Definition of Purchase Money Loan

A purchase money loan allows some home buyers to afford a home.
••• sureeporn / Getty Images

If potential homebuyers can't qualify for a traditional bank mortgage loan, they can investigate a loan provided by the home's seller, called a purchase money loan.

Some people have the desire to own a home but find themselves short when it comes to the cash needed for a down payment. They may also lack the right credit score to qualify for a loan with a decent interest rate.

Purchase Money Loans Defined

A purchase money loan is a type of mortgage loan used to buy a home. In some ways, it is easier to describe what a purchase money loan is not. It is not a loan that is taken out after you buy a home such as a home equity line of credit or a home equity loan. It is not a refinance mortgage. A purchase money loan is evidenced by the trust deed or mortgage a home buyer signs at the time the home buyer purchases the home.

A borrower can obtain a purchase money loan from a bank, a savings and loan, a credit union or a private source of funds, including from the seller who is selling the home. If the seller makes a loan to the buyer, it is called owner financing, but it is still purchasing money.

A hard money loan is financing that is typically not considered a purchase money loan because the loan is generally granted based on the equity in the property and not necessarily the borrower's creditworthiness.

Vanilla Loan Varieties

The simplest way to figure out your loan balance is to deduct from the sales price the amount of the down payment, and the leftover number is the loan amount.

The gold standard for a loan is typically 20 percent down and an 80 percent loan, but there are a huge variety of loans that vary from that standard. Although 20 percent is common, it doesn’t mean a buyer can't put down more; buyers are free to put down any amount above 20 percent.

Conventional Purchase Money Loans

The most common type of purchase money loan is a conventional loan. Most banks make these types of loans and initiated by banks or mortgage brokers. They often comply with Fannie Mae or Freddie Mac regulations so they can be packaged and sold after closing in the secondary mortgage market.

Down payment requirements for a conventional loan range from zero for exceptional borrowers in special categories to 3 percent, 5 percent, 10 percent, 15 percent, and 20 percent or more.

If a borrower is tight on ratios, the lender might require a down payment higher than 20 percent to lower the loan amount to fit within the required ratios. It is one way a buyer can purchase a more expensive home for more than the borrower would be approved for with 20 percent down.

For example, if a borrower is approved for an 80 percent purchase money loan of $160,000, based on a $200,000 sales price, but the borrower is in love with a home priced at $225,000, the transaction can still happen if the buyer puts more down.

In this instance, a borrower could still obtain a $160,000 purchase money loan by bridging the difference between $225,000 and the loan and putting down $65,000.

FHA Purchase Money Loans

The second most common type of purchase money loan is FHA. The minimum down payment requirement for an FHA loan is very low, presently 3.5 percent of the sales price. Some states offer secondary financing to help with the down payment and closing costs so a borrower can effectively put down zero. FHA loans are insured by the Federal Housing Administration, governed by Housing and Urban Development.

An investor cannot obtain an FHA loan. All FHA loans are granted to borrowers who will occupy the property.

VA Purchase Money Loans

The third common type of purchase money loan is VA, available to active- and non-active military and their spouses under certain circumstances. VA stands for Veterans Affairs.

A VA loan is typically zero down, but again, a borrower can put down any amount. The government guarantees VA loans. Borrowers are restricted from paying certain fees in a VA transaction, and the VA requires a clear pest completion.

Once a purchase money loan is paid off through a refinance, it is no longer purchase money financing. The refinance is now a hard money loan. The reason a homeowner should care is that in some states, hard-money loans carry recourse against the borrower; whereas, purchase-money loans might not.