If you’re in the market for a new home but are having trouble winning loan preapproval, owner financing is an alternative that can keep your dream of homeownership within reach. Though not all sellers will be willing—or able—to provide direct financing to the buyer, it can be an excellent way to buy a property while also simplifying the closing process.
That said, owner-financed homes can be complex and necessitate a written agreement—so it’s important to understand the process before signing on the dotted line. We’ll walk you through how owner financing works, how it can help you as a buyer or seller and how to structure an owner-financed deal.
What Is Owner Financing?
Owner financing—also known as seller financing—lets buyers pay for a new home without relying on a traditional mortgage. Instead, the homeowner (seller) finances the purchase, often at an interest rate higher than current mortgage rates and with a balloon payment due after at least five years.
This can simplify the process of buying and selling a home by eliminating the need for a lender, appraisal and inspection.
How Owner Financing Works
Just like a conventional mortgage, owner financing involves making a down payment on property and paying off the rest over time. That said, this alternative to traditional financing is typically more expensive and requires repayment or refinancing into a traditional loan in as little as five years. Still, seller financing is usually faster and easier to get than a government-backed mortgage—if the seller is willing and able to provide it.
And, while most owner financing requires some form of background or credit check, it can help otherwise unqualified borrowers achieve homeownership. Not only are there no banks or traditional lenders involved, owner financing doesn’t necessitate an inspection or appraisal unless the buyer wants them.
Once a buyer and seller agree to terms, monthly payments are made to the owner-seller according to an agreed-upon amortization schedule. Depending on that schedule, the borrower also may face a large lump-sum payment at the end of the loan term. Unlike traditional mortgages, however, tax and insurance payments generally are not rolled into monthly debt service, and the buyer must make them directly.
At the end of the loan term, the buyer either makes the balloon payment or obtains a mortgage refinance and pays off the sellers with the proceeds of a new loan. Depending on how the owner financing was originally structured, the buyer will get title to the property for the first time or the seller will execute a Satisfaction of Mortgage indicating the mortgage has been paid in full and releasing the lien on the property.
Owner Financing Example
Say, for example, a homebuyer wants to purchase a historic home that doesn’t qualify for a conventional mortgage due to its age and condition. The borrower offers to purchase the home for $80,000 with a $25,000 down payment—just over 30% of the purchase price.
The seller agrees to finance the remaining $55,000 at an interest rate of 7% for a five-year term and amortized over 20 years—resulting in a balloon payment of about $47,000 due at the end of five years. Over the course of the loan, the buyer makes monthly payments of $426 and is responsible for property tax and insurance payments.
At closing, the buyer receives title to the home that is subject to a mortgage held by the seller. After five years of on-time monthly payments, the buyer makes the final balloon payment and the mortgage lien is released.
Advantages and Disadvantages of Owner Financing
Owner financing is a popular option for borrowers because it can make it easier to finance the purchase of a home. Sellers might opt for owner financing to expedite the closing process and collect interest rather than taking a lump sum payment. Still, there are disadvantages that may prevent a buyer or seller from signing on for owner financing.
Advantages for Buyers
- Can provide access to financing that a borrower may not otherwise have qualified for
- Enables buyers to finance homes that don’t qualify for conventional financing
- Lets buyers and sellers shorten the due diligence period for quicker closing
- Reduces the cost of closing by eliminating appraisal costs, bank fees and—if the buyer so chooses—inspection costs
- Eliminates down payment minimums imposed for government-backed mortgages
Advantages for Sellers
- Allows owners to sell their property as-is, without having to meet a lender’s appraisal requirements
- Presents an investment opportunity with better returns than most traditional investments
- Shortens the selling process by reducing due diligence requirements and eliminating the lending process
- Still offers the ability to sell the promissory note to an investor for an up-front payment
- Lets sellers retain title to their home—as well as money paid toward the mortgage—if the buyer defaults
Disadvantages for Buyers
- Often involves higher interest rates than a traditional mortgage
- May require borrowers to make a balloon payment at the end of the loan term
- Depending on the borrower’s creditworthiness, the seller may not be willing to provide owner financing
- Seller’s mortgage may include a due-on-sale clause that requires them to pay off the mortgage upon selling the house, thus precluding them from offering owner financing
Disadvantages for Sellers
- Exposes sellers to the risk of non-payment, subsequent default and—in some cases—a need to initiate the foreclosure process
- Puts seller on the hook for repairs and other consequences of deferred maintenance if the borrower defaults
- Federal law may preclude sellers from offering owner financing, limit balloon payments and require the parties to involve a mortgage loan originator
Typical Owner Financing Terms
As with any real estate agreement, owner financing arrangements should be detailed in writing to ensure that both buyers and sellers understand their responsibilities under the contract. Be sure to include these common terms in your owner financing agreement:
- Purchase price. When drafting seller financing documents, always include the total purchase price for the property. This will help involved parties calculate the total loan amount.
- Down payment. Likewise, an owner financing agreement should list how much the buyer is contributing as a down payment at closing. If there was an earnest money deposit, this amount should also be included in the agreement.
- Loan amount. Subtract the down payment, earnest money and other upfront payments from the purchase price to get your loan amount.
- Interest rate. An owner financing agreement should also include the loan’s interest rate. In general, seller financing rates are higher than on traditional government-backed mortgages but can be negotiated by the parties.
- Loan term and amortization schedule. The loan term is the amount of time a buyer has to pay back the loan. Stated another way, it’s the number of monthly payments the buyer will make. The amortization schedule, on the other hand, reflects the period of time over which the loan is amortized—a number that determines the monthly payment amount.
- Monthly payment. Make sure your owner financing terms include the number of monthly payments, due date, what constitutes late payment and whether there is a grace period.
- Balloon payment details. Many seller financing arrangements are amortized for 20 or 30 years but have a term that’s much shorter. This results in a balloon payment—or lump sum—that must be paid at the end of the loan term. Keep in mind, however, that these may be restricted by federal law.
- Tax and insurance payment. Although taxes and insurance payments are often rolled into traditional mortgages, buyers with owner financing often make those payments to governments and insurance companies directly. Either way, the owner financing agreement should describe who will be responsible for these payments.
- Additional terms. Every real estate deal is different so make sure your owner financing agreement spells out anything that’s unique to your deal. For example, if you’re selling a historic home, you may include a requirement that the buyers not remove or otherwise alter certain elements of the home without your prior written approval.
How to Structure a Seller Financing Deal
An owner financing agreement between buyer and seller should always be memorialized in a written document that includes the specifics of the deal. However, there are a few different ways to accomplish this, and the best option will depend on your specific needs and circumstances. Here are three main ways to structure a seller-financed deal:
1. Use a Promissory Note and Mortgage or Deed of Trust
If you’re familiar with traditional mortgages, this model will sound familiar. The buyer and seller agree to the terms of a promissory note that details terms like the loan amount, interest rate and amortization schedule. The mortgage is secured—or collateralized—by the house, the buyer’s name goes on the title and the mortgage is recorded with the local government.
2. Draft a Contract for Deed
Also known as an installment sale or land contract, a contract for deed is when a buyer does not receive the deed to owner-financed property until he makes the final loan payment. Alternatively, the buyer receives title if he refinances the loan with another lender and pays the seller in full.
3. Create a Lease-purchase Agreement
This option, also referred to as rent-to-own or a lease option, involves a seller leasing a property to a buyer who has the option to buy it for a set price. The buyer pays rent and, at the end of the lease term, can purchase the property or give up his lease option. If he opts to buy the property, rent paid during the lease period is applied toward the purchase price.
Because owner financing can be complex, we recommend working with a licensed attorney who will consider your best interests when drafting the necessary documents.
Frequently Asked Questions (FAQs)
Is owner financing safe?
Owner financing is a safe way to finance the purchase of a home as long as the buyers and sellers take precautions to protect their financial interests. Most importantly, the financing terms should be clearly spelled out in a written agreement that’s ideally prepared by a licensed attorney.
And, while seller financing eliminates the need for a lender-mandated appraisal and inspection, buyers should consider taking steps to ensure the purchase price isn’t too high. Likewise, sellers don’t have to run a credit check on a buyer before agreeing to finance the sale. However, it’s a smart way to reduce the risks of owner financing and improve the likelihood of a buyer making on-time payments.
Who pays property taxes on an owner-financed home?
When working with a traditional mortgage lender, property taxes and insurance premiums are often rolled into the monthly mortgage payment. With owner financing, the borrower typically pays taxes directly to the relevant agency and insurance premiums to their insurance company. Importantly, though, buyers and sellers can use the owner-financing agreement to dictate how these payments are handled.
What if the buyer defaults?
If a buyer defaults on owner financing, the consequences—and seller’s relief—depend largely on the type of agreement between the buyer and seller. For example, if the deal was structured as a lease option, the seller must initiate eviction proceedings to remove the non-paying buyer. With an installment sale—or contract for deed—state requirements vary and the seller may have to foreclose on the buyer.
For this reason, sellers should use the financing agreement to protect themselves from unknowns and set clear expectations for the buyer. This can involve detailing what constitutes late payment, whether there is a grace period and what happens in the case of borrower default.