Owner Financing

For prospective home buyers, applying for a mortgage from a bank or other type of mortgage lender can mean a ton of paperwork and sweating out the approval process.

Some home buyers are going to run into problems when looking for a bank-approved mortgage to arrange the financing for their purchase of a home. A traditional lender may decide their credit score is too low, or their debt-to-income ratio is too high to qualify for the loan amount and monthly payments of a traditional mortgage.

The Owner-Financing Alternative

But other options are available — buyers and sellers just need to do a little homework before they use them.

Owner financing, also known as seller financing, is a common method that has been around for years. In an owner-financed arrangement, the seller of the property assumes the risk that a bank normally does — that the prospective buyer may default on the mortgage.

A big advantage of owner financing is that both the buyer and seller can save a lot of time that’s often wasted during the approval of a traditional mortgage. There’s no lengthy loan approval process, and there are no closing costs.

How Owner Financing Works

Buyers still have to come up with a down payment and agree to make monthly payments for the mortgage’s duration. The terms are likely to be spelled out in a promissory note the buyer signs when the deal is closed.

The promissory note will specify the:

• Purchase price
• Down payment
• Loan amount
• Payment schedule and monthly payment amounts
• Details of a balloon payment at the end of the loan
• Penalties for missed payments or default

Unlike a traditional, 30-year home mortgage, real estate purchased through owner financing may only have a five- or ten-year duration and require a large balloon payment to pay down the balance of the loan amount at the end of that term.

Types of Owner Financing

Not all owner-financing agreements rely on promissory notes, although they may have some common attributes. The other types of owner-financing arrangements include:

• Deed of trust: This is a form of a promissory-note agreement that is similar to a mortgage deed. With a deed of trust, the home’s title is held by a third-party trustee. When the sales contract terms are satisfied, the trustee releases the title to the buyer.
• Contract for deed: In this type of sale, the seller retains the property deed and title until the buyer pays for the property in full.
• Lease-purchase agreement: Lease-purchase agreements are sometimes called rent-to-own agreements. The buyer leases the property for a period of time before agreeing to the final terms of purchasing the property. The rent paid during the lease goes toward the sale of the home.

Requirements of Owner Financing

Overall, the requirements of owner financing are relatively modest compared to a traditional mortgage. For example, sellers often don’t have to worry about making repairs to the property. The buyer will often incur the cost of getting the home and property fixed up. But there are still some steps sellers and buyers should take to protect themselves.

Sellers will want to:

• Get current copies of the buyer’s credit report and run a credit check on them
• Confirm the buyer’s current employment and recent job history
• Have a lawyer and an accountant review the promissory note in advance of the closing
• Make sure the buyer can arrive at the closing with a sufficient down payment

Buyers will want to:

• Have a certified engineer inspect the home
• Have a title inspection and buy title insurance
• Hire an appraiser to certify the home’s value before the promissory note is drafted
• Have the promissory note reviewed by a lawyer and accountant

Are There Risks and Downsides to Owner Financing?

There are indeed some risks to owner financing for both the buyer and seller. Some of these may be greater than with a traditional mortgage, but this is where the footwork each party to the contract does before the closing can come in handy.

For the seller, there’s always the risk that the buyer could default. At the time of closing, the seller only gets the down payment, while in a traditional mortgage, they receive the full sales price. A seller has to wait five or ten years until the balloon payment is due to receive the total price.

An owner-financing agreement also puts the lender at risk if they are still carrying a mortgage on the property, and they need the buyer’s monthly payments to cover the seller’s mortgage costs. If the buyer defaults on the owner-financing agreement, then there’s a risk that the buyer and seller could both lose the real estate.

For buyers, the downsides of purchasing an owner-financed property have mainly to do with cost. The buyer doesn’t have to deal with the paperwork and delay of getting a bank to approve a traditional mortgage, but they pay for that ease and speed with a higher interest rate and higher monthly payment for the loan’s duration. They also incur the risk that they may not be able to afford the balloon payment at the end of the loan term.

Related Resources

Amortization

Credit Report Analysis

Credit Score

Seller Financing

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