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Owner financing is a financial arrangement between the seller and buyer of a home. Instead of working with a lender to get a mortgage loan, the buyer makes monthly payments to the seller.
If you’re a real estate investor looking to buy your next property for your business, owner financing may be able to give you opportunities you can’t get with traditional mortgage lenders.
Before you start looking for sellers who are willing to provide such an arrangement, though, understand how the process of owner financing works and both the benefits and drawbacks to consider.
What is owner financing?
Owner financing allows homebuyers—mostly real estate investors, but anyone can use it—to purchase a home and pay the seller directly instead of getting a mortgage loan. This arrangement can provide the buyer with less strict eligibility requirements.
For example, if your credit score is relatively low, you’re self-employed or you’re having a hard time verifying your income, owner financing could be an alternative where traditional mortgage lenders won’t work with you.
For the owner, the primary benefit is getting a steady stream of income (with interest attached) until the property is paid for in full.
Depending on where you live, owner financing can go by many names, including:
- Owner financing
- Seller financing
- Owner carried financing
- Owner carryback
- Owner will carry (OWC)
All of these terms essentially mean the same thing, but we’ll use “owner financing” and “seller financing” for the sake of simplicity.
Seller financing terms
In general, the terms with a seller financing arrangement will look somewhat different than what you might find with a conventional loan or bank financing.
This is primarily because unlike a lender, which owns hundreds or even thousands of mortgage loans, a seller may only have one owner financing arrangement. This gives sellers a little more flexibility, but it can also pose a higher risk. Here’s a summary of what to expect with owner financing terms.
A home seller doesn’t have any minimum down payment requirements set by a bank or government agency. Instead, they can choose their own requirements based on how much risk they want to take.
In some cases, you may be able to find an owner financing arrangement with a low down payment. But you’re more likely to see higher down payment requirements, some as high as 25% or more.
That’s because the down payment amount is what you stand to lose if you default on the loan. The higher your down payment, the more “skin in the game” you have, and you’re less likely to stop making payments.
Whatever the seller asks for, however, it may be negotiable. So if you don’t have the amount of cash the seller wants or you do but want to maintain an emergency fund, ask if there’s any wiggle room.
Because a seller doesn’t have a large portfolio of loans to help reduce the risk of one or two borrowers defaulting, you can generally expect to pay a higher interest rate to compensate them for that risk.
In some instances, you may see interest rates as high as 10% (or more), depending on your creditworthiness, down payment and the overall structure of the deal. In others, interest rates may be lower.
A 30-year mortgage is pretty typical for a standard mortgage loan, though you may choose to go down to 15 years instead. With a seller financing agreement, you may be able to choose a 30-year repayment, but the term will most likely be much shorter than that.
For example, the loan may amortize over 15 or 20 years, because the owner doesn’t want to drag out the process over three decades. Alternatively, you may get a longer repayment term to keep the monthly payments low, but the seller may require a balloon payment after five or 10 years to pay off whatever remains of the principal balance at that point.
Seller financing example
Every owner financing arrangement is different, but to give you an idea of how it might be structured, here’s an example of a loan with a 30-year repayment term and a balloon payment after 10 years.
|Down payment (15%)||$30,000|
|Repayment term||30 years|
|Balance at 10 years/balloon payment due||$149,131.96|
|Total of all payments to the seller||$328,819.96|
Now, let’s say you can negotiate with the owner of the home and exchange a higher down payment for a lower interest rate and a balloon payment at 15 years. Here’s how that might look.
|Down payment (25%)||$50,000|
|Repayment term||30 years|
|Balance at 10 years/balloon payment due||$108,839.24|
|Total of all payments to the seller||$329,497.24|
In the second scenario, you would save on the loan’s monthly payment. But because you’re drawing out the repayment for five more years, the interest catches up, and you’ll end up spending a little more than with the first option.
Advantages of owner financing
There are plenty of benefits of owner financing for both the seller and the buyer. Anyone who has applied for a mortgage through a bank or financial institution knows it can be a hassle. A mortgage loan originator will ask for significant documentation. Seller financing can be an easier process. Depending on which side of the deal you’re on, here’s what you need to know.
Pros for buyers
- Faster closing time: Because it’s just you and the seller working out the deal, you don’t need to wait for the loan underwriter, officer and bank’s legal department to process and approve your loan.
- Less expensive to close: You don’t have to worry about traditional lender fees or a lot of other expenses associated with closing on traditional financing. According to Zillow, those costs can amount to 2% to 5% of the purchase price. That’s not to say you won’t have any out-of-pocket costs, but they’ll likely be much cheaper.
- Flexible credit requirements: If your credit is less than stellar, but your cash flow and reserves look good, you may have an easier time getting approved for a seller financing arrangement than a mortgage loan from a traditional lending institution.
Flexible down payment: While some sellers may require higher down payments, some may offer to take less than what a bank might require for the same financing deal.
