Vendor finance is often promoted as an alternative way for people to get onto the property ladder if they can’t secure a traditional loan, but consumer groups say that a lack of regulation and transparency in the area can result in “financial ruin” for buyers and sellers.
What is vendor finance?
Vendor finance is a private arrangement between a buyer and a seller, wherein the buyer borrows money from a seller (otherwise known as a vendor) to help pay for a product or service from that seller. It is sometimes seen as a way of securing financing without taking out a loan from a traditional bank or finance institution.
What is vendor finance for property?
In a real estate sense, vendor financing is when the seller (vendor) of a property loans the buyer all, or part of, the money needed to buy that property. Traditionally, when taking out a home loan, a buyer would borrow money from a financial institution to help pay for the property. That financial institution would only loan funds to a person if they passed through a rigorous (and regulated) application process, which is designed to check if the buyer could reasonably afford to pay back that loan. By contrast, if a buyer was to purchase a property using vendor finance, the loan transaction would be done privately between the buyer and the seller, potentially with much less formality and potentially without the consumer protections a more regulated process could provide.
How does vendor finance work for property?
In general terms, under a vendor finance arrangement, the seller of a property loans money to the purchaser, so the purchaser can buy the property the vendor is selling. The buyer may, or may not, pay the vendor an initial deposit to secure the property, and would then be expected to pay the remaining balance, plus any interest that the parties have agreed upon, over a set period of time.
Vendor finance is a private sale between parties, so there are a number of different ways it can work. In general terms, though, Canstar has found that there are generally three different types of ‘vendor finance’ that you might encounter – an instalment plan or ‘wrap-around loan’, a rent-to-buy arrangement or a financed deposit.
Instalment plan/‘wrap around loan’
In this kind of arrangement, the seller of a property will take a mortgage out over the property in question, and then the buyer will pay off the seller’s mortgage in instalments, as one would with a standard mortgage. An arrangement like this is also known as a ‘wrap-around loan’, and is called this because the loan between the seller and the buyer is ‘wrapped around’ the seller’s own mortgage.
Generally speaking, the seller of a property will charge the buyer an interest rate above what they are paying on their mortgage, as this is how they will make money on the deal.
Rent-to-buy schemes, otherwise known as ‘rent-to-own’ or ‘lease options’, are arrangements wherein a prospective buyer agrees to pay rent to the seller of a property, on the understanding that some of this rent will count towards equity in the home. The buyer will eventually take ownership of the property (or the mortgage applying to that property), however, they will not be the legal owner until the loan is fully repaid, and the title has been registered in their name.
Typically in this scenario, a buyer borrows a portion of a property’s value from a traditional bank or lender – a standard amount might be 80%, as this is the amount most lenders are willing to offer without charging lenders mortgage insurance (LMI). Rather than pay a deposit to the vendor, the borrower would instead borrow that amount from the vendor – in the above example, in which the buyer borrows 80% from a traditional bank, the remaining amount would be 20%.
If a buyer was to opt for a financed deposit, they would have two loans to pay off – one would be their mortgage, which would be paid off to the bank or lender, and the other would be the loan they took out from the seller.
Why would you use vendor finance?
Vendor finance is an option that a buyer might consider when purchasing a property. It could be a wise idea to seek professional financial advice, as these types of loans could present a higher risk to other types of home loans. Hypothetical scenarios where this might be considered could include:
- The buyer does not have enough money saved to pay for a home loan deposit, or does not wish to pay a deposit from their savings, in which case, they might opt for a financed deposit from the vendor.
- The buyer is self-employed or runs their own business, and therefore might not have the paperwork that home loan lenders typically want to see, such as pay as you go (PAYG) payslips or other proof of income.
- The buyer has a poor credit score, which may include such things as defaults and bankruptcies, meaning a traditional lender might be less likely to loan them funds for a property purchase.
Is vendor finance a good idea?
There has been a great deal of criticism about vendor finance over the years, including in the 2017 Royal Commission into the banking sector.
The Consumer Action Law Centre’s Director of Policy and Campaigns, Alix Pearce, told Canstar that, while vendor finance and rent-to-buy schemes are often promoted as a cheap option for Australians who could not otherwise afford to enter the housing market, they come with significant risks attached.
“[These] agreements are often a rip-off that see people paying large amounts of money without any chance of eventually owning the property,” Ms Pearce said. The Centre is highly critical of vendor finance, calling for reforms so that these types of loans adhere to the same rules as other credit arrangements.
Ms Pearce said other common challenges with vendor finance agreements include:
- confusion about who actually owns the property during the loan contract period, causing problems in such areas as who has to maintain the property and pay utility bills;
- people being obliged to pay above and beyond the actual value of the property they’re buying, which means they can’t recover what they paid for it when it comes time to sell, or can’t later refinance with a bank;
- unclear rights for both parties due to complex agreements, which means in many cases recorded by the Centre, the buyer doesn’t end up owning the property, or the vendor is left out of pocket;
- a lack of consumer protections people would normally have if they had a more typical mortgage.
In particular, Ms Pearce said that vendor finance and rent-to-buy contracts could be complex, making it hard for consumers to understand exactly what they were agreeing to, and how much it would cost them in the long term or if they missed a payment.
Their murky legal status also means that it is unclear what consumer protections apply, such as coverage by the National Credit Code (NCC), she said. In many cases, she said unlike traditional home loans, there was no legal protection for buyers in vendor finance arrangements.
Rent to buy arrangements can also be financially risky from a seller’s point of view. For example, if a property is mortgaged in your name and a buyer is paying you money in a ‘wrap-around loan’ arrangement, the buyer could stop making payments, but you would still be legally required to pay off the mortgage.
“Consumer Action, other legal services and consumer regulators across Australia have seen numerous risky rent-to-buy and vendor finance deals fail,” Ms Pearce said. “These have resulted in financial ruin for buyers and significant losses for some vulnerable vendors.”
What are the risks of vendor finance?
While vendor finance deals are sometimes seen as a way for buyers to obtain finance when they can’t meet the criteria of more traditional lenders, there are a number of potential pitfalls. Vendor finance can be more expensive than a standard home loan, there may be harsh conditions imposed, and there is less security than if you were to purchase a home directly.
If you purchase a property with a vendor finance arrangement, the vendor themselves will need to make money from the deal, and will therefore pass costs on to you. You may end up paying more than market value for a property, and it is likely that a vendor will also charge you a higher interest rate than the one they paid (or are currently paying) the bank, meaning overall you could be at risk of paying a significant amount more.
As vendor finance is a private arrangement between a buyer and seller, this type of loan is less regulated than traditional home lending. These types of loan arrangements can lack the standard consumer protections that apply when borrowing funds from a bank or lender that is required to follow rules enforced by the Federal Government. This means that vendors can charge a buyer interest rates that are much higher than a traditional home loan lender might, and could impose other strict conditions – for example, if you miss a payment, the vendor might decide to reserve the right to void the contract, leaving you with nothing to show for the money you’ve paid.
Lack of security
In many vendor finance arrangements, the title to the property and the mortgage could remain in the seller’s name for a long period of time. In the eyes of the law, you may not be considered as owning the property (or part of the property) until your name is added to the property title, even if you have paid money towards a loan on it. If the mortgage and title are in the seller’s name and they default on it, the lender could repossess the property. If your name is not on the title, you may have no legal claim to it, meaning you will have nothing to show for the money you’ve paid even though you’ve kept up your end of the vendor loan deal. There is also a risk that, if your name is not on the property title, your investment may not be protected if the vendor decides to sell the property or refinance their mortgage over it. That’s why it could be a wise idea to seek suitably qualified legal and financial advice when considering vendor finance.
Cover image source: Ronstik Productions/Shutterstock.com