fee or the option money. The fee gives buyers the right to buy the home some day in the future. Option fees are negotiable.
When entering a rent-to-own agreement, know there are two different types of contracts. A lease option contract gives buyers the ability to buy the home but not the obligation. In a lease-purchase agreement, buyers must buy the home at the end of the lease.
You negotiate the home's purchase price when the contract is signed. It is typically purchased for a higher than current market value because sellers account for home appreciation and market changes.
During the lease term, a percentage of each rent payment counts towards the purchase price. If you are looking to buy a home but lack the money today, this scenario helps build equity towards a down payment. Buyers can also negotiate that part or all of the option money be applied to the eventual purchase price at close.
Making a rent-to-own contract can be attractive if you have a property you are in love with but lack the ability to put down a down payment or to secure financing at this time. You live in the home, build funds towards a down payment, and have time to fix your credit to qualify for a conventional loan.
If you do decide not to buy the property or are unable to get financing by the end of the lease, the option expires. You risk losing the option money and any earned rent credits.
Rent-to-own in Texas
Rent-to-own deals are legal in Texas. They are also known as “contracts for deed” or “executory contracts.” In this case, the buyer does not gain immediate equity in the property while making payments. While the deal closes, the seller still holds something over the buyer: the title of the property.
The Texas Attorney General warns, “Contracts for deed can also have strict conditions. Some consumers with a contract for deed have lost their homes because they were a few days late on one payment. This meant that despite making timely payments for years, the contract forced them to leave the property with no stake in the investment. It is therefore critically important for you to know exactly what type of contract you are signing and to make sure you can meet all the conditions.”
Today, lease-purchases and lease-option contracts, because they often involve owner-financing, fall under the same regulations as owner-financing detailed above in owner-financing. For more information, see Chapter 5 of Texas’ Property Code. Additionally, refer to a breakdown of executory contract requirements in Texas here.
Subject-to
You're more apt to find a subject-to deal if the property is under stress. In this type of real estate transaction, the buyer takes over paying the seller’s mortgage balance without making it official with the original mortgage lender. This makes it a popular option among real estate investors.
In this agreement, the buyer makes payments to the seller's mortgage company. There is no official agreement with the lender, and the buyer has no legal obligation to make the payments. If they choose not to repay the loan, the lender could foreclose on the property. But in this case, the foreclosure would be in the original mortgage holder’s name.
A subject-to deal reduces the cost of buying a home because there are no closing costs, origination fees, commissions, and other associated costs. These deals can be attractive if the seller’s interest rate is lower than existing interest rates. Buyers also use subject-to when they may not qualify for a mortgage loan with better terms and fewer interest costs over time.
Real estate investors use subject-to by locating borrowers usually in foreclosure. A subject-to deal helps the seller avoid foreclosure and gains the investor a high-profit property.
If this financing sounds appealing to you, research the variations of how to structure a subject-to deal.
A subject-to transaction comes with risk. Many lenders add language into their mortgages and trust deeds that give them the right to require the loan balance in full upon the transfer of a property. If the loan can’t be paid in full upon demand, the bank could start foreclosure proceedings.
Note a subject-to deal is not a loan assumption in which a bank is notified of the buyer taking over payments and has given permission. There is generally an assumption fee for this process.
Peer-to-Peer or Crowdfunding
Yes, it’s possible to “Kickstarter” or “GoFundMe” towards a home purchase. Peer-to-peer lending is a form of debt financing that does not require a traditional financial institution.
The payback terms and conditions are different across the different crowdlending platforms. Generally, most platforms support more real estate investment purchases than an individual’s single-family home, but that is not to say it has not been done or cannot be done. See a list of peer-to-peer lenders here.
This option could be attractive if you are struggling to get a conventional loan and do not prefer other types of alternative financing.
Financing a home purchase
Securing financing is one of the most important steps in purchasing your home. You want to find the best terms for your individual situation.
Buying a home is usually the most significant purchase people make in their lifetimes. It’s essential to be well-informed and make decisions for your long-term financial health. Working with a real estate agent that understands how the financing fits into your home purchase picture is important to meet this goal.
At Chicotsky Real Estate Group, we have guided our clients through the stickiest of situations. We encourage clients to be informed about all financing options and speak with lending professionals.
