Asking a seller to effectively lend you money to buy their home isn't something most homeowners, or even their listing agents, usually consider. But owner financing is definitely a viable option for a seller whose home isn't selling, or for a buyer who's having trouble with traditional lender guidelines.
Also known as "seller financing," it's especially popular when the local real estate scene is a buyer's market.
- Owner financing is an alternative to a traditional mortgage, although it may be used in addition to a traditional mortgage.
- Owner financing can take the form of a mortgage, land contract, or lease-purchase contract.
- For buyers, owner financing can be more streamlined and flexible than other types of mortgages, but they are at the seller's mercy when it comes to issues such as interest rates and balloon payments.
- For sellers, financing a buyer's purchase can provide a stable source of income, but sellers become responsible for issues such as taxes and any potential foreclosure proceedings.
What Is Owner Financing?
Owner or seller financing means that the current homeowner puts up part or all of the money required to buy a property. In other words, the buyer borrows the money from the seller instead of taking out a mortgage with a conventional lender.
Buyers can completely finance a purchase in this way, or they can combine a loan from the seller with one from a bank.
It doesn't matter if the property has an existing mortgage against it, although the homeowner's lender might accelerate the loan or call it immediately due upon sale due to an alienation clause.
The seller generally retains the title to the home until the buyer has repaid the loan in full.
How Owner Financing Works
The buyer and seller agree on an interest rate for the financed portion, as well as the monthly payment amount, schedule, and other details of the loan. The buyer gives the seller a promissory note agreeing to these terms. The promissory note is generally entered in the public records, so it protects both parties.
Sellers and buyers are free to negotiate the terms of owner financing, subject to state-specific usury laws and other local regulations. For example, some state laws prohibit balloon payments.
It's not required, but many sellers do expect the buyer to make some sort of down payment on the property. Their rationale is similar to that of any mortgage lender: They assume that buyers who have some equity in a home are less likely to default on the payments and let it go into foreclosure.
Types of Seller Financing
Owner financing can take several forms. Some variations include the following.
Land contracts give buyers an equitable title to the property, but they don't convey full legal title of the property. The buyer makes payments to the seller for a certain period of time, then receives the deed upon final payment or when they refinance.
Equitable title designates that the buyer has the use of the property but does not actually own it.
Sellers can carry the mortgage for the entire balance of the purchase price less the down payment, which might include an underlying loan. This type of financing is referred to as an "all-inclusive mortgage" or "all-inclusive trust deed" (AITD). It's also known as a "wraparound mortgage."
The seller receives an override of interest on the underlying loan. They also might carry a junior mortgage; in which case, the buyer would take title subject to the existing loan or obtain a new first mortgage. The buyer receives a deed and gives the seller a second mortgage for the balance of the purchase price, less the down payment and the first mortgage amount.
A lease-purchase agreement, also known as a "rent-to-own option," means the seller is leasing the property to the buyer and giving them an equitable title to it. The buyer receives the full title and typically obtains a loan to pay the seller upon fulfillment of the lease-purchase agreement, after receiving credit for all or part of the rental payments toward the purchase price.
Pros and Cons of Owner Financing for Buyers
Terms can be flexible
Down payments are negotiable
There are fewer closing costs
The closing process moves along more quickly
Qualifying can be much easier
Sellers can demand higher interest rates in exchange for financing
The seller's lender can foreclose if the seller has an existing mortgage that includes an alienation clause
The term of the loan can be short, culminating in a balloon payment
- Terms can be flexible: Financing is tailored. Unlike conventional loans, sellers and buyers can choose from a variety of loan-repayment options, such as interest-only, fixed-rate amortization, or less-than-interest. Interest rates can adjust periodically or remain at one rate for the term of the loan.
- Down payments are negotiable: Sellers will sometimes let a buyer make periodic lump-sum payments toward a down payment when they want a larger down payment than the seller can come up with.
- There are fewer closing costs: There are no loan or discount points without an institutional lender. There are no origination fees, processing fees, administration fees, or any of the other assorted miscellaneous fees that lenders routinely charge, which saves money on the buyer's closing costs.
- The closing process moves along more quickly: Buyers and sellers aren't waiting for a lender to process the financing, so they can close sooner. Thus, buyers can have possession of the property sooner than they likely would with a conventional loan transaction.
- Qualifying can be much easier: There's little or no qualifying involved. The seller's interpretation of the buyer's qualifications is typically less stringent and more flexible than those imposed by conventional lenders.
- Sellers can demand higher interest rates in exchange for financing: It can be something of a red flag to sellers that the buyer can't qualify for a traditional mortgage. They might want something in exchange for taking a risk that a conventional lender wouldn't, such as a more prohibitive interest rate.
- The seller's lender can foreclose if the seller has an existing mortgage that includes an alienation clause: An alienation or due-on-sale clause can kick in if the seller has an existing mortgage on the property. These clauses can call that existing mortgage due in its entirety if the seller sells the property without paying off the initial mortgage.
- The term of the loan can be short, culminating in a balloon payment: Sellers can demand other terms that are more favorable to them, such as a balloon payment after a period of time. The buyer would have to pay off the entire loan on that date, which could mean having to apply for a traditional mortgage to access the money.
Pros and Cons of Owner Financing for Sellers
Monthly cash flow is improved
Sellers can ask for a higher-than-usual interest rate in exchange for financing
Offering seller financing sets them apart from other available inventory
Sellers can hold out for full list price
Sale proceeds will likely be taxed at ordinary income tax rates rather than capital gains rates, which can be lower
Sellers will have to handle foreclosure proceedings if the buyer defaults on the financing
- Monthly cash flow is improved: Payments from a buyer increase the seller's monthly cash flow, resulting in a spendable income.
- Sellers can ask for a higher-than-usual interest rate in exchange for financing: The owner-financed loan can carry a higher rate of interest than a seller might receive in a money market account or other low-risk types of investments.
- Offering seller financing sets them apart from other available inventory: Offering owner financing is one way to stand out from a sea of inventory in a buyer's market, attracting a different set of buyers and moving an otherwise hard-to-sell property.
- Sellers can hold out for full list price: Sellers can be in a position to command full list price or higher when they're offering the financing.
- Sale proceeds will likely be taxed at ordinary income tax rates rather than capital gains rates, which can be lower: The seller might have to pay income tax on an installment sale, although they'd only have to report the income received in each calendar year. This could nonetheless move them into a higher tax bracket. This income would be taxed as ordinary income rather than the more favorable capital gains tax rate that would result from an outright sale.
- Sellers will have to handle foreclosure proceedings if the buyer defaults on the financing: This could result in legal nightmares.
Is Owner Financing Right for You?
As advantageous as it can be, owner financing is a complex process. Neither the buyer nor the seller should rely only on their respective real estate agents, but they should engage real estate lawyers to help them negotiate the transaction and to ensure their agreement conforms to all state laws, covers every contingency, and protects both parties equally.
Frequently Asked Questions (FAQs)
Who holds the deed in owner financing?
The seller technically holds the deed until the buyer finishes paying off the loan. The buyer receives equitable title in the property, but full ownership doesn't transfer until payment is complete.
Who pays property taxes in owner financing?
Responsibilities for property tax and insurance payments should be outlined in the owner-financing agreement. Typically, the buyer will pay those to the seller in monthly installments, and the seller will pay the annual totals directly to the respective agencies. That is different from a typical mortgage, in which a buyer pays into escrow each month, and the lender pays the appropriate agencies.