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Pros for sellers
- Can sell “as is”: With a typical mortgage loan, the lender may have certain requirements of the collateral (the property) to protect its interests. In some situations, that may mean that you’ll need to make costly repairs to meet bank loan standards. With a seller financing agreement, there is no bank to satisfy, and you may be able to sell the home as-is, saving you some time and money. (The buyer, in turn may use creative financing such as business credit cards to fix and flip the property.)
- Potentially good investment: Depending on the interest rate you charge, you may be able to get a better return on an owner financing arrangement than if you were to sell the home for a lump-sum payment and invest the money somewhere else. And unlike the stock market, you don’t have to worry about the return changing based on market conditions — the interest rate is set for the life of the loan (if that’s how you structure the financing terms).
- Faster sale: You can usually sell a home faster through owner financing than you can when you involve a traditional mortgage lender.
- Keep the title: As the lender, you retain the title to the home until the buyer pays off the balance of the loan. What’s more, if the borrower defaults, you keep the down payment, whatever has been paid to you so far, and the home itself.
- Payment flexibility: As the owner, you can be flexible on the loan terms. You can choose the frequency of installment payments; for example, you can take monthly payments from the borrower plus a balloon payment in a specific number of years. Or you can even can sell the promissory note to an investor and get a lump-sum payment.
Disadvantages of owner financing
While there are some pros to using seller financing over a traditional mortgage, there are also some clear drawbacks that might make you think twice before entering such an agreement.
Cons for buyers
- More expensive: Even if it may be easier to qualify for seller financing than a traditional mortgage loan, you’ll typically be charged a higher interest rate and pay more over the life of the loan.
- Balloon payment concerns: If you can’t afford to make the balloon payment with your own cash reserves, you may need to get financing to cover the cost. If you don’t do either, you risk losing the house and all the money you’ve paid up to that point.
- No price-shopping: With a traditional mortgage, you can shop around and compare rates and other terms on a single home. With owner financing, however, the terms of the deal are set by the property’s current owner. While they’re not always set in stone — you can try negotiating on some points — you don’t have the option to price-shop.
- An existing mortgage can be problematic: If the owner still has a mortgage on the property and the loan has a due-on-sale clause, the lender can demand immediate payment of the remainder of the principal balance once the sale goes through to you. If neither you nor the owner pay, the bank can foreclose on the home. To avoid this, make sure the seller owns the property free and clear. If not, consider one of the options below.
Cons for owners
- More work: While you can close on the home with the buyer faster than you could with a traditional mortgage loan, seller financing may require more work in general. If you want to sell your home and be done with it, the regular process is the way to go.
- Potential for foreclosure: If the buyer defaults on the loan but doesn’t leave the property, you may need to start the foreclosure process, which can get complicated and expensive.
- Potential repair costs: If you end up needing to take back the property, you may be on the hook for repair and maintenance costs if the buyer didn’t take good care of the home.
Different ways to structure owner financing deals
If the owner has an existing mortgage loan on the property, it likely has a due-on-sale clause attached to it. There are some situations, however, where the lender may agree to seller financing under certain conditions. And there may be other ways to make it happen without involving the original mortgage lender at all.
Here are a few ways you can structure an owner financing deal if there’s already a loan on the property, as well as a couple where the seller owns the property outright. As you think about which one is right for you, consider hiring an attorney to help you draft up the agreement to avoid potential problems down the road.
Buy “subject to” the existing loan
With this arrangement, you effectively take over the monthly payments on the seller’s mortgage loan, but they’re still legally responsible for making the payments under their contract with the lender — in fact, the lender may not even know that you’ve assumed the monthly payments.
This means that if you stop making payments, they’re still on the hook, and it could ruin their credit if they don’t take up payments again. In addition, if the holder of a residential mortgage loan becomes aware of this arrangement they may call the loan due immediately.
The setup may work if you already have a relationship of trust with the owner. But otherwise, don’t expect many sellers to get excited about this option because of the increased risk they’re required to take on.
With a wraparound mortgage, you’re creating a loan that’s big enough to cover the existing loan plus any equity the owner has in the property.
You make the payment on the larger wraparound mortgage, and the owner takes a portion of that amount to make the payment on the original mortgage loan. The difference between the payments is the owner financing on the equity portion of the home.
The primary drawback of a wraparound mortgage is that it’s junior to the original mortgage loan. So if the owner of the property stops making payments on the first loan, the lender may foreclose on the home, leaving the buyer high and dry.
Lease option or lease purchase
With this setup, you ultimately lease the property from the seller with an option to buy it. In some cases, you may even have a contract drawn up to buy the home at a set date in the future. This option allows the buyer to ensure control over the property, and it can give the owner some time to finish paying off the original mortgage loan.
As with a wraparound mortgage, however, the buyer is still at the mercy of the owner, and if the latter defaults on their loan, the lease agreement will no longer be in effect when the bank forecloses.
