Editor's note: This article is the first part of a two-part look at seller financing. Read the second part, on what it means for the buyer, here.

NEW YORK (MainStreet) — Buyers are skittish, lenders are stingy and appraisers can be downright picky. Whether you are trying to buy a home or sell one, it’s a tough market out there, so perhaps it’s time to consider “seller financing,” a technique that can help buyer and seller overcome obstacles to a deal.

Seller financing is just what it sounds like. Instead of getting a lump sum when the sale closes, the seller accepts the buyer’s promissory note covering terms such as the loan rate, the years the loan will be in effect, the monthly payment (Calculate yours with BMW's handy calculator) and so forth.

While seller financing can work well for both parties, they need to study the terms very closely because sometimes the details could lead to decades of misery. Today, we’ll look at the basics, as well as the pros and cons from the seller’s point of view. Later this week we’ll focus on issues for the buyer.

In many seller-financed deals, the seller provides the only financing the buyer needs to purchase the property. Some sellers demand a cash down payment, others will finance the entire purchase.

In other cases, the seller provides the buyer with a deal to cover just a down payment, with the buyer using an ordinary mortgage for the bulk of the purchase price. This makes it possible to sell to a buyer who cannot afford the down payment required by an ordinary lender. In these deals, the buyer’s ordinary mortgage lender typically demands that the seller’s loan be subordinate to the lender’s. In a foreclosure, the mortgage lender must get all it is owed before the seller/financer gets anything.

Seller financing has a number of benefits for sellers: The property purchase may be made sooner than it would have been otherwise, and the seller may be able to set a loan rate higher than if he or she cashed out and put the sale proceeds in an interest-bearing account. Today, a seller might get upward of 5%, far more than one could earn with bank savings.

But there are some downsides, too. Instead of getting a lump sum, the seller gets a string of payments for a number of years. The interest earnings might seem generous at the start, but would be disappointing if prevailing rates were to rise.

Many sellers minimize this risk by demanding a balloon payment a number of years down the road. For example, monthly payments could be calculated with an amortization schedule of 30 years, but the balloon payment would actually retire the debt after only five years. Typically, the parties assume the buyer will be able to refinance the loan to cover the balloon payment.

Another seller’s consideration: A seller-financed deal would not provide the seller with cash to buy another property. If the seller then needed to borrow for a new home, lenders might consider income from the seller-financed deal to be too uncertain to count toward the loan qualification.

A seller who finances a home deal also would have to chase down the borrower for any missed payments, and someday might face the hassle and expense of foreclosing. In the worst case, the borrower might let the property deteriorate, or market prices could fall, leaving the seller to foreclose on a property worth less than when the deal was closed. It is critical, then, for the seller to carefully assess the buyer’s creditworthiness.

Here are some other considerations for sellers:

  • If the seller still has a sizable mortgage, the seller’s lender will have to sign off on the deal. Seller financing is most common when the seller owns the property free and clear or owes little enough to be paid off with the buyer’s down payment.
  • The seller should require a thorough loan application from the buyer and check out the buyer’s assets, income sources, credit history, employment and references. Be sure to get a complete list of the buyer’s other debts.
  • Each party should have a real estate lawyer and tax adviser to help them go through the paperwork. The contract should be clear about the seller’s rights should the buyer fall behind in payments. Typically, a title company is used to close the deal.
  • To make life easier, the seller should consider hiring a loan servicing company to collect payments, maintain an escrow account for taxes and insurance and deal with the buyer. A typical fee is $15 for each monthly payment, $30 if the servicer also manages an escrow account.

As another payment option in the increasingly limited world of home financing, buyers and sellers may find that this arrangement opens new doors to the deal.