Owner financing: What it is and how it works

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. This arrangement is also referred to as seller financing or purchase-money mortgages.

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. It 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.

This arrangement involves a buyer making a down payment to the seller, and the buyer assuming the seller’s mortgage. In addition, the buyer pays the difference between the balance on the mortgage they’re taking over and the sale price of the property they’re purchasing. The difference between the mortgage balance and the home’s sale price is the part of the purchase that the seller finances.

How does owner financing work?

In a typical owner financing arrangement, the owner (seller) records a mortgage against the property, which is sold via deed transfer to the buyer. Once the sale is complete, 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,” says Chris McDermott, real estate investor, broker and co-founder of Jax Nurses Buy Houses in Jacksonville, Florida. “After that time, the mortgage commonly comes due in the form of a balloon payment owed by the buyer.” This is where owner financing homes can get complicated since, at this point, the buyer might have to find funding for their balloon payment — typically through a mortgage refinance.

Reasons for owner financing

There are several scenarios where owner financing can make sense, including:

• Your credit is not sufficient to qualify for traditional financing.
• The selling price is too high to secure a standard mortgage.
• You want to seal the deal fast.
• You’re seeking ways to curb closing expenses.
• You have limited funds on hand for a down payment.

Pros and cons of owner financing

Owner financing offers advantages and disadvantages to both homebuyers and sellers.

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 Bruce Ailion, a real estate attorney, investor and Realtor with RE/MAX Town & Country in Alpharetta, Georgia.

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.”

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.”

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 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.

Requirements for owner financing

The terms and conditions of the deal should be included in a promissory note, which is a document that features the borrower’s promise to repay the loan along with the agreed upon interest rate, loan term and repayment schedule. It also mentions the potential outcomes should the loan become delinquent through missed payments.

If you’re the buyer, it’s also worth paying for a title search to ensure there are no claims against the property besides the current mortgage (if applicable). This ensures the owner can sell the property, and you can receive the home’s title once you pay the amount you owe in full.

Types of owner financing

The many forms of owner financing come 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 could 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, 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, 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, a 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 a party other than the original borrower can legally take over  — can be used in wraparound financing. While FHA, USDA and VA loans are eligible for this type of financing, conventional mortgage loans are not.
• Hard money loans – Yet another type of owner financing, hard money loans involve working with private investors. These investors focus more on the value of the property being purchased (since it serves as collateral for the loan) and less on the borrower’s qualifications. But there are drawbacks to this approach, including higher interest rates that can make it a costly option. In addition, repayment terms are often short.

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: Before ownership is transferred to the buyer, a title company or attorney does a title search to confirm there are no other claims on the property. The deed to the property is recorded by your local government to confirm the transfer from buyer to seller. (With owner-financing, the transfer takes place once the loan is paid in full). Both processes come at a cost to the buyer.
• Property taxes: If you buy a house with a conventional mortgage, these taxes are generally bundled into the mortgage payment. In an owner-financed purchase, the borrower is responsible for paying taxes specified in the contract to the collecting government agency.
• Homeowners insurance: These premiums are also your responsibility in an owner-financing arrangement. More information on how to remit insurance payments is generally disclosed in the financing agreement.
• Closing costs: Ailion says owner-financed closing costs “are usually substantially less than you’d pay with bank financing.”

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 for sale with owner financing. Here’s how to move forward if you’re the seller:

• Step 1: Structure the deal. Common ways of arranging an owner financing contract include a promissory note and deed of trust or rent-to-own contract.
• Step 2: Vet the prospective buyer. McDermott says it’s important to do your due diligence. Since you’re not relying on the sophisticated credit-risk modeling loan underwriters use, 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,” says McDermott. “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.”
• Step 3: Review and execute the agreement. “Just be sure the promissory note you sign is legally compliant and clearly lays out the terms of the deal,” says Andrew Swain, co-founder of Sundae, a San Francisco-headquartered residential real estate marketplace for distressed properties. 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.

If you’re on the other end of the transaction as the buyer, you’ll also need to review the promissory note before signing on the dotted line. The same applies if you plan to enter into a rent-to-own contract instead.

“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,” says Swain.

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 both the buyer’s and the seller’s interests are protected.

FAQ about owner financing

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  What are the key terms of an owner-financing agreement?

  Whatever the construction of an owner financing agreement, it needs to spell out some key terms, including:

  • 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: This schedule lays out the timeline for repayment.
  • Conditions for balloon payment: These conditions include the amount and payoff date.
  • Monthly payment: This payment includes terms governing the due date.
  • Late payment and default penalties: These terms must 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.
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  What if a buyer defaults on the mortgage?

  If a buyer defaults on the mortgage, the recourse for a seller depends on the structure of the purchase agreement. For a lease agreement, the seller can attempt to evict the purchaser. However, if the deal was written as an installment sale, the seller’s recourse varies by state. Ultimately, however, the seller may need to foreclose on the buyer in an installment sale.
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  Who holds the deed in owner financing?

  The seller retains possession of the deed until the buyer makes the final loan payment.