Why vendor finance may be too risky to try

Vendor finance can allow you to skip the bank application process and secure your next property, but the risk involved means you may be better off avoiding it.

Often referred to as “seller finance”, vendor finance is an alternative way to achieve home ownership without having to take out a mortgage with a traditional lender. Vendor finance also refers to ways in which you can start owning and paying off your home even if you have poor credit or 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.

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, but the purchase price or the repayments are typically higher compared to a standard loan.

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 pay off the balance in a lump-sum payment.

Generally, most buyers are required to refinance with a bank to complete the purchase, which typically occurs 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.

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 installments 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, but you will generally be required to complete a deposit of around 2-5% of the property purchase price. However, 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 $850-$1600. 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.

Frequently asked questions about vendor finance

• Is vendor finance legal?

  Yes. State and federal legislation provide legal frameworks that govern vendor finance in Australia.

  Purchasing a property where the seller provides finance is legal when conducted correctly. As a rule of thumb, private owners can normally sell their properties through vendor finance legally, but businesses must either carry a real estate licence or a credit licence, depending on the type of transaction being undertaken.

  However, some argue that current legislation is not adequate to deal with the loopholes and risks associated with vendor finance.

  If you’re thinking of purchasing or selling property through vendor finance, you should seek a solicitor to run you through the process and legal considerations.

• Why would a seller engage in vendor finance?

  There are many homeowners and investors who may not immediately need the money that is tied up in their property and therefore don’t mind if it is paid off over time.

  Like any transaction, the seller will want something in return for their flexibility. It is therefore likely that you will pay a slightly higher price for the property, around 3-7% of the value on the sale date. This is the premium you will pay in return for alternative and flexible short-term finance.

• What if the property is damaged?

  The contract will normally specify that the purchaser is responsible for recovering costs associated with repairing a damaged property. It’s a good idea to take out insurance as a precaution.

• Am I protected if my name isn't registered as the owner?

  Although you won’t be the legal owner, you have the option of having your name registered on the title. Your solicitor can lodge a legal document that will prevent the vendor from selling the property without your approval.

• What happens if I make repayments late?

  If you don’t make your repayments on time, it’s likely that the vendor will also fail to meet their own repayments on their mortgage given that your repayments will most likely form their repayment amount. If this happens, the vendor’s lender may charge late fees or other penalties and the vendor may pass this cost onto you.

  If you’re experiencing financial hardship and you don’t think you’ll be able to make your repayments, then you should get in touch with the vendor as soon as possible to negotiate a new arrangement or set up a different repayment schedule.

• Is there a timeframe in which I need to refinance by?

  No. You should be able to refinance with a bank at any time. As soon as you have built up enough equity and a good repayment history, you should refinance and pay out the vendor. You should refinance as soon as possible, as it’s likely that you’ll pay less interest to a lender than you would to the vendor.

• Who is responsible for covering repair and maintenance costs?

  As the buyer, you are responsible for looking after repairs and maintenance to the property.

• How about rates, taxes and insurance?

  You need to reimburse the vendor for council rates, water rates, insurance and taxes related to the upkeep of the property.

• Can I renovate the property?

  Generally, you can conduct cosmetic renovations to the property, such as painting or installing a new kitchen, without seeking the vendor’s permission. However, if you want to make major structural changes to the property, you will normally need to speak to the vendor (and the local council) first.