A purchase money mortgage is a home financing arrangement in which the seller of a property, rather than a bank, extends credit to the buyer for part or all of the purchase price. The buyer makes a down payment, signs a promissory note for the remaining balance, and gives the seller a lien on the property as security. Payments then flow directly to the seller under whatever terms the two sides negotiated, and if the buyer stops paying, the seller can foreclose the same way a bank would.
People reach for this structure when a conventional loan is out of reach or inconvenient. Self-employed buyers, buyers with thin or damaged credit, and buyers who want to close quickly all show up on the buyer side. On the seller side, it can widen the pool of interested buyers and turn a lump-sum sale into a stream of interest income. It can also sit as a second loan behind a primary bank mortgage, sometimes called a piggyback, to cover a slice of the price that would otherwise trigger private mortgage insurance.
How the Lien Works and Why Priority Matters
The seller’s security interest is created at the same moment the buyer takes title. In most jurisdictions, that timing gives a purchase money mortgage priority over other liens or judgments already attached to the buyer personally, as long as the mortgage is recorded when the deed transfers. The reasoning is that the buyer never owned the property before the transaction, so earlier creditors had no claim to it. This super-priority is what protects the seller from being pushed behind the buyer’s pre-existing debts.
Because the deal is negotiated privately between two parties instead of run through a bank’s underwriting, closings tend to be faster and transaction costs lower. That flexibility is the appeal, and it is also the risk: nothing in the structure forces either side to do the checks a lender would ordinarily do.
Terms the Buyer and Seller Negotiate
The financial terms of the loan come from the parties themselves, not a rate sheet. A few pieces show up in every deal.
The loan amount is the purchase price minus the down payment. On a $300,000 home with $30,000 down, the seller finances $270,000.
The interest rate is typically higher than a conventional mortgage because the seller is taking on more risk than a bank would. Rates commonly land between 6% and 10%, though the actual number depends on the buyer’s credit, market conditions, and what the two sides agree to. There is also a floor set by tax law, discussed below.
The term and amortization usually diverge. Most seller-financed loans run five to ten years, far shorter than a 30-year bank mortgage. Monthly payments are often calculated on a longer amortization schedule to keep them manageable, with the unpaid balance due as a balloon payment at the end of the shorter term. Balloon structures are only available under one of the federal exemptions described below.
Late fees, grace periods, and default triggers should be written into the note rather than left to assumption.
Taxes and insurance are handled differently than in a bank loan. Purchase money mortgages rarely include an escrow account, so the buyer usually pays property taxes and homeowner’s insurance directly. Unpaid property taxes can produce a tax lien that threatens the seller’s security, so many agreements require the buyer to show proof of paid taxes and current insurance on a regular schedule. Some sellers set up a private escrow to collect these amounts with the monthly payment.
Federal Limits on Seller Financing
Federal law does not ban seller financing, but the Truth in Lending Act and Regulation Z generally require a mortgage originator license for anyone who offers or negotiates residential mortgage terms. Sellers financing the sale of their own property can avoid that license only if they fit inside one of two narrow exemptions.
The One-Property Exemption
A natural person, estate, or trust selling a single property in any 12-month period qualifies for the more flexible exemption. The loan must carry a fixed rate, or an adjustable rate that does not reset for at least five years, and the repayment schedule cannot produce negative amortization. This exemption does not require full amortization, so a balloon payment is permissible. The seller also does not have to have built the property in the ordinary course of a business.
The Three-Property Exemption
A seller financing up to three properties in any 12-month period faces a stricter set of rules. The loan must be fully amortizing, which effectively rules out balloon payments. The seller must determine in good faith that the buyer has a reasonable ability to repay, using evidence of income, assets, or employment; the property’s value alone does not count. The same interest-rate limits apply, and the seller cannot have built the home as a contractor in the ordinary course of business.
Financing four or more sales in a year without a license could trigger federal enforcement. Anyone planning to offer seller financing on multiple properties should talk to a real estate attorney about licensing before doing so.
The Due-on-Sale Trap
If the seller still owes money on an existing mortgage, offering seller financing to a buyer creates a specific hazard. Most conventional mortgages contain a due-on-sale clause allowing the lender to demand full repayment if the property is sold or transferred without written consent. Federal law expressly permits lenders to enforce these clauses, and it overrides state law to the contrary.
