A mortgage might be the most common way to finance a home, but not every homebuyer can meet the strict lending requirements. One alternative to a mortgage is owner financing, a real estate agreement in which the seller of the property finances the purchase for the buyer. Here are the pros and cons of owner financing for both buyers and sellers.
- Owner financing can be a good option for buyers who don’t qualify for a traditional mortgage.
- For sellers, owner financing provides a faster way to close because buyers can skip the lengthy mortgage process.
- Another perk for sellers is that they may be able to sell the home as-is, which allows them to pocket more money from the sale.
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What Is Owner Financing?
A home is typically the largest single investment that a person ever makes, and the process is challenging for anyone, particularly a first-time home buyer. Because of the hefty price tag, there’s almost always some type of financing involved, usually a mortgage. One alternative to a mortgage is owner financing, which happens when a buyer finances the purchase directly through the seller, instead of going through a conventional mortgage lender or bank.
How Does Owner Financing Work?
With owner financing (also called seller financing), the seller doesn’t give 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. Then, the buyer makes regular payments until the amount is paid in full.
The buyer signs a promissory note to the seller that spells out the terms of the loan, including:
- Interest rate
- Repayment schedule
- Consequences of default
The owner sometimes keeps the title to the house until the buyer pays off the loan.
Less Stringent Loan Approval
Even the most sophisticated sellers are unlikely to subject borrowers to the stringent loan approval procedures that traditional lenders use. Still, this doesn’t mean that they won’t run a credit check. Potential buyers can be turned down if they are a credit risk.
Most owner-financing deals are short-term loans with low monthly payments. A typical arrangement is to amortize the loan over 30 years (which keeps the monthly payments low), with a final balloon payment due after only five or 10 years. The idea is that after five or 10 years, the buyer will have enough equity in the home or enough time to improve their financial situation to qualify for a mortgage.
Owner financing can be a good option for 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.
Use a Real Estate Attorney
It’s a good idea to consult a qualified real estate attorney for the sales contract and promissory note as well as answers to any owner-financing questions.
Pros and Cons for Buyers
For buyers, owner financing has a number of advantages and disadvantages that should be considered before entering into the arrangement.
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.
- Alternative for buyers who can’t get financing: A good option for buyers who are not able to secure a mortgage.
Cons for Buyers
- Higher interest: The interest you pay will likely be higher than you would pay to a bank.
- Need seller approval: Even if a seller is game for owner financing, they might not want to be your lender.
- Due-on-sale clause: If the seller has a mortgage on the property, then their bank or lender can demand immediate payment of the debt in full as soon as the house is sold (to you). That’s because most mortgages have due-on-sale clauses—and if the lender isn’t paid, then the bank can foreclose. To avoid this risk, make sure that 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 or 10 years. If you can’t secure financing by then, you could lose all the money you’ve paid so far—plus the house.
Pros and Cons for Buyers
Flexible down payment
Good option if you can’t get a mortgage
Need seller approval
Pros and Cons for Sellers
Of course, there are pros and cons for sellers in owner-financing deals as well.
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 that you raised from selling your home than you would from investing the money elsewhere.
- Lump-sum option: The promissory note can be sold to an investor, providing a lump-sum payment right away.
- Retain title: If the buyer defaults, then you keep the down payment, any money that was paid—and the house.
- Sell faster: Potential to sell and close faster, since buyers avoid the mortgage process.
The Dodd-Frank Act owner-financing restrictions don’t apply to rentals, vacant land, commercial properties, and non-consumer buyers, including limited liability companies, corporations, trusts, and limited partnerships.
Cons for Sellers
- Dodd-Frank Act: Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, new rules were applied to owner financing. Balloon payments may not be an option, and you might need to involve a mortgage loan originator, depending on the number of properties that the seller finances under owner-financing deals each year.
- Buyer default: The buyer could stop making payments at any time. If this happens and they don’t just walk away, then you could end up going through the foreclosure process.
- Repair cost: If you do take back the property (for whatever reason), then you might end up having to pay for repairs and maintenance, depending on how well the buyer took care of the property.
Pros and Cons for Sellers
Can sell as-is and sell faster
Potential to earn better rates
Dodd-Frank Act complications
Risk of buyer default
Repair costs if you take back the property and there’s damage
Finding Owner-Financed Homes
If you can’t qualify for a mortgage, you might be wondering where you can find owner-financed homes. Here are some options:
- Real-estate websites. Most real estate aggregator websites let you filter by keyword, e.g., “owner financing." You can also do an Internet search for “owner-financed homes near me” to find local businesses that connect buyers and sellers.
- Real-estate agents. Agents and brokers in your area might know about unpublicized deals in your area—or they might even know a motivated seller willing to offer owner financing.
- Search FSBO listings. Find for sale by owner (FSBO) listings in your area. If a property interests you, reach out to the seller and ask if owner financing is an option.
- Search rental listings. Likewise, if you see a home you like that’s for rent, ask the owner if they’re interested in selling with financing. You might get lucky and find someone who is tired of being a landlord but still looking for monthly income.
Who Holds the Deed in an Owner-Financed Deal?
It depends on the way the deal is structured, but often the owner holds the deed until they are paid in full—which happens when the buyer either makes the final payment or refinances with a mortgage from another lender.
Who Pays Taxes and Insurance on Owner-Financed Loans?
On owner-financed deals, buyers make property tax and insurance payments directly to the government and insurance companies. (With mortgages, these fees are usually included in the monthly payments.)
How Is the Buyer’s Credit Checked?
Almost all sellers will check the buyer’s credit history and certain other financial information (employment, assets, financial claims, etc.), but the process will not be as stringent as a traditional mortgage approval.
The Bottom Line
While it’s not common, under the right circumstances, seller financing can be a good option for buyers and sellers. Still, there are risks for both parties that should be weighed carefully before signing any contracts.
If you’re considering owner financing, it’s generally in your best interest to work with a real estate attorney qualified to represent you during negotiations and review the contract to make sure that your rights are protected.