how does owner financing work

How Does Owner Financing Work?

March 30, 2022

Produced by:
Carmel Woodman

With over 8 years of expertise, Carmel brings a wealth of knowledge as the former Content Manager at a prominent online real estate platform. As a seasoned ghostwriter, she has crafted multiple in-depth Property Guides, exploring topics such as real estate acquisition and financing. Her portfolio boasts 200+ articles covering diverse real estate subjects, ranging from blockchain to market trends and investment strategies.

A quick outline

Owner financing is a creative financing solution for people who’d like to buy a house but don’t qualify for a traditional loan. It’s offered by sellers to buyers directly and is therefore an easy way for buyers and sellers to cut out the middleman and arrange a deal between them to pay off a home. So, how does owner financing work?

Main Topics

Buying a house is one of the biggest purchases many people will make in their lifetime, and as such lots of people simply don’t have the funds for it. Aside from the traditional ways of getting financing for a house purchase, there are also various creative financing methods which can be extremely useful for both home buyers and real estate investors alike. One of these methods is called owner financing or seller financing.

What is owner financing?

Owner or seller financing happens when the seller or current homeowner finances the purchase, without the buyer having to get traditional financing for it. The owner therefore becomes the lender in the situation, and often they will use higher interest rates and require a balloon payment after a few years. The owner will retain the title to the home until the loan has been fully repaid by the buyer.

house for sale

How does owner financing work on a house?

Once a deal has been made for a buyer to use owner financing, the buyer and seller discuss the terms of the loan. Just like traditional loans, owner financing usually requires a down payment of some sort and then the rest of the money is paid back over a period of time. This period is agreed upon between the buyer and the seller as part of the loan terms, but typically it’s a shorter timeframe than traditional loans, often just 5 years.

The buyer will give the seller a promissory note which shows their agreement with the terms. The promissory note includes the interest rate, schedule of payments that the buyer will make to the seller, and the consequences for the buyer if they default on any of these payments. This note is captured in the public records so that both parties are held to it. State laws need to be considered when deciding on loan terms because some states prohibit things like balloon payments.  

Advantages of owner financing

Advantages for sellers

  • Sell the house as is: Sellers won’t need to fix up the house and can often sell it as is. Which means that they can save on renovations and upgrading the house.
  • Get full asking price: A seller’s chances of getting their full listing price for the property is higher when they are providing the financing.
  • Investment opportunity: If a seller charges the buyer a higher interest rate on the loan, this could work out better for them than investing their money in a bank account where it wouldn’t earn the same interest.
  • Investor option: A seller can sell the promissory note to an interested investor for an upfront payment if they need to get out of the deal or get the money quicker.
  • Property as collateral: The seller retains the title to the property, as well as the down payment, which can be used as collateral in the case of a defaulting buyer.
  • Stand out listing: A property that offers owner financing will stand out from the crowd in online listing space and is more likely to get interest.

Advantages for buyers

  • Closing costs are lower: There are lower closing costs associated with owner financing, which is a great advantage for buyers. This is because there are no transaction costs, origination fees and other costs that crop up as a result of traditional mortgages or loans.
  • Faster closing time: The process is a lot quicker, so buyers can wrap up the purchase faster without all the hassles of mortgage applications.
  • Flexible terms: One of the most common reasons for buyers to go the owner financing route is for the flexible repayment terms that can be arranged. With financing going directly through the seller, this means that the buyer and seller can negotiate payment terms that are best for both of them. For example, if a buyer can’t pay the down payment all in one go, a seller could allow it to be paid over time in 3 smaller amounts.
  • Easier to qualify: Getting approved for a mortgage or real estate loan can be tricky, particularly for those who don’t have a good credit score. So, owner financing is a great option for buyers who are struggling to qualify for traditional loans as the lending criteria aren’t as stringent.

Disadvantages of owner financing

house for sale

Disadvantages for sellers

  • Defaulting buyer: If a buyer defaults, the seller will have to handle the foreclosure process themselves which can be a daunting task.
  • Tax: Sellers may be subject to income tax on the loan repayments, instead of capital gains tax. Income tax is higher than capital gains tax, so this leaves the seller paying more for tax.
  • Responsibility: The seller is responsible for any repairs and property maintenance that was deferred if a buyer defaults on their payments.
  • Agreements: The agreement made between the buyer and seller can be complicated and limiting for the seller.

Disadvantages for buyers

  • Balloon payments: A common way of structuring owner financing payment terms is a shorter loan with a balloon payment at the end, which makes life a bit harder for buyers who need to make sure that they can pay this back on time.
  • Higher interest rates: Typically, a seller will demand a higher interest rate than what a buyer could get on a traditional loan. This is because the loan is a risk for the seller, so they need to offset this by upping the interest rate and making it worth their while.
  • Not all sellers are willing: This is not a common financing method, so not all sellers are willing to entertain this option.
  • Seller mortgage: Some mortgages will prevent a seller from offering owner financing because they are required to pay back the entire mortgage upon the sale of their home. This is called a due-on-sale clause.

Owner financing example

making a deal

If a buyer wants to purchase a home, but they don’t qualify for a traditional loan, they can ask the seller of a house they’d like to buy, if they can make an owner financing arrangement. Let’s say the house is listed for a price of $150,000, and the buyer offers to buy it for $165,000 with a $40,000 down payment to sweeten the deal.

The seller could then agree to this and offer to finance the remaining $125,000 over a period of 5 years, with the loan amortizing over 20 years, and an interest rate of 7.5%. The buyer would then pay off the monthly installments for that over 5 years and at the end of the 5 years, a balloon payment will be made for the remaining amount. The buyer will then receive the title to the house once the loan is paid back in full.

How to find homes with owner financing

  • Real estate listing websites: Websites that list homes for sale will often have a search function that allows you to filter according to owner financing, which is a great help for finding these properties.
  • FSBO listings: For Sale By Owner listings are another place to look for properties that are owner financed, you can reach out to these owners and check whether they are offering financing or would be open to it.
  • Real estate agents: Get in touch with your local real estate agents and brokers, they may have insight into which properties in the area could be open to owner financing, even if it isn’t advertised.

Alternatives to owner financing

These are also a creative financing option for real estate investment purchases, however hard money loans are offered by private lenders and are short-term loans, usually 12-24 months. Hard money loans also come with higher interest rates, but they can offer more than traditional loans, with flexible loan terms to suit your needs.

Crowdfunding is becoming popular in the real estate space, both for investors who are wanting to diversify their portfolios into real estate, and for people who are wanting to do real estate projects but don’t have the funds. It works by a group of investors pooling their funds online to finance your real estate project or purchase.

  • Cash-out refinance

In this financing method the equity in your home is used to find funds for your real estate investment. In other words, you’d borrow enough money to pay off your mortgage and then you’d be left with the difference. Whatever you have built up over time can then be used for your next investment.

Final Thoughts - Is owner financing a good idea?

Owner financing can be a useful creative financing option for buyers who can’t get traditional loans, and who can find a willing seller. However, it’s important to remember that it can come at a price, which is higher interest rates and potential balloon payments. It’s vital to weigh up the pros and cons of owner financing, before going down this route. Make sure to get an attorney involved in the proceedings so that everything is done correctly according to the law.

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