When a seller transfers the property under a seller-financing arrangement without first paying off the underlying loan, the original lender can treat that as a violation, accelerate the debt, and begin foreclosure if the seller cannot pay in full. Federal law protects certain transfers from triggering the clause, such as transfers to a spouse or child, transfers into a living trust where the borrower remains the beneficiary, and transfers on the borrower’s death. A sale to an unrelated buyer is not among them.
Before agreeing to seller financing, both parties should check whether an existing mortgage carries a due-on-sale clause and either get the lender’s written consent or pay off the existing loan at closing.
Tax Consequences for Each Side
The Seller Reports an Installment Sale
When a seller finances a sale and collects payments across more than one tax year, the IRS treats it as an installment sale. Each payment contains three pieces: a return of the seller’s adjusted basis, gain on the sale, and interest income. Gain is reported gradually as payments arrive, using Form 6252, rather than all at once. Interest is reported separately as ordinary income on Schedule B.
Depreciation recapture, if the property was used in a business, must be reported in the year of sale regardless of when payments come in. A seller can also elect out of installment reporting and recognize the full gain up front using Form 8949 or Form 4797. On larger deals, where the price exceeds $150,000 and outstanding installment obligations exceed $5 million at year end, the seller may owe interest on the deferred tax.
The Interest Rate Has a Federal Floor
The IRS requires seller-financed loans to charge at least the Applicable Federal Rate (AFR), which the IRS publishes monthly. Set the rate too low and the IRS will treat part of the principal payments as disguised interest, called imputed interest or original issue discount, and tax the seller on interest income never actually received. As of early 2026, the long-term AFR for loans with terms over nine years has run roughly 4.6% to 4.7%, but the rate changes every month. Check the current AFR before locking in a rate.
The Buyer Can Still Deduct the Interest
Interest paid on a seller-financed mortgage is generally deductible on the buyer’s federal return, the same as bank-loan interest, provided the buyer itemizes on Schedule A and the loan is secured by a home the buyer owns and lives in (or a qualified second home). Since the seller is not a financial institution, there is no Form 1098. The buyer reports the interest on Schedule A, line 8b, and must include the seller’s name, address, and taxpayer identification number. Each side is required to give the other their TIN, and failure to exchange the numbers can bring a $50 penalty for each party.
The Two Documents That Make It Enforceable
A purchase money mortgage rests on two core documents. The promissory note is the buyer’s written promise to repay, and it lays out the loan amount, interest rate, payment schedule, total repayment period, and default terms. Without it, the seller has no enforceable claim to the debt itself.
The security instrument, called a mortgage in some states and a deed of trust in others, ties that debt to the property and gives the seller (or a trustee) the right to foreclose if the buyer fails to pay. It must include the full legal description of the property in whatever format the jurisdiction requires, along with both parties’ full legal names and mailing addresses.
Every financial term has to appear consistently in both documents. A payment amount or maturity date that reads one way in the note and another way in the mortgage is an invitation to a future dispute. Both documents should be drafted or reviewed by a real estate attorney familiar with local formatting and disclosure requirements.
Once signed and notarized, the security instrument is filed with the county recorder or register of deeds. Recording puts future creditors and buyers on notice of the seller’s lien. The promissory note itself is not recorded; it stays with the seller as physical evidence of the debt until the loan is paid off.
What Happens If the Buyer Stops Paying
If the buyer defaults, the seller’s main remedy is foreclosure, and the process is the same one a bank would use. How it unfolds depends on state law.
In judicial foreclosure states, the seller files a lawsuit, a judge reviews the default, and the court orders a sale if the seller prevails. The process can take a year or more, which gives the buyer time to cure the default or negotiate. If the sale does not cover the balance, some states allow the seller to pursue a deficiency judgment for what remains.
In states that permit non-judicial foreclosure, typically where the security instrument is a deed of trust, the seller or a named trustee follows a statutory notice procedure that can involve mailing a notice of default, publishing a notice of sale, and posting notice on the property. The process moves outside the courtroom and can conclude in a few months.
As an alternative, the buyer and seller can agree to a deed in lieu of foreclosure, where the buyer voluntarily transfers the property back to satisfy the debt. It saves time and expense for both sides, but it works cleanly only when no other liens sit on the property. A title search before accepting a deed in lieu will show whether second mortgages, tax liens, or other claims would survive the transfer.
Because the seller here is acting as a lender, obtaining a lender’s title insurance policy is worth serious consideration. It protects the seller’s lien interest against title defects that existed before the mortgage was created, and it stays in force until the loan is paid in full.