While a residential mortgage loan is the most common type of financing used to purchase a home, owner financing is an alternative that has advantages and disadvantages for both buyers and sellers.
Owner Financing: An Overview
A home is typically the largest single investment a person ever makes. Because of the high cost, it usually involves some type of financing. Owner financing happens when a home buyer finances the purchase directly through the seller – instead of through a conventional mortgage lender or bank.
With owner financing (also called seller financing), the seller doesn’t hand over any money to the buyer as a mortgage lender would. Instead, the seller extends enough credit to the buyer to cover the purchase price of the home, less any down payment, and then the buyer makes regular payments until the amount is paid in full. The buyer signs a promissory note to the seller, which spells out the terms of the loan, including the interest rate, repayment schedule and the consequences of default. The owner sometimes keeps the title to the house until the buyer pays off the loan.
Most owner-financing deals are short term and a typical arrangement might involve amortizing the loan over 30 years but with a final balloon payment due after five. The theory is that after five years the buyer should have enough equity in the home and/or have had enough time to improve his financial situation to qualify for a conventional mortgage loan.
Owner financing can be a good option for both buyers and sellers but there are risks. Here’s a look at the pros and cons of owner financing, whether you’re a buyer or a seller.
Advantages of Owner Financing
Owner financing can be a good option for both parties in a real estate transaction:
Pros for Buyers
- Faster closing – no waiting for the bank loan officer, underwriter and legal department to process and approve the application.
- Cheaper closing – no bank fees or appraisal costs.
- Flexible down payment – no bank or government-required minimums.
- A good option for buyers who are not able to secure a mortgage.
Pros for Sellers
- Can sell “as is” – potential to sell without making costly repairs that traditional lenders might require.
- A good investment – potential to earn better rates on the money you raised from selling your home than you would from investing that sum other ways.
- Lump-sum option – the promissory note can be sold to an investor, providing you with a lump-sum payment right away.
- Retain title – if the buyer defaults, you keep the down payment, any money that was paid, plus the house.
- Sell faster – potential to sell and close faster since buyers avoid the mortgage process.
A qualified real estate attorney should be consulted to answer any questions as well as write the sales contract and promissory note.
Disadvantages of Owner Financing
Although owner financing can be beneficial to both buyers and sellers, it also has some legal, financial and logistical disadvantages:
Cons for Buyers
- Higher interest – the interest you pay will likely be higher than what you’d pay to a bank.
- Will still need seller approval – even if a seller is game for owner financing, he might not want to become your lender.
- Due on sale clause – if the seller has a mortgage on the property, his bank or lender can demand immediate payment of the debt in full if the house is sold (to you). This is because most mortgages have “due on sale” clauses and if the lender isn’t paid, the bank can foreclose. To avoid this risk, make sure the seller owns the house free and clear or that the seller’s lender agrees to owner financing.
- Balloon payments – with many owner financing arrangements, a large balloon payment becomes due after five years. If you can’t secure financing by then, you could lose all the money you’ve paid so far, plus the house.
Cons for Sellers
- Dodd-Frank Wall Street Reform and Consumer Protection Act – Under this Act new rules were applied to owner financing. Balloon payments may not be an option and you might have to involve a mortgage loan originator depending on the number of properties you owner finance each year.
- Default – the buyer could stop making payments at any time. If this happens and he doesn’t just walk away, you could end up going through the foreclosure process.
- Repair cost – if you do take back the property for whatever reason, you might end up having to pay for repairs and maintenance, depending on how well the buyer took care of the property.
- Owner financing can help sellers sell faster and help buyers get into homes, even if they would be unable to secure a traditional mortgage.
- There are advantages and disadvantages that both buyers and sellers should be aware of when considering or engaging in an owner-financing arrangement.
- Both buyers and sellers need to consult a qualified real estate attorney to answer questions and facilitate the sale/purchase properly.