How seller financing payments work: note, interest, balloon, servicing

The documents: a note and a security instrument

The promissory note is the buyer's written promise to repay. It states the amount borrowed, the interest rate, the payment schedule, late charges, the maturity date, and what counts as a default. The security instrument, usually a mortgage or deed of trust depending on your state, ties that promise to the property and is recorded so the public knows you hold a lien.

The two work together. The note says what is owed. The security instrument says what you can do about it if it is not paid. Both should be prepared or reviewed by a real estate attorney in your state, because foreclosure procedures, required notices, and limits on terms vary.

Principal, interest, and amortization

Principal is the amount the buyer still owes. Interest is what the buyer pays for the use of that money, calculated on the remaining principal. Amortization is the schedule that spreads repayment over time so each payment covers that month's interest plus a slice of principal.

In the early years of a long amortization, most of each payment is interest and only a small portion reduces the balance. Later the balance is smaller, so less interest accrues and more of each payment goes to principal. The total payment stays level on a fixed-rate schedule; only the split changes.

Interest rates in seller-financed deals are negotiated, but they are not unlimited. States have usury laws, and federal rules affect certain terms. The rate also has tax consequences: the IRS expects adequate stated interest on installment sales, and interest you receive is generally taxed as ordinary income.

A hypothetical example with round numbers

This example is hypothetical and illustrative only. It is not a quote, a recommendation, or a typical deal. Suppose a house sells for $200,000. The buyer puts $20,000 down at closing, and the seller carries a note for $180,000 at 7 percent fixed interest, amortized over 30 years.

The monthly principal-and-interest payment on that schedule works out to about $1,198. In the first month, interest on $180,000 at 7 percent is $1,050, so only about $148 reduces the balance. Over the first five years, the buyer would pay roughly $71,850 in total, but the balance would fall by only about $10,560, to roughly $169,400.

Now suppose the note includes a balloon at the end of year five. On that date the buyer would owe the remaining balance of about $169,400 in one payment, usually by refinancing with a bank or selling the property. If the buyer cannot do either, the seller faces a choice between extending the note, negotiating, or enforcing it.

Balloons: why they exist and where they are limited

A balloon lets a seller get the bulk of the money back in a few years rather than waiting decades, while keeping the monthly payment affordable for the buyer. The risk is that the buyer may not be able to refinance when the balloon comes due, because rates have risen, credit has slipped, or the property has not held its value.

Federal rules treat balloons differently depending on the seller. Under Regulation Z, the exclusion for sellers who finance up to three properties in a year requires the financing to be fully amortizing, which means no balloon. The narrower exclusion for a natural person, estate, or trust financing one property a year does not have that requirement, but it does bar negative amortization and restricts adjustable rates. State law may add its own limits.

Servicing: who collects and keeps records

Servicing is the work of collecting payments, applying them correctly to interest and principal, tracking late fees, issuing payoff statements, and sending year-end interest statements for taxes. Some sellers do this themselves. Many hire a third-party loan servicing company for a monthly fee, which creates a neutral record if there is ever a dispute.

Servicing also covers escrow for property taxes and insurance if the note requires it. If the buyer stops paying taxes, a tax lien can take priority over your lien. If the house burns without insurance, your collateral is gone. Ask that you be named on the buyer's insurance policy as mortgagee and that you receive proof of tax payments.

• Payment due date, grace period, and late charge
• How partial or early payments are applied
• Escrow for taxes and insurance, or proof of payment
• Annual interest statements for both parties' tax filings
• Payoff statement process when the buyer refinances or sells

Taxes and the bigger picture

Under IRS Publication 537, each installment payment generally has three parts for tax purposes: interest income, a return of your basis, and gain. You report the sale on Form 6252 and the interest separately. Depreciation recapture on rental or business property can be taxable in the year of sale even if you have not received the cash. You may also be able to elect out of installment reporting. A tax professional should run the numbers for your situation.

Seller financing can be a useful tool, but it turns a sale into a long-term financial relationship. If you would rather be paid at closing, a cash sale or a traditional listing avoids the servicing and default risk entirely. Prominent Cash Offer's primary service is buying houses for cash with a written, no-obligation offer; flexible arrangements are evaluated case by case, and not every property, seller, or state qualifies.