A home purchase is a very expensive one and typically requires some type of financing. The more common way to finance such a large purchase is to obtain a mortgage from a lender or bank, but there are other more creative ways to get your hands on the money you need to pay for your new home.
Owner financing is one way to finance a home purchase instead of going the conventional route, and involves going directly through the seller.
What Exactly is Owner Financing?
Also commonly known as “seller financing,” this arrangement essentially involves the seller offering financing to the buyer. The seller extends just enough credit to cover the purchase price of the home (minus the down payment). Instead of making payments to a lender, the buyer makes regular monthly payments to the seller until the loan is fully paid off. The buyer will sign a promissory note that details the terms of the mortgage, and the owner will retain title to the property until the entire loan is paid off in full.
Owner financing loans are usually short term. After all, sellers don’t exactly want to be tied to the home or the buyer for decades. Typically, these types of loan arrangements come with a 30-year amortization period with a lump sum repayment – referred to as a “balloon payment” – of the outstanding principal amount due in five years.
The hope is that enough equity will have been built up in the home as a result of an increase in value at the five-year mark to help cover the remainder of the loan. It also provides buyers with the opportunity to improve their financial situation so they’re better able to obtain financing with a conventional lender.
Advantages of Owner Financing
Not only can buyers benefit from owner financing, so can sellers.
Advantages For Buyers:
- No approval needed – Many buyers who aren’t able to meet the stringent requirements of traditional lenders might not be able to get approval for a conventional home loan. Owner financing can provide them with the financing needed to buy a home, which is perhaps the biggest advantage of this arrangement for buyers.
- Quicker closing – There’s no need to have to wait weeks for the underwriter and lender to review the mortgage application and extend the funds. Instead, the financing can be issued almost immediately without delaying the closing of the real estate transaction.
- Fewer costs – Banks and lenders typically charge administrative and appraisal fees along with their mortgage products, which is not the case with owner financing.
- Flexibility with down payment amounts – Conventional mortgages require a minimum of 5% down, and require private mortgage insurance (PMI) for down payments less than 20%. Owner financing does not come with such required minimums.
Advantages For Sellers:
- Quicker closing – Sellers don’t have to wait for buyers to secure financing in order to close on a deal.
- Sellers can hold onto title – Technically, the home is still in the possession of the seller, which means if the buyer defaults, the seller can keep the deposit and the property.
- Lump-sum payment option – The promissory note that the buyer signs can be sold off to an outside investor, which can provide the seller with a lump-sum amount almost immediately rather than waiting for the buyer to pay off the mortgage in full.
Disadvantages of Owner Financing
Along with the pros of owner financing comes the inevitable cons.
Disadvantages For Buyers:
- Higher interest rate – The interest rate that a bank or lender might charge will likely be lower than what the seller might charge for the convenience of not having to go through the hoops of a traditional mortgage process. That means the mortgage itself can be more expensive over the long haul.
- Approval required – This might not necessarily be considered a disadvantage since approval would be needed no matter which outlet is chosen. However, it should still be noted that approval is necessary on the part of the seller before this arrangement is extended.
- The seller’s lender must approve such an arrangement – Ideally, the seller should own the property free and clear, without any outstanding mortgage still left to pay on it. Otherwise, the seller will need the lender to agree to owner financing. Not only that, the lender may demand immediate payment for the remainder of the mortgage if the home is sold as a result of a “Due on Sale” clause that allows the bank to foreclose on the home if full payment on the mortgage is not made.
- Balloon payment obligation – A large balloon payment will be due after five years. That’s a lot of money to be on the hook for, and if you can’t come up with the full amount of the mortgage or secure conventional financing by that point, you could stand to lose the home.
Disadvantages For Sellers:
- The buyer could default – The biggest risk that sellers take in extending owner financing is if the buyer defaults on the payments. Sellers can end up having to go through the foreclosure process if this happens.
- Free and clear title needed – As stated above, the seller might have to outright own the home without any outstanding mortgage left to be paid. If a mortgage is still being held by the seller, approval from the lender will be required.
The Bottom Line
Whether you’re a buyer or a seller in a real estate transaction that involves owner financing, you might want to speak with a real estate lawyer who’s experienced in dealing with such arrangements. Buyers should work with financial advisers to help focus on building their credit score and improving their financial situation in order to be able to secure traditional financing once the five-year term is up. Sellers should ask for a hefty down payment, run a credit check on buyers, conduct a thorough investigation into the buyer’s finances, ensure the loan is secured by the home, and speak with an accountant who can uncover any potential tax implications associated with owner financing.