Mortgage alternatives are risky – and often not necessary
Millions of home buyers worried about a mortgage are turning to alternative options like seller finance and lease purchase agreements.
Although these programs work sometimes, they are much riskier than traditional home loans. And they are often unnecessary.
Many home buyers with lower credit or incomes qualify for a mortgage – or could do so with minimal hassle – thanks to the flexible loan programs available today.
So if you don't think you are eligible for a mortgage, we strongly encourage you to review your options before using alternative financing. You might be surprised.
Check Your Mortgage Eligibility (October 6, 2020)
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Not everyone can qualify for a mortgage
Over the years, mortgages have become more accessible.
There are loan programs that you can use to buy a home with:
However, there is no point in pretending that anyone can qualify for a standard mortgage.
Certain issues can certainly prevent someone from buying a home, including:
Bad Credit Lots of red marks on your credit report. Insufficient income or employment history. Too much existing debt. Not enough savings to make a deposit
If you are facing any of these obstacles, you may want to wait and improve your finances before buying a home.
Now, if you are still looking to buy without a mortgage, you should know that some alternative financing options are much better than others.
If you choose to go this route, here are some things you need to know.
Check Your Mortgage Eligibility (October 6, 2020)
Seller Financing: Use with caution
With seller financing, you can buy a house and pay off in installments, with payments made directly to the seller.
There is nothing wrong with the seller financing as such.
At the very least, you can own the property when the loan starts. In that respect it is similar to a mortgage – and different from some other "alternative" home loans.
However, homebuyers who have walked this route report that they sometimes encounter title issues.
If you are using seller financing, have a real estate attorney review your agreement and make sure you fully understand the terms of sale.
Someone else might come along with ownership or use of the property. And that means the house is worth a lot less than the buyer originally thought – if anything.
So if you want a seller funded deal, do a title search. And with property insurance you are even more secure.
Have a real estate attorney review your agreement to make sure there are no “gotcha” clauses – and that you fully understand what you are getting yourself into.
Lease purchase agreements: Use with caution
Hire purchase contracts are also known as "hire purchase".
This is because you are renting out your home with a hire purchase agreement. However, the landlord gives you the right to buy the house within a specified period of time.
If you do so, you should usually get full ownership right from the start.
However, you will need to borrow the purchase price from anywhere: possibly from the seller or, if you qualify for a mortgage at the time, from a bank, credit union, or mortgage lender.
Often times, the rent you paid by the date of purchase reduces the purchase price.
There's nothing wrong with these agreements, provided you make sure you understand what you're getting into.
However, if you are borrowing from the seller, the caveats in “Seller Financing” (above) apply.
In addition, certain problems can arise if the tenant has the opportunity to buy the house.
If home values have fallen, the tenant may not want to buy. If they still can't qualify, they may not be able to afford it. And breaches of contract by the tenant can mean that they are no longer allowed to buy when the time comes.
Charter contract: avoid
Contract works a bit like seller finance, but there is one big difference: you don't get ownership of the home until you have made your final payment on the loan.
If you are in default (likely from skipped payments, but contract terms may vary) you can be evicted. And every penny you put into "your" new home can be forfeited.
Contract arrangements work like vendor finance, except that you have no ownership or equity in the home until it is paid off in full.
Worse, this includes everything you have spent on repairs and maintenance, which is stated as the buyer's responsibility in some contract sales.
When someone offers you a "real estate contract" or an "installment sale contract", they are indeed contractual transactions. They are just alternate names for the same thing.
Concerning contract lenders, Pew notes, "Some companies have recently been investigated for predatory practices."
Remember, there are no laws to protect the buyer in such transactions. The contract contract is not a regulated type of loan like a mortgage loan.
Indeed, the worst lenders can rest assured that borrowers will not get through the life of the loan without default.
In this case, the borrower can be evicted with the lender keeping all the deposited money and not giving anything back to the buyer.
A negative track record
There is a well-documented history of contract sales intentionally being used to defraud home buyers – especially non-white home buyers.
As NPR reported in 2019, "Black families in Chicago lost between $ 3 billion and $ 4 billion in wealth due to predatory housing contracts in the 1950s and 1960s."
With such a poor track record and without consumer protection, contract sales are better avoided whenever possible.
Personal Property Loans: An Option For Mobile Homes
Personal property loans generally only apply to prefabricated homes, sometimes referred to as mobile homes or caravans. You finance your purchase with a "security loan".
This is a type of secured borrowing. If you don't keep up with the monthly payments, the lender can repossess your prefabricated home.
Again, nothing in itself is wrong provided you take the time to understand your loan agreement.
However, watch out for high pressure sales of funds by park owners. Don't sign anything until you've verified that you can't get cheaper loan from a mainstream lender.
I am waiting to buy a house with a mortgage
If you wait to qualify for a mortgage – which may be easier than you think – you will get the same low interest rates and consumer protection as other major borrowers.
Going back with financing from a private owner can potentially help you buy a home sooner.
But it's inherently riskier.
