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Why vendor finance may be too risky to try
Vendor finance may help you buy a property without having to apply for a bank loan, but there are some major risks involved, including the big risk of losing your home.
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Often referred to as seller finance, vendor finance is an alternative way to buy a home without having to take out a mortgage with a bank or lender. Vendor finance is a fancy name for a situation when the seller of the property "loans" you the money (or part of the money) to buy their property. It generally appeals to people who have poor credit or a poor employment history, or you’re unable to qualify for a traditional home loan for any other reason.
The purchaser and vendor arrange the finance terms privately rather than through the banks, and the purchaser pays off the purchase price of the property via instalments to the vendor. Because this happens as more of a private arrangement than a transaction through a bank or lender, there are a number of risks you need to be aware of.
While these agreements are normally established over a 30-year term, the intention is to pay out the contract as soon as the purchaser is in a position to refinance the debt through a conventional home loan.
Vendor finance provides the buyer with the opportunity to finance a property through an alternative means. Essentially, it helps borrowers who are not “finance ready” by allowing them to access finance and pursue home ownership with flexible terms.
However, vendor finance carries with it a number of risks. A study by the Consumer Action Law Centre found vendor finance schemes were often detrimental to would-be buyers, and commonly ended in buyers being unable to complete their purchase. Before entering into any agreement, you should consult a solicitor.
How does vendor finance work?
With vendor finance, the buyer normally pays a small deposit to the seller and makes repayments to the seller over time. These repayments may or may not include interest, and the purchase price (and therefore the repayments) are typically higher compared to a standard loan.
For instance: a standard home loan may come with an interest rate of 2.5%, but the vendor finance provider charges 4%. Or the property would normally sell for $500,000, but you agree to pay an inflated price of $550,000.
Depending on the individual agreement, you will either have the option of paying the instalments until it is paid off in full or you will make the repayments until you’re in a position to qualify for a mainstream mortgage, in which case you’ll refinance and pay off the balance in a lump-sum payment.
Generally, this would occur 2-5 years after moving into the property. As it’s likely that you’ll need to refinance with a bank at some point, you need to ensure that you can meet the repayments, save enough for a deposit and maintain a good credit rating to qualify for a home loan during this time period.
Should everything work according to plan, once you’ve made the last repayment, you assume ownership of the property. However, such agreements often end with buyers losing the funds they've put toward their home.
Would vendor finance suit me?
There may be some situations in which vendor finance could be a viable option, including:
- Lack of genuine savings: If you’re unable to complete a large deposit, such as 20% of the purchase price, which is a requirement of many lenders for a home loan, then vendor finance may provide you with the time and flexibility to get your finances in order before refinancing with a bank.
- Poor credit file: If you have a poor credit rating or a lack of sufficient credit history, it may be hard to qualify for loan with a lender. Vendor finance may be a suitable option in this case.
- Self-employed: If you run your own business but you have poor cash flow and unable to demonstrate financial discipline or savings, vendor finance may be a solution.
Buyer beware!
Vendor finance carries some significant risks, many of which may far outweigh its potential benefits.
- Market risk. If the property depreciates over time, the bank may not want to lend you the money to refinance.
- Expensive. The purchase price and subsequent repayments are normally higher than market value, which can make it harder for you to build up equity and qualify for a traditional loan when you need to refinance.
- Ownership. As your name won’t be included on the property title, your interest in the property is at risk. For instance, if the vendor goes bankrupt, others can make claims against the property. This is why you should ensure that there is a clause in the contract that explicitly states that the title will be transferred to your name when the final payment is made so that you assume ownership of the property.
- Harsh penalties. As laws regulating vendor finance are extremely murky, the buyer is often at the mercy of the seller. This means sellers can impose harsh penalties for missed payments, which can include the buyer forfeiting everything they've paid toward the property.
What are the different types of vendor finance?
There are three common forms of private vendor finance, including:
- Terms finance: This structure occurs where the purchase price is repaid by instalments and the title remains with the vendor until the final instalment is paid or the loan is refinanced with a bank. The duration of the contract may be 25-30 years, but a purchaser normally pays it out as soon as they can refinance, which normally occurs within 2-5 years.
- Mortgage-back finance: A mortgage-back finance structure is when the vendor loan is used as deposit finance, where the deposit is funded by the vendor with an external party and title transfers to the buyer right away. The vendor therefore funds the difference between the price and the external finance and takes security for payment through a second mortgage over the property.
- Lease option finance: In this scenario, the property is leased to the purchaser while payments are made under an option towards the deposit on the purchase of the property.
Will I have to put down a deposit?
It depends on the vendor and the agreement you enter into. It may be possible to purchase the property with no deposit. But you will generally be required to hand over a deposit of around 2-5% of the property purchase price. This compares favourably to a 10-20% deposit required by most Australian lenders for a standard mortgage product.
What are the costs involved?
The same fees and taxes are payable with vendor finance as they would be with a standard home loan. However, the additional complexity means more legal work and higher costs than would normally be associated with a traditional mortgage product.
- Legal fees. Legal charges for vendor finance could set you back around $1000-$2000. This fee is charged to have a legal professional look over the agreement and ensure that all the paperwork is in order for you to take ownership of the property.
- Taxes. The amount of stamp duty payable will vary depending on which state you live in and the value of the property.
- Repayments. You'll need to ensure that you have sufficient funds to meet the monthly repayments. If in doubt, consult the services of an accountant or financial advisor to ensure that you're in a strong financial position to service the repayments.
While vendor finance may seem like a potential solution for borrowers who have trouble saving a deposit or fall outside lenders' criteria, the risks involved can far outweigh the potential benefits. Before entering into any agreement, it's crucial you seek the advice of a solicitor and make sure your interests are protected. However, considering the risks, vendor finance may be too fraught with potential pitfalls to be worthwhile.
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