Owner financing: What it is and how it works
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If you have bad credit or a short credit history, you might find qualifying for a mortgage to buy a home difficult or impossible. If you’re selling your home, finding a willing buyer who also qualifies for financing can be a hassle that adds time and stress to making a sale. One solution could be a purchase-money mortgage, known colloquially as owner financing.
What is owner financing?
Owner financing is similar to conventional home financing, except the property owner, rather than a bank or other mortgage lender, provides total or (more frequently) partial financing directly to the buyer.
“The agreement here is very similar to a mortgage loan, except the owner of the home owns the debt instead of a bank or other lender,” says Michael Foguth, founder and president of Foguth Financial Group headquartered in Brighton, Michigan.
Despite the similarities, there are a few important distinctions with owner financing homes.
Chris McDermott, real estate investor, broker and co-founder of Jax Nurses Buy Houses in Jacksonville, Florida, has experience with owner financing on investment properties he has sold and says it is more commonly used for certain types of properties or sales. “For rural land or homes that a seller owns free and clear,” owner financing can have advantages, McDermott says.
This arrangement also can have benefits for sellers seeking a reliable income stream, but is less likely to be financially feasible for sellers who need the proceeds from the sale of their home to buy their next residence.
Owner financing is usually not reported on the buyer’s credit report. This can be helpful for buyers who would not otherwise qualify for a mortgage, but it can be a drawback in that timely on-time monthly payments don’t bolster the borrower’s credit score, as they would with a typical bank-issued mortgage. Borrowers seeking to buy a home using owner financing can expect to have to make a substantial down payment (usually 10 percent to 15 percent), which makes up for the fact that the financing isn’t dependent on their income or credit history — although sellers are advised to perform a credit check regardless.
An owner-financed loan can benefit buyers who aren’t eligible for a loan from a mortgage lender, or if they only qualify for a portion of the purchase price. In the latter scenario, a buyer might be able to take out a conventional mortgage up to the amount the lender approves, and then obtain owner financing for the difference. There is a “buyer beware” caveat, here, though: If you’re qualified for traditional mortgage financing but can’t get approved for the amount you seek, the shortfall could be due to the home being overpriced and, as a result, a risky bet for the lender.
How does owner financing work?
In most owner financing arrangements, the owner (seller) records a mortgage against the property, which is sold via deed transfer to the buyer. One variation is a land contract arrangement (more on that below), in which the owner property retains the title as leverage until the loan is repaid.
“Typically, the owner lets the buyer take over and move into the house without a mortgage, but after the buyer makes a down payment,” says Andrew Swain, co-founder and president of Sundae, a San Francisco-headquartered residential real estate marketplace for distressed properties.
In a typical owner financing arrangement, the buyer makes mortgage payments to the seller based on an amortization schedule at a fixed interest rate agreed upon by both parties. “Typically, the seller will not hold that mortgage for longer than five or 10 years. After that time, the mortgage commonly comes due in the form of a balloon payment owed by the buyer,” says McDermott. This is where owner financing homes can become complicated, since it’s likelier than not that the buyer will at this point have to find a funding source for their balloon payment.
Ideally, the buyer will qualify for and obtain a mortgage refinance to make that balloon payment. While this is the ideal outcome, though, there’s no guarantee the buyer will qualify for a mortgage to refinance their initial loan, especially if their credit and financial circumstances haven’t improved.
John Kilpatrick, managing director of real estate analysis and investment firm Greenfield Advisors in Seattle, says another approach to owner financing is for the buyer to obtain a regular mortgage from a bank or other lending institution while the seller takes a second claim on the property in lieu of part or all of the buyer’s down payment.
“Say you want to buy a $200,000 house,” Kilpatrick says. “The bank will only loan you $160,000. If the seller will take back a second mortgage for $40,000, the deal may be able to close.”
With this kind of arrangement, though, you’ll likely need the lender’s approval — and it’s no guarantee a lender will agree to these conditions, Kilpatrick cautions. If you’re considering buying a home under these conditions, it would behoove you to be wary of the seller’s motivation here, too. Are they struggling to find other buyers? Could the home be overpriced?
