Owner Financing: What You Need to Know

If you’re trying to buy a house but are having problems getting loan pre-approval, owner financing is an option that may help you move forward with your plans. Direct seller financing can be an excellent option for purchasing a home and shortening the closing process, but not all dealers will be ready to or able to do so.

However, owner-financed homes can also be complicated and require a written agreement; therefore, it is necessary to fully grasp the process before putting pen to paper. Find out how owner financing works and how it might benefit both the client and the dealer.

What Is Owner Financing?

Instead of getting a mortgage from a bank, a property dealer and client can work out a payment plan directly with one another through an arrangement known as “owner financing.” Owner financing is similar to a traditional bank loan in that the dealer fronts the money for the purchase of the home, and the client repays the dealer over the course of the loan.

For starters, there will be a sizable down payment towards the home’s purchase price, followed by regular loan repayments consisting of principal and interest. In most cases, the interest rate for owner financing is higher than that of a bank loan. However, it is a possibility for home clients who may have trouble getting approved for financing from a conventional lender.

How Does Owner Financing Work?

Here is a broad explanation of how owner financing works.

1. Payment arrangements are settled upon by the client and dealer. The owner financing process officially begins once a promissory note outlining the financing arrangements is signed by both the client and dealer. The owner financing terms include the interest rate, the amortization schedule (the timeframe for regular mortgage payments), and the due date for the loan.

2. A down payment is made by the client. After the dealer and the client settle on a financing plan, the client will make a down payment to secure the deal.

3. The purchaser repays the loan on a monthly basis. In most cases, the client will make monthly payments against the loan’s principal. Owner financing does not factor in recurring costs like property taxes and insurance, which are part of a standard mortgage.

4. Loans are repaid by the client. To settle any outstanding balances at the conclusion of the loan term, the client will typically be required to make balloon payments or a single, large payment. If the client is unable to come up with the money for the balloon payment, they may take out a second mortgage to cover the remaining principal and interest on the home.

Example of Owner Financing

Let’s use the example of a home client who wants to buy a historic property but can’t get a traditional mortgage because of the property’s age and condition. To cover slightly over 30% of the asking price, the borrower proposes a $25,000 down payment on a home being offered for sale at $80,000.

The remaining $55,000 will be financed by the dealer at 7% interest for a five-year period and amortized over twenty years, with a balloon payment of roughly $47,000 due at the conclusion of the term. The client is responsible for paying $426 every month in addition to the loan’s interest, principal, property taxes, and insurance premiums.

The mortgaged property will be transferred to the client upon closing. After making all of their regular monthly mortgage payments for a period of five years without missing a beat, the client completes a final balloon payment and then the mortgage is freed.

Types of Owner Financing

The following are some types of owner financing that can be used.

1. Promissory note or mortgage. In this arrangement, the client signs a document giving the lender a security interest in the property until the loan is repaid, just as they would with a conventional mortgage deed. Both the mortgage and the client’s name appear on the public record under this arrangement.

2. Deed of trust. Similar to a mortgage deed, this is a form of the promissory note. The home’s title is transferred to an independent third party, the “trustee,” when a deed of trust is in place. When all financing requirements have been met, ownership passes to the purchaser.

3. Contract for deed. The client understands and agrees that until the Loan is paid in full, the Seller will retain legal title to the Property. Until that time, the dealer retains all legal ownership interests in the property.

4. Lease-purchase agreement. With lease-purchase agreements or “rent-to-own” contracts, the client rents the property for a certain period of time before making the final commitment to buy. Lessee’s total rent payments will be credited toward the purchase price of the property upon its sale at the conclusion of the lease term.

Owner Financing: Pros and Cons

Before agreeing to owner financing, both the client and the dealer should weigh the pros and cons of the agreement.

Buyer Pros

• Less stringent requirements for both credit and property – The owner might not insist that you have a stellar credit history or that the house is in excellent condition.
• Lessen the amount of money spent on the closure – You won’t have to pay any fees to the bank, and you may not even have to pay for the appraisal or the inspection.
• Faster closing – Due diligence can be shortened, allowing the closing to take place much more quickly.

Seller Pros

• Reduced housing requirements – A lender’s evaluation is not necessary for a sale, so you can sell the property in its current condition.
• Faster closing – A quicker transaction closing is possible with fewer due diligence obligations.
• Positive investment return – In exchange for the loan, you will receive both the first payment and the regular repayments, plus interest.
• The flexibility of investments – You may be able to keep the money you’ve received plus reclaim the property if the client fails after you sell the loan to an investor, but that will depend on the laws in your state.
• Tax advantages – Any taxes incurred from capital gains could be paid over several tax filing seasons.

Buyer Cons

• Higher rate of interest – Interest rates charged by owner financiers is often greater than those of traditional lenders.
• Availability is limited – Unfortunately, not all vendors are prepared to provide owner financing.
• High down payment – In many transactions, the minimum down payment is 20%.
• Balloon payment – There is no assurance that you can refinance with a different lender, and many packages call for a balloon payment that might be difficult to save up for.

Seller Cons

• Additional work is required – The purchaser’s income and credit history must be verified, among other things.
• Increased risk – The client may fail to make their loan payments or cause property damage, leaving you with no choice except to foreclose and assume the costs of restoration.
• The law is often difficult to understand – As a matter of consumer financial safety, federal and state law can place constraints on owner financing contracts as well as balloon loans.
• One must have ownership – In an owner-financing transaction, the dealer must have already obtained a release from his or her own mortgage and possession of the property’s title.

How to Find a Home that Offers Owner Financing

You may ask where to find owner-financed properties if you cannot obtain a mortgage. Here are a few options:

1. Real-estate websites. To narrow your search, you can use keywords like “owner financing” or “client financing” on most real estate listing websites. Looking up “owner-financed homes near me” online will also yield results for local companies that act as a go-between for potential home clients and dealers.

2. Real-estate agents. Local real estate professionals may have information about offers that haven’t been advertised, or they may know a motivated dealer who is prepared to negotiate terms such as owner financing.

3. Check out the for-sale-by-owner classifieds. Look up FSBO ads in your neighborhood. Talk to the dealer to determine whether owner financing is available if you’re interested in purchasing the home.

4. Check out local rental ads. A similar strategy would be to approach the landlord of a desirable rental property and inquire as to whether or not they would consider selling their home to you on an owner-financing basis. Someone who is sick of collecting rent every month could be your lucky break.

Is Owner Financing Safe?

If both the client and the dealer take the necessary steps to safeguard their respective financial interests, owner financing is a secure method of financing the acquisition of a home. A written agreement, preferably drafted by a qualified attorney, outlining the funding terms is essential.

Although a client using dealer financing can avoid having to get an appraisal and inspection done by a bank, they still might want to take precautions to make sure they aren’t paying too much. Sellers are under no obligation to perform a credit check on a client who requests dealer financing. 

On the other hand, it’s a prudent strategy for lowering the dangers of owner financing and raising the prospect of a client making timely payments.

Bottom Line

If you’re having trouble getting a mortgage or loan from a regular financial institution, a good real estate representative can assist you in finding properties where the owner is willing to provide finance.

Although owner financing is not popular, it can benefit both clients and dealers in certain situations. However, prior to signing any contracts, each party should thoroughly consider the associated risks.

It is highly recommended that anyone pursuing owner financing have their interests represented by a real estate attorney during contract discussions and reviews.