Buyers using options such as seller finance, contract and hire purchase agreements can be more prone to problems with their home later. And they have fewer resources for recourse.
So what should you do when you wait and want to buy a home with a regular home loan?
Qualifying for mortgages may be easier than you think
The truth is that many of those who get into trouble with these alternative forms of borrowing could likely have a traditional mortgage.
And if they couldn't have done this right away, they could possibly have qualified for a mortgage in a matter of months or two or three years.
Many struggling with alternative forms of borrowing could likely have obtained a traditional mortgage. Or they could qualify for one in a matter of months, or two or three years.
These four obstacles mentioned above (damaged credit, insufficient income, too many other debts, and insufficient savings to make a down payment) are often much easier to overcome than many assume.
Let's go some ways around them.
Buying a home with bad credit
Did you know that some lenders will approve your mortgage if your credit score is only 580?
The main loan program for low credit buyers is the FHA loan, which allows:
Credit scores from 500 with a down payment of 10% Credit scores from 580 with a down payment of 3.5%
But what if yours is underneath?
We recommend waiting until you've taken the time to apply to upgrade your credit score to 580 – or better yet, 620 or higher.
Even if home prices are rising sharply where you want to buy, you may be better off waiting than with alternative forms of borrowing.
In the meantime, check out our guide to improving your credit score for some tips.
Buying a low income home
There is no income rule for qualifying for mortgages. Homebuyers qualify for all types of mortgage loans, including those on low incomes.
For more information, see our list of 8 Low Income Mortgage Programs.
Of course, lenders want to be sure that you can conveniently afford to pay back the loan. But they don't really have earnings-related scales that say you can borrow x if you earn y.
Your income and expenses should show that you can easily take payments on a new mortgage.
But what if you can't show that?
One option to consider is the Fannie Mae HomeReady mortgage. People with a current roommate can invite them to share the new residence they want to buy.
Up to 30% of your qualifying income can come from rental payments.
All you need to do is provide documentation that your roommate shared a residence with you for at least 9 years in the past 12 months. You may also need a letter stating that they intend to continue living with you in the newly purchased house.
The debt to income ratio (DTI) is important
Mortgage lenders study income much more closely as it relates to your existing debt payments.
This is known as the debt-to-income ratio (DTI) and it plays a huge role in approving your mortgage application.
It's true there is no shortcut to this one. All you have to do is pay back your existing debts – credit cards, car loans, student loans, personal loans, and other inevitable obligations like child support – until your DTI reaches acceptable levels.
However, your DTI doesn't have to be extremely low either.
Most mortgage loans allow a DTI of up to 43% – meaning that your debt (including your mortgage) is 43% of your gross monthly income.
Some programs, like FHA loans, even allow a DTI of up to 50%. But you need to find a lender willing to be that flexible.
Buying a house without a large down payment
Saving for a down payment is most commonly cited as the main barrier to home ownership. Yet it is often the easiest to erase.
First of all, if you opt for a traditional loan (which most homebuyers do), you only need to cut 3% off the purchase price. However, you need to have decent creditworthiness to get one of these.
If this is a problem, FHA loans offer more leeway than loans. And you only have to pay 3.5% of the purchase price.
Some types of mortgages do not require a down payment at all, including:
VA loan (almost exclusively for veterans and those currently serving)
USDA loan (for those with modest incomes who shop in designated sparsely populated areas)
If you qualify for one of these programs, you may not need cash for a down payment.
Advance payment assistance
Better still, there are thousands of Down Payment Assistance (DPA) programs nationwide – even where you might want to shop.
These vary greatly.
You may be offered a low-interest loan to cover the down payment that you will pay back in parallel with your main mortgage.
Other data protection agencies offer interest-free loans that are made after you've lived in your place of residence for a certain number of years.
Some even offer down payment subsidies – essentially free money that you don't have to pay back at all.
Most lenders are willing to work with deposit support programs and some are even ready to help you find and apply for such a program.
With a co-borrower
There is one more option that can help you purchase a home if you do not qualify for a mortgage.
A co-borrower – someone who has a loan or income to supplement your own loan – can sign the mortgage with you. That way, you can qualify based on someone else's strong finances.
A co-borrower or co-signer is usually a family member or friend.
This option may sound the easiest, but there are risks to be considered.
If you fail to make payments or default on the loan, the lender will come after the co-signer or co-borrower for all the money you owe.
This can deplete that person's savings and also seriously degrade their creditworthiness.
When you go down this route, you want to be sure that your lower income or credit rating is not holding you back from making mortgage payments. And you and your co-signer should be aware of the terms of the agreements and the potential risks.
The final result
Mortgage alternatives aren't always a bad thing. Particularly when it comes to seller financing, some find a quick way to home ownership.
However, borrowers lack the legal and regulatory protection that any mainstream mortgage brings. So you need to proceed with the utmost caution.
Better yet, work on becoming a qualified mortgage borrower yourself.
It can't be as hard as you think. In fact, you might already be one without even knowing it.
Check your new plan (October 6, 2020)