Understanding Owner Financing

What is Owner Financing & How Does It Work?

Owner financing also called seller financing is a tool to purchase real estate when a traditional mortgage is not an option. With a traditional mortgage, you borrow money from a bank to pay for the property. Then, you make payments back to the bank to pay off the loan. With owner financing, you make arrangements to pay the owner in installments, typically of principal and interest or interest only, until you’ve paid off the purchase price of the property. Alternatively, you have a shortened term of possibly 5 years interest only installments with a balloon payment at the end of the period (during which time you re-finance, likely using a bank loan/mortgage).

An owner financed transaction involves a certain amount of legal paperwork. Below, we’ll talk about promissory notes along with mortgages and trust deeds. This paperwork is fairly standard; more important, it protects everyone involved.

Owner financing can be used by anyone and for any type of property from a single-family home to an apartment building or even piece of unimproved land. 

Typical Owner Financing Terms:

Down Payment

While there’s been a lot of discussion over the past 3 or 4 decades about “nothing down” or “no money down” that is not a common occurrence. To the seller, a down payment is your “skin in the game”; it’s what you stand to lose if you default. So, you can expect sellers to ask for 5% – 25% (and more) for down payments.

While a seller may ask for a hefty down payment, be aware that, unlike working with a bank, when you do seller financing, there’s often room for negotiation.

Loan Amortization

The public is used to a 30-year mortgage. With owner financing, you won’t typically get 30-year amortization periods because sellers normally won’t want payments over 3 decades. While a 30-year amortization schedule is possible, expect the loan to be wrapped up earlier with a balloon (see below). Otherwise, expect to amortization periods normally in the 15 to 20-year range.

Balloon Payment

When a longer amortization period is offered, it is usually truncated with something called a balloon payment. With a balloon payment, either a large chunk of principal is due – or, more commonly, the entire remaining balance is due in full at some period of time before the end of the normal payback period.

Let’s use the example from the table above. Instead of accepting payments for 30 years, perhaps the seller agrees to set up the 30-year payment schedule but wants a balloon payment at the end of 10 years. That means the seller is not interested in dragging out those monthly payments past the 10-year mark. Instead, you must pay off any remaining balance with cash or by getting a new loan.

Owner Financing Terms In Action:

Let’s look at an owner financed scenario that involves both a down payment of 10%, a 30-year amortization period, but a balloon for the remaining balance due in year 15.

Owner Financing Example

Keep in mind that when the balloon comes due, you either have to come up with $66,614 in cash to pay off the balance or otherwise borrow that money to pay off the seller. If you end up borrowing the funds, then you will acquire a new loan payment to make on that $66,614 even after paying off the seller.

Typical Owner Financing Documents:

In order to set up an owner financed situation, either you or the seller will need to have two forms of paperwork. One is called a promissory which spells out the loan terms and expectations for repayment. The other will be either a mortgage document or something called a deed of trust which provides security for the loan. Be sure to hire an attorney or use a brokerage/agent that understands this process and has access to the appropriate documents.

Some Complications With Owner Financing: 

Owner Financing Options with Existing Loan on the Property

One of the most common questions raised – and one of the most difficult situations to wrestle with in an owner-financed deal is if there’s an existing loan on the property.

Most mortgages today have what is called a due-on-sale clause which makes them un-assumable because any remaining loan balance has to be paid in full at the time of sale. It is recommended that you enlist the services of legal help if you attempt any of these creative financing strategies.

Here’s a brief rundown on 5 techniques for putting together owner financing if there’s an existing mortgage present:

1. Buying “Subject To” the Existing Loan

This is remotely similar to assuming a mortgage. However, unlike an assumption, the original holder is still the one legally responsible for the payments. If you don’t pay, they are on the hook. Very few discerning sellers will agree to this.

2. Wraparound Mortgage

A wraparound mortgage creates one loan that is big enough to pay on the existing loan plus any additional equity in the property. With a “wrap” mortgage, you make this larger payment to the seller. In turn, you entrust the seller to pay the underlying mortgage. The difference between the two is the owner financing on the equity. Be aware – buyers can be on the hook if the seller doesn’t pay their underlying loan.

3. All-Inclusive Trust Deed

An all-inclusive trust deed is basically a wraparound mortgage. It’s a legal term used in many states to denote the same process.

4. Lease Option or Lease Purchase

With this approach, you actually lease the property from the seller with an option to buy, or a contract is already drawn up to buy, but at a later date. This allows you to control the property and selling price until you can arrange for outside financing. Again, buyers need to be wary in case the seller fails to make their payments while the lease option is in effect.

5. Land Installment Contract

This is, perhaps, the most complicated of all forms of creative financing. With this approach, a contract is set up for the buyer making stipulