A vendor take-back mortgage refers to a type of mortgage in which the buyer of a property obtains a loan from the seller to secure the sale of the property. It is also referred to as a seller take-back mortgage.
Vendor take-back mortgages provide benefits to both the seller and the buyer of the transaction. The seller is able to sell their property, while the buyer may be able to purchase property above prior bank-determined financing limits.
How Vendor Take-Back Mortgages Work
Usually, when a buyer wishes to buy a property and finance the purchase with a loan, the buyer will go to a bank or other financial institution for funding. However, if the financing provided by the bank or financial institution is not enough to fund the purchase, the purchaser may need to look for second lien financing. A lien simply refers to a claim or legal right on assets used to satisfy a debt. If the debt is not fulfilled, then first lien lenders are paid back first, and second lien lenders receive a subsequent claim.
Banks and financial institutions extend loans based on the credit quality of the buyer who is borrowing money. The credit quality is usually evaluated with a credit score or credit rating, which indicates the credit risk of the borrower and the probability of defaulting on the loan.
In a vendor take-back mortgage, the seller retains the equity or ownership portion of the property. The seller continues to own a certain percentage of the equity value of the property that is equal to the loan. The dual ownership continues until the purchaser pays off the principal of the loan plus interest. The second lien is in place to guarantee the repayment of the loan. If the purchaser defaults and does not fill the contractual obligations, then the seller can take ownership of the property.
Traditional Mortgage vs. Vendor Take-Back Mortgage
Traditional mortgages are often extended by a bank. A mortgage is a type of debt instrument that is secured by the collateral of a real estate asset. Traditional mortgages often come in the form of a fixed-rate mortgage, where the borrower is subject to a fixed interest rate over the life of the loan. The mortgages generally come with a 10-year or 30-year term.
Interest rates on a loan from a bank or financial institution may be affected by the following factors:
Size of the loan
Term of the loan
Credit quality of the borrower
All the factors above relate to the risk that the lender is taking. A large loan, a long-term loan, or a loan extended to a borrower of low credit quality all increase the risk that the lender is taking. Therefore, the lender is compensated with a higher interest rate.
Vendor Take-Back Mortgage
A vendor take-back mortgage usually occurs additionally along with a traditional mortgage. The purchaser will use the property as collateral for the mortgage loan. The bank or financial institution can then make a claim on the house in the event that the purchaser defaults on the loan.
In the case of a foreclosure, the bank or financial institution may evict the occupants and re-sell the property, using the income from the sale to clear the mortgage debt. The seller can also do the same in the case of a vendor take-back mortgage.
Since a vendor-take back mortgage is the second lien, it comes with a second or subordinate claim on assets. With the additional risk, the seller must be compensated with a higher interest rate. It is why, typically, a vendor take-back mortgage comes with a higher interest rate than a traditional mortgage.
Example of a Vendor Take-Back Mortgage
Consider an example where a purchaser wishes to buy a house for $1,000,000. They are required to make a 20% down payment on a fixed-rate mortgage extended by a bank. The down payment is required to be $200,000 ($1,000,000 x 20%). However, the purchaser takes a vendor take-back mortgage to fund the $200,000.
The seller of the property lends the purchaser $100,000 toward the mortgage down payment and pays the other $100,000 portion. Now, the property includes two separate loans:
1. The fixed-rate mortgage loan of $800,000 owed to the bank; and
2. The vendor take-back mortgage loan of $200,000 owed to the seller.