Costs of owner financing
Bypassing a bank-issued mortgage means the costs of owner financing homes can potentially be lower — but just because a seller is providing the funds doesn’t mean the buyer won’t pay closing costs. According to McDermott, buyers purchasing a home using owner financing can still expect to pay charges, including deed recording and title search fees.
In addition, property taxes also need to be taken into consideration. If you buy a house with a conventional mortgage, these taxes (along with homeowners insurance payments) are generally bundled into the mortgage payment. In an owner-financed purchase, the borrower is responsible for paying taxes and insurance premiums to the collecting government agency and insurance company, respectively. Ideally, the owner finance contract will specify the payment requirements for property taxes as well as insurance.
If you’re considering owner financing as a buyer, though, the good news is that closing costs probably won’t add as much as 5 percent on top of your purchase price, as they can with typical mortgage financing. Bruce Ailion, a real estate attorney, investor and Realtor in Atlanta, says owner-financed closing costs “are usually substantially less than you’d pay with bank financing.”
Example of owner financing
Consider the following example to get a sense of how owner financing works, and how it affects the finances of both buyer and seller: Both parties agree to a purchase price of $450,000. The seller requires a down payment of 15 percent — $67,500. The seller agrees to finance the outstanding $382,500 at an 8 percent fixed interest rate over a 30-year amortization, with a balloon payment due after five years.
In this example, the buyer agrees to make monthly payments of $2,806.65 to the seller for 59 months (excluding property taxes and homeowners insurance that the buyer will pay for separately).
At month 60, a balloon payment of $366,448.81 will be due. The seller will end up collecting $532,041 after 60 months, broken down as:
- $67,500 for the down payment
- $149,541 in total interest payments
- Total principal balance of $382,500
Pros and cons of owner financing
Owner financing offers advantages and disadvantages to both homebuyers and sellers.
- Faster closing (not subject to bank underwriting and processing delays)
- Potentially lower closing costs
- Flexible down payment
- Minimal — if any — credit requirements
- Higher interest rate
- Contingent on seller willingness
- Short loan term, with likelihood of a large balloon payment at end
- Difficulty getting supplementary funding from most conventional lenders
Main advantage: “The buyer can get a loan they otherwise could not get approved for from a bank, which can be especially beneficial to borrowers who are self-employed or have bad credit,” says Ailion.
The chief drawback for buyers lies in the higher interest incurred, and the shorter amount of time to pay the loan off. “The interest rate charged by a seller is usually much higher than a traditional mortgage lender would charge,” says McDermott. “The balloon payment that comes due after a few years will be significant,” he adds.
- Higher return on your sale with the right buyer
- Potentially faster sale
- Steady income stream
- Complexity of agreements
- Limitations imposed by lenders unless home is owned free and clear
- Onus falls on seller to vet the buyer and their financial situation
- Risk of loss via buyer default and/or property damage, costs associated with foreclosure and repairs
- Potential tax implications
The advantages to a seller seeking to undertake owner financing are myriad. Owner financing allows a seller more leeway to sell a property as-is, without needing to make repairs that the traditional underwriting process would flag and require as a condition of closing the loan.
“Additionally, sellers can obtain tax benefits by deferring any realized capital gains over many years, if they qualify,” says McDermott. “Depending on the interest rate they charge, sellers can get a better rate of return on the money they lend than they would get on many other types of investments,” he adds.
The process is not without risk to the seller, though. If the buyer stops making their payments, the seller might have to undergo a time-consuming and costly foreclosure process. If they discover during the course of the foreclosure process that the buyer didn’t properly maintain the property, the seller could also find themselves facing costly repair or renovation bills even after they complete foreclosure.
Types of owner financing
There are many different forms of owner financing, each with unique benefits and drawbacks:
- Second mortgage – If a would-be buyer can’t qualify for a traditional mortgage for the full purchase price of the home, one version of owner financing entails the seller offering a second mortgage to the buyer to make up the difference. Typically, this second mortgage will have a shorter term and carry a higher interest rate than the first mortgage obtained from the lender. The shorter term means the buyer needs to be prepared to pay off the remaining balance when the balloon payment comes due. Without cash in hand at that point, the buyer coulld be forced to refinance — a potentially expensive endeavor.
- Land contract – In a land contract agreement (also called a contract for deed, bond for title or installment land contract), the buyer makes payments to the seller as stipulated in the contract, and when they finish making those payments, they get the deed to the property. Since a land contract typically doesn’t involve a bank or mortgage lender, so it can be a much faster way to secure financing for a home. As a buyer, though, one big drawback is that many states allow sellers to reclaim the property if you miss a payment, and the process lacks the protections a bank foreclosure affords to borrowers.
- Lease-purchase – With a lease-purchase agreement (also referred to as rent-to-own), the homebuyer agrees to rent the property from the owner for a period of time, at the end of which, the buyer has the option to purchase the home, at a prearranged price. Typically, the buyer needs to make an upfront deposit before moving in, a deposit they will lose if they choose not to buy the home. The buyer in this situation should negotiate the price of the purchase option and make it subject to financing, clear title and other contingencies, analogous with the traditional home-buying process.
- Wraparound mortgage – Home sellers can use wraparound financing (also called a carry-back loan) when they still have an outstanding mortgage on their home. In this situation, the buyer makes a down payment plus monthly loan payments to the seller, who in turn uses those payments to pay down their existing mortgage. (Often, the buyer pays a higher interest rate than the interest rate on the seller’s existing mortgage.) Only assumable loans — that is, mortgages that can legally be taken over by a party other than the original borrower — can be used in a wraparound financing arrangement. While FHA, USDA and VA loans are eligible for this type of financing, conventional mortgage loans are not — an indication that wraparound financing harbors potentially serious risks to the buyer: If the seller defaults on the underlying loan, the buyer could lose the home — and all the payments they contributed. It’s highly recommended for buyers considering wraparound financing to have an experienced attorney in their corner.
How to buy or sell a home with owner financing
If you can’t get the financing you need from a bank or mortgage lender, an experienced Realtor or real estate agent can help you find properties being sold with owner financing.
“Just be sure the promissory note you sign is legally compliant and clearly lays out the terms of the deal,” says Swain. “It’s also a good idea to revisit a seller financing agreement after a few years, especially if interest rates have dropped or your credit score improves — in which case you can refinance with a traditional mortgage and pay off the seller earlier than expected.”
If you want to offer owner financing as a seller, mentioning the arrangement in your home’s listing can help attract buyers interested in this prospect.
McDermott says it’s important to do your due diligence. Since you’re not relying on the sophisticated credit-risk modeling used by loan underwriters, it’s in your best interest to make sure your buyer is willing and able to hold up their end of the bargain.“Be sure to require a substantial down payment — 15 percent if possible,” he advises. “Find out the buyer’s position and exit strategy, and determine what their plan and timeline is. Ultimately, you want to know the buyer will be in the position to pay you off and refinance once your balloon payment is due.”.
There are different ways to structure an owner financing contract. Common types of arrangements include:
- Promissory note
- Deed of trust
- Rent-to-own contract
Whatever the construction of an owner financing agreement, it needs to spell out a number of key terms. These include:
- Purchase price: The agreed-upon price for the home is the foundation for the remainder of the contract calculations
- Down payment amount: If the arrangement includes a deposit of earnest money, record that along with the negotiated down payment amount
- Loan amount: Calculate this by subtracting the down payment and any other upfront monies (such as earnest money) from the purchase price
- Interest rate: The loan interest rate is a key variable to determine the buyer’s monthly payment
- Loan term: This timeline specifies the number of monthly payments the buyer will make
- Amortization schedule: Lays out the timeline for repayment
- Conditions for balloon payment: Includes the amount and payoff date
- Monthly payment: Include terms governing the due date
- Late payment and default penalties: Include the grace period permitted, if any
- Tax and insurance payment amounts: Along with the amounts, this section also governs whether the seller or buyer is responsible for these obligations
Finally, It’s critical to have a knowledgeable real estate attorney with experience preparing owner financing agreements draw up or review all the documents involved to ensure that both the buyer’s and the seller’s interests are protected.