Understanding vendor finance

Vendor finance is essentially a loan or purchase agreement between a property seller and a property buyer, in which the buyer agrees to pay for a property over a period of time. 

As vendor finance agreements are made privately, they can be customised to the preferences of buyers and sellers and may or may not operate similarly to a traditional mortgage. However, they don't offer the same protections as traditional home loans and have proven financially devastating for many hopeful homebuyers.

Here's what you need to know if you're considering providing or taking out a vendor home loan.

What is vendor finance?

Vendor finance - sometimes called a vendor loan or seller finance - isn't new to Australia. In fact, it's been around for more than a hundred years. In the early 1900s, developers often offered newly-subdivided plots to buyers, who could put down an initial deposit and repay the remaining balance, plus interest, in installments. Of course, that's very similar to how home loans work today. While vendor finance is far less common these days, it still pops up every now and again.

If you're considering a rent-to-own scheme or buying a property by paying the seller in installments, that's likely a form of vendor finance.

Vendor finance is often structured as a short-term arrangement, with the expectation that the buyer will refinance with a traditional home loan after building equity in the property. However, many buyers resort to vendor finance precisely because they can't qualify for a conventional home loan. Unfortunately, even after making payments and improving their 'equity position,' they may still struggle to secure financing from a lender, potentially leaving them empty handed and out of pocket.

How does vendor finance differ from home loans?

Perhaps the biggest difference between the vendor finance route and the home loan pathway is that, if you follow the former, the seller will retain ownership until you've repaid all you owe or you take out a home loan to buy the property. That's also typically the biggest risk with such agreements, as the buyer doesn't hold legal ownership over any portion of the property until the seller hands over the papers.

Contrastingly, if you take out a home loan to buy a property, your bank or lender will pay the purchase price to the seller. Your lender will then keep the property's contract safe until you've repaid your mortgage, and you're entitled to sell, rent, improve, or change your home in the meantime.

Home loan lenders must also abide by laws and regulations when loaning funds to purchase property. Borrowers must be deemed able to repay their home loan without falling into undue financial hardship. That's not necessarily the case with vendor finance arrangements, as these are typically private agreements between a seller and a buyer.

Sellers have also been known to provide unscrupulous financing agreements, perhaps with built-in rate rises or hidden fees, that place buyers in financial stress and without claim to the property they believe they're buying.

Common types of vendor finance agreements

There are three common vendor finance methods that exist in Australia, each designed to fit different scenarios. Here's how they work:

1. Instalment contract

In an instalment contract, the buyer pays the seller in regular instalments over a specified period, similar to how you might repay a home loan. However, ownership over the property remains with the seller until the final payment is received.

How it works:

• The buyer agrees to pay a (typically inflated) purchase price.

• They then make an initial deposit, followed by monthly or periodic instalments.

• Ownership is transferred only after the final payment is made.

Key features:

• Customisable repayment terms.

• Buyer typically covers property-related costs like maintenance, insurance, and council rates.

• If the buyer defaults on the agreement, they may lose both the property and previous payments.

• The seller might also lose some control over the property due to the presence of an instalment contract, such as the right to mortgage the property.

2. Rent-to-buy

A rent-to-buy agreement or lease option allows the buyer to rent a property with the option to purchase it later by taking out a traditional home loan. A portion of the rent is typically credited toward the purchase price. These arrangements can be particularly problematic, potentially leaving a renter-buyer in a significantly worse financial position - without ownership of the property and with little to no recourse.

How it works:

• Buyer signs a rental agreement and a purchase option agreement.

• Both the rent and purchase price are typically inflated, with buyers often convinced the value of the property will rise over the course of the lease term.

• The buyer might expect to purchase the property at the end of the lease term by taking out a traditional home loan.

Key features:

• Potential for homeownership with minimal upfront cost.

• Flexibility to back out if the buyer cannot secure financing.

• If the buyer can't exercise the purchase option (as often happens if they can't secure a home loan) they may lose all rent paid.

3. Vendor mortgage

In this type of arrangement, the seller acts as the lender, offering a mortgage directly to the buyer. The buyer makes home loan repayments to the seller instead of a bank.

How it works:

• The seller agrees to 'carry' the mortgage for the buyer.

• A formal loan agreement is created, including repayment terms, interest rates, and loan duration.

Key features:

• Works similarly to a traditional mortgage.

• Ownership usually transfers at the time of sale, with the seller holding a mortgage over the property (ergo, the right to repossess the property if repayments aren't met).

• Generally demands higher interest rates and offers limited legal protections compared to regulated home loans.

Vendor financing: Risks and red flags

Vendor finance can be a viable pathway to homeownership for buyers who might otherwise struggle to secure a traditional mortgage, but it comes with notable risks. Because these agreements are typically private and less regulated, interested buyers and sellers must proceed with caution.

In a submission to the 2017 Banking Royal Commission, the Consumer Action Law Centre said it's helped many people who were "financially ruined" by vendor financing strategies. It said entities spruiking the strategies "typically target people who could not otherwise buy a home, because of their income, savings, or credit history".

"They often operate without [Australian Financial Services Licences] and do not comply with other regulations," the centre said.

In an earlier publication, it noted the legalities of vendor finance schemes can be "extremely complex", that it hadn't seen a single example of a successful rent-to-buy deal, and many of the same obstacles facing buyers in rent-to-buy agreements also exist for those turning to instalment contracts.

"People who have signed up to rent-to-buy deals because they could not obtain a mainstream mortgage will find it virtually impossible to refinance," Consumer Action said in 2016.

"A buyer [entering an installment vendor finance contract] will often need to refinance within several years, and will face the same obstacles as those seen in rent-to-buy deals.

"Consumer Action has seen multiple examples of failed vendor finance deals.

"Many buyers have paid significant amounts towards what they hope will be their home, only to find that they cannot complete the purchase and will lose everything."

Here are some key risks and red flags to watch out for when using vendor finance:

1. No legal ownership until final payment

In most vendor finance agreements, the seller retains legal ownership until the buyer completes all payments. This creates several risks:

• Loss of payments: If the buyer defaults, they may lose both the property and any payments already made.

• Limited legal recourse: Buyers may struggle to enforce their rights without a well-structured, legally binding contract.

• Hidden costs: Buyers may still be required to cover expenses such as maintenance, council rates, and insurance, even though they don't technically own the property.

• Forfeited equity: If the buyer breaks the agreement or is forced to move, they might lose all they've paid, even after making significant financial contributions.

2. Inflated purchase prices

Properties sold through vendor finance are often priced above market value. Sellers may factor in higher prices due to the perceived risk to them, longer repayment terms, or simply because their target market mightn't have other options. The impact of this can be two-fold:

• Overpaying for the property: Buyers might pay more than they would if they were to purchase through the open market.

• Refinancing challenges: When it comes time to refinance to a traditional home loan, the property's market value - not the agreed-upon purchase price - will largely determine how much a lender will loan the buyer. If the property is worth less than expected, the buyer may struggle to borrow the desired amount or end up with a smaller equity stake than anticipated.

Tip: Compare the agreed price with similar properties in the area to avoid paying more than necessary.

3. High interest rates and hidden fees

Vendor finance agreements often have higher interest rates than standard home loans, along with additional fees, including:

• Late payment penalties

• Early exit fees

• Legal and administrative charges

• Option fees, charged in exchange for the option to buy a property

4. Lack of regulation and legal oversight

Unlike traditional home loans governed by strict lending regulations, vendor finance agreements don't necessarily offer consumer protections.

Further, without a detailed, professionally drafted contract, disputes can arise about payment schedules, interest calculations, and ownership terms.

Anyone considering a vendor finance agreement, or any similar agreement, should seek independent, specialised legal advice.

Red flag: Sellers offering deals that seem too good to be true without clear, legally binding contracts.

5. Vendor's financial instability

One significant but less obvious risk of vendor finance is a seller's financial stability. Because legal ownership typically remains with the vendor until the buyer completes all agreed payments, if the vendor has unresolved debts or falls into financial distress, their creditors could repossess the property. That would see the buyer losing the property despite making regular payments.

Offering a vendor finance arrangement can, in itself, be a red flag, as it might mask an attempt at a quick cash-grab.

Buyer's safeguards

• Title search: Conduct a title search to check if the vendor has an outstanding mortgage or financial claims on the property.

• Legal advice: Consult a property lawyer before entering any agreement, ensuring the vendor has full legal ownership and no unresolved debts.

• Contract protections: Ensure the contract includes clauses requiring the vendor to stay financially solvent and protect the buyer's interests in case of repossession proceedings.

Red flag: Be cautious if the vendor or broker is reluctant to disclose financial details or provide documentation proving the property or vendor is free from encumbrances.

_{Image by Alexander Andrews on Unsplash}