Contract for deed
A contract for deed is a common option for seller financing that we’ve covered in detail above. It works only when the seller owns the home free and clear because the owner holds onto the property title while the buyer makes monthly payments.
Once the buyer finishes the repayment term — which can be whatever the two parties agree to — they’ll receive the deed to the home. If they default, however, the owner retains the deed and can repossess the home.
Rent to own
With a rent-to-own financing arrangement, the buyer moves in and rents the home, with a portion of their monthly payment acting as a deposit or down payment, which they can use to purchase the home down the road.
For example, let’s say you pay $1,200 per month, with $1,000 covering the cost to rent the home and $200 — this is sometimes called the rent premium — going into an escrow account.
There are different ways to set up a rent-to-own agreement. For example, the tenant may have the option to buy the home at any point during the lease, or they may be required to buy at the end of the lease.
If the buyer doesn’t go through with purchasing the home, the seller may be able to keep the rent premiums. As a result, this may not be a good choice if you’re on the fence or want to avoid the risk of something changing.
Owner financing for commercial properties
Owner-financed commercial property sales or owner financed land sales are not uncommon. A commercial property owner may have any number of reasons for being open to this type of real estate transaction, including all the above benefit, plus tax advantages. Owners of commercial or rental properties, unlike homeowners, may not need an immediate lump sum from a sale to buy another home.
The commercial real estate industry has been hit hard by the coronavirus crisis in many parts of the country. It has become increasingly difficult to get certain types of small business loans, including some commercial real estate loans. That may lead to sellers being open to creative financing options.
If you are a potential buyer, don’t be afraid to ask whether the seller is open to this type of arrangement. If you are an investor, consider offering seller financing to attract more prospective buyers. Tip: Always check a buyer’s personal and business credit scores so you’ll be alerted to potential risks.
Frequently asked questions
As we researched how owner financing works, we came across several questions about the process and how to know if it’s right for you. Here are some of the more common questions, along with their answers.
Are there closing costs with owner financing?
One of the benefits of using owner financing instead of a traditional mortgage loan is that you’ll save on closing costs. That’s because you won’t have to deal with any lender fees, such as application and origination fees, interest points, and more.
That said, you can still expect some closing costs with a seller financing arrangement. For example, your local government may charge a fee to record the sale of the home, and you might want to get an appraisal to ensure you have the right sales price. Also, there may be a fee associated with transferring ownership of the property to the buyer.
Finally, some counties may require that you have an attorney run a title search before completing the sale to make sure there aren’t any other claims or liens that could come up later.
While the cost of these fees won’t be anywhere near what you’d expect to pay on a mortgage loan, it’s still important to make sure you have enough cash to cover them.
Does owner financing go on your credit?
In most cases, a seller financing agreement won’t help your credit in any way because the owner likely won’t be reporting your monthly mortgage payments to the national credit reporting agencies. There are, of course, some exceptions to this rule, especially if the owner is a business that meets the credit bureau requirements for credit reporting.
While there’s not a lot of potential upside for your credit with owner financing, it could damage your credit if you default and the owner hires a debt collection agency, which will report the past-due debt.
There are plenty of reasons to consider owner financing, but if you’re hoping to use it to build your credit history, you may end up disappointed.
Building, establishing, and managing personal credit is a lifetime job for the average consumer. Building and leveraging your business’ credit is often forgotten by many business owners. Business owners who understand their business credit were 41% more likely to be approved for a business loan. Check your business credit scores for free on Nav today.
How do you calculate owner financing?
The terms of an owner financing agreement will depend on what both the buyer and seller are willing to accept. Once you’ve nailed down the specific terms of the loan, you’ll want to run the numbers to make sure it’s affordable.
Start by using an online mortgage calculator to determine your monthly payment using the mortgage amount, amortization term and interest rate. If the agreement includes a balloon payment, use a mortgage balance calculator to see how much the principal balance will be after you’ve made the predetermined number of monthly payments.
To get the total amount you’ll pay to the seller, multiply the monthly payment amount by the number of payments before your balloon payment. Then add that figure to the balloon payment amount and the down payment amount.
Going through this process will help you not only determine whether you can afford the monthly payment and the balloon payment, but also how much financing you need if you can’t afford the balloon payment when it’s due.
Is owner financing safe?
In the right circumstances, owner financing is a safe way to finance an investment property or even a residential home. That said, not all buyers and sellers are experienced in the process. Also, there are always risks inherent to an owner financing arrangement, even if both the buyer and the seller are acting in good faith.
As you consider both the benefits and drawbacks of owner financing, it’s up to you to determine whether you’re comfortable with the process and how to proceed. While you can find seller financing contracts and owner financing addendums online, this is one time where you don’t want to skimp. Whether you’re a buyer or a seller, take time to vet the other party to establish trust, and be sure to hire an attorney to help draw up the arrangement so it’s legally sound.
This article was originally written on November 1, 2019 and updated on November 6, 2019.
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