How Does Owner Financing Work?

March 15, 2021 | 7 Minute read

How Does Owner Financing Work?

In the majority of real estate transactions, properties are acquired or sold using cash or bank financing. If a buyer can’t afford to purchase a property outright, they will undergo various underwriting procedures to see if they qualify for a loan.

Many people haven’t heard of owner finance homes and have no idea that there’s an alternative option for buying and selling homes. So today, we’re going to answer the following questions:

  • What is owner financing?
  • What is seller financing?
  • What do owner financing contracts entail?
  • What are seller financing homes?

First, let’s break down and define owner financing:

What Does Owner Financing Mean?

Otherwise referred to as ‘seller financing’, owner financing is a kind of transaction where a property’s seller finances the purchase with the person or entity buying it. Owner finance homes help sellers sell faster and help buyers secure homes, even if they fail to meet traditional mortgage criteria.

Also known as ‘seller carryback’ and ‘seller carryback financing’ (because the owner ‘carries back’ the financing), this process is similar to bank financing. However, the buyer repays the seller in monthly installments as opposed to the bank. Additionally, both buyer and seller agree on a specified interest rate and terms before owner financing commences.

Seller financing is popular among investors who buy and sell properties, but it can be orchestrated by anyone interested in real estate and finance. Although this financing method is less common than bank loans, it’s a lucrative option and is more common than you may think.

There are no restrictions concerning owner finance homes, with properties ranging from self-storage facilities to fourplexes being sold using this type of financing.

Owner financing is ideal for people who fail to qualify for traditional financing due to their employment, previous foreclosures or bankruptcies, or economic factors that make lending guidelines more stringent.

Check out this free owner financing calculator.

Types of Owner Financing

When there are houses for sale via owner financing, lenders typically have several options from which to choose:

Seller-Held Financing

In a lending environment where money is tight, sellers can decide to provide financing to potential homebuyers. Usually, the seller sets out loan terms, annual interest rates, and a purchase price.
Buyers have the option to accept these terms or present a counteroffer. However, if a seller has received little interest in their property, buyers may negotiate more favorable interest rates or lower purchase prices. Seller-held financing options can provide short or long-term payment plans.

Junior Mortgage

Junior mortgages can be issued to make up the amount of a buyer’s primary loan. In this process, a seller could hold a second mortgage that provides the difference between your first mortgage and the property purchase price.

For instance, if your bank offers you 80% towards a home that costs $100,000, your mortgage loan would be $80,000. In this case, an owner-financed junior mortgage can be combined with your down payment to clear the $20,000 balance.

Lease-Purchase Option

Lease-purchase options work as written agreements for the purchase of a property between the buyer and the seller.

For example, if a buyer requires more time to save money for a down payment or to repair their credit, the owner may help them by offering a lease-purchase option. Typically, a lease-purchase option displays the deposit amount, purchase price, required monthly payment, and any additional terms in the agreement.

Lease options tend to be structured to credit part of the buyer’s monthly payment and the deposits toward closing costs or settlements. In typical circumstances, a buyer will forfeit their deposit and all other credits if the option to buy the property expires short of the allotted time frame.

Owner financing when buying and selling a home

How Does Seller Financing Work?

During the seller financing process, the seller assumes the role of the lender. Rather than providing cash for the buyer, the seller extends enough credit to purchase the property without paying a down payment.

The buyer and seller both sign a promissory note (containing the terms of the loan). They also record a mortgage (or a ’deed of trust’ in certain states) with their local public records authority. Next, the buyer pays the loan back to the seller, with interest, over time.

These loans tend to be short term. They work on the theory that, within several years, the home will have increased in value, or the buyer’s financial situation will be good enough that they can seek financing from a traditional lender.

From a seller’s perspective, the short time period is practical and advantageous as most sellers can’t guarantee they will have the same life expectancy as their mortgage lending institution or the patience to wait for 30 years to pay off a loan. Additionally, sellers don’t want to risk extending their credit any longer than necessary.

Next, we’ll outline some of the advantages and disadvantages of owner financing for buyers:

Advantages of Owner Financing

  • Cheaper closing: There are no appraisal costs or bank fees.
  • Alternative for buyers who can’t secure financing: This is an excellent option for
    buyers who cannot get a traditional mortgage.
  • Flexible down payments: There are no government or bank-required minimums.
  • Faster Closing: There is no need to wait for the underwriter, legal departments, or bank loan officers to process and approve applications.

Owner Financing Disadvantages

  • Higher interest rates: Interest rates tend to be higher than what you would pay a bank during a traditional mortgage.
  • Due-on-sale clause: If the seller already has a mortgage on the property, their lender can demand immediate payment of the outstanding debt in full if the house is sold. This is because the majority of mortgages have due-on-sale clauses. Therefore, if the lender isn’t paid, the bank can issue a foreclosure. To avoid foreclosure and mitigate risk, buyers must ensure that the seller owns the house and is clear of debt, or their lender agrees to owner financing.
  • Balloon Payments: With most owner financing agreements, a significant balloon payment is due after five years. If this amount cannot be secured, you may lose all the money that you’ve paid so far, along with the property.
  • Seller approval: Even if a seller favors owner financing, they may not want to become your lender.

Owner Financing Terms to Note

Length of the Loan

The length of the loan is the period over which the buyer has to repay the amount borrowed. It could be 5, 10, 15, 20, or 30 years—or anywhere in between. Although 30-year mortgages are popular in seller financing, shorter terms are more common in owner finance home loans. These short term loans tend to have balloon payments due as they come to an end.

Down Payment

A down payment is the amount of cash a buyer pays to a seller to secure their home investment. This money is deducted from the purchase price, and the remaining balance is financed.
Recently, the average down payment for residential properties on owner finance homes was around 19% . However, it’s worth noting that large down payments aren’t the only factors contributing to lower default risks.

Interest rate

Interest rates for owner financed homes are generally higher than what would be offered by a traditional lender. The seller takes a risk when they provide financing, and they may increase their interest rates to offset this risk.
Average interest rates tend to range between 4-10%. However, every state has usury laws, which govern the maximum interest rates that can be applied to a loan.

Balloon Payments

Balloon payments are one-off lump sums that are paid when a loan period ends.
Loans with balloon payments usually require monthly payments for a short length of time before the rest of the principal balance is cleared at the end of the loan. This payment can be raised via refinancing, savings, or selling the property.
These payments are relatively common with owner finance homes as lenders rarely want to wait 15 or 30 years to get their money back. These payments may also increase the return on investment, so savvy real estate investors often elect this as a term.

Financing Solutions: Reali Can Help

We’re here to make home buying and selling simple, affordable, and stress-free. You can apply for a home loan online and lock in low mortgage rates in minutes, helping you to save on monthly payments and sourcing cash to help remodel your home or clear high-interest debt.

Now, that’s real estate that works for you!

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