Seller financing: the promissory note and what goes with it

In a seller-financed sale, the buyer pays part of the price at closing and owes the rest to the seller over time. The seller does not hand over cash. The seller hands over the property and takes back a promissory note for the unpaid balance. People also call this owner financing, a seller carry-back, or a purchase-money loan.

Sellers use it for a few recognisable reasons.

• The buyer cannot get a bank loan on the timeline or the terms the sale needs, but the seller is satisfied the buyer can pay.
• The property is hard to finance conventionally: raw land, a mixed-use building, a small business with thin records.
• The seller prefers monthly income at a stated rate over a lump sum, or wants to spread the taxable gain across several years.
• The two sides already know each other, as in a sale between relatives or from an owner to a long-time manager.

Whatever the reason, the seller has made a loan. The sale closes once, but the loan lasts for years, and it needs the same documents and the same bookkeeping as any other private loan.

A seller-financed sale of real property rests on three instruments. Each does one job, and none of them can do the others.

• The purchase agreement. This is the sale contract. It states the price, the down payment, the closing date, and that the seller will finance the balance on the terms set out in the note. It governs the transfer of the property, not the loan.
• The promissory note. This is the buyer’s written promise to repay. It states the principal, the interest rate, the payment amount and schedule, the maturity date, any late fee and grace period, whether prepayment is allowed, and what counts as default. The note is the debt. If the buyer stops paying, the seller sues on the note.
• The mortgage or deed of trust. This is the security. It gives the seller a lien on the property so that, if the buyer defaults, the seller can foreclose and recover the balance from the property. Which instrument is used depends on the state. It is recorded in the county land records, and recording almost always requires notarized signatures.

The note and the deed of trust refer to each other, but they are separate. A note without a recorded lien is an unsecured loan: enforceable, but with nothing to foreclose on. A lien without a note secures nothing. Both are needed.

Our guide to promissory notes sets out what the note itself must contain.

There is no standard seller-financing loan, but the terms tend to cluster.

• Down payment. Sellers usually ask for 10 to 30 percent of the price. The buyer’s equity is what keeps the buyer paying when the property loses value, and it covers the seller’s costs if a foreclosure becomes necessary.
• Interest rate. Seller rates often sit a point or two above bank rates for the same property, because the seller is taking the risk a bank declined. State usury limits apply to private loans, so the rate should be checked against them before the note is signed.
• Term and amortization. A note might amortize over 30 years so the payment is affordable, but come due in full after 5 or 10 years. That final payment is a balloon. The expectation is that the buyer refinances with a bank before the balloon falls due. A buyer should have a credible plan for that, and a seller should ask what it is.
• Full amortization. Some sellers prefer a shorter, fully amortizing note, say 15 years at a level payment, with no balloon. The payments are higher, but the loan retires itself. Our comparison of repayment structures shows how the choice affects the payment and the total interest.
• Prepayment. Most seller notes allow prepayment without penalty. A seller who wants the income stream for a set period can say so in the note, within whatever limits the state allows.

On a $400,000 house with $80,000 down, a $320,000 note at 7 percent amortized over 30 years carries a payment of about $2,129 a month. If the note matures in 7 years, the balance due at that point is roughly $292,000. The buyer needs to be able to borrow that amount from a bank in year 7, or the seller needs to be willing to extend.

When the property is a residence and the buyer will live in it, the seller is extending consumer mortgage credit, and federal and state rules reach the transaction. A seller cannot treat it as a private matter between two people.

Under the Dodd-Frank Act’s loan originator rules, a person who finances the sale of a home ordinarily has to be a licensed mortgage loan originator. There are exceptions for individuals and estates that finance a small number of sales. One exception covers a seller who finances a single property in a 12-month period. Another covers up to three properties in 12 months, with conditions that include a fixed rate or a properly limited adjustable rate, no balloon payment, and a good-faith determination that the buyer can repay. The details matter, and they change, so a seller should confirm which exception applies before the terms are set.

State law adds its own layer: licensing rules, usury limits, foreclosure procedure, and disclosure requirements. Some states have their own seller-financing statutes.

The practical advice is short. Use a licensed real estate attorney or a title company to prepare and record the documents, handle the closing, and confirm that the structure complies. The cost is small against the price of the property and the length of the loan.

After closing, the seller has a loan to run. For a 10-year note that is 120 payments, each of which splits differently between interest and principal. The bookkeeping is the same as for a bank loan, and it has to be kept.

• The schedule. An amortization schedule sets out every payment, how much of it is interest, how much is principal, and the balance after it. Both sides should have the same schedule before the first payment is due.
• Payments. Each payment is recorded against the schedule on the day it arrives. A payment that arrives late or short changes the interest on every payment after it, so the record has to be exact.
• Taxes and insurance. The buyer owns the property and is responsible for property tax and insurance, with the seller named as loss payee on the policy. Some sellers collect an escrow with each payment and pay these themselves. If so, the escrow is tracked separately from the loan.
• Annual statements. The seller reports the interest received as income, and the buyer may deduct it as mortgage interest. Each needs the year’s interest total, and each needs the other’s taxpayer identification.
• Payoff and release. When the buyer refinances or sells, the seller issues a payoff statement for the exact balance on the closing date. Once paid, the seller signs a release or reconveyance of the lien and it is recorded. Until that is done, the title is still clouded.

NoteHouse keeps the schedule, the payment record and the payoff figure in one place for both parties; see how it works.

The note says what default is: a payment missed beyond the grace period, unpaid taxes, lapsed insurance, or a sale of the property without the seller’s consent. An acceleration clause lets the seller declare the whole balance due once a default has occurred and any cure period has passed.

Enforcing the lien means foreclosure, and foreclosure follows the procedure of the state where the property sits. In some states it runs through the courts. In others a deed of trust allows a trustee’s sale after notice. Either way there are required notices, waiting periods, and a public sale, and the borrower has defined rights to cure or redeem along the way.

A seller cannot change the locks, remove the buyer, or retake the property on their own authority. Self-help of that kind is unlawful in every state and exposes the seller to damages. The right course is to engage the attorney who prepared the documents at the first serious default. Our guide on late payments covers the steps that come before that point.

Seller financing is common when an owner sells a business to an employee, a partner, or an outside buyer. The buyer pays part of the price at closing and signs a note for the rest. The structure mirrors a real estate sale with one difference: the security.

Instead of a mortgage, the buyer grants the seller a security interest in the business assets under a security agreement, and the seller files a UCC-1 financing statement with the state to make the lien public. The collateral might be equipment, inventory, receivables, and the shares or membership interests of the company itself. A personal guarantee from the buyer is usual.

The note terms follow the same logic: a down payment large enough to keep the buyer committed, a rate that reflects the risk, and a term the business’s cash flow can carry. Five to seven years, fully amortizing, is typical. Because the collateral is a going concern, sellers often add covenants: keep the books, keep the insurance, send quarterly financials, and do not sell major assets or take on senior debt without consent.

A business sale raises its own tax questions, including how the price is allocated among assets and whether the seller reports the gain on the installment method. An accountant should be involved before the terms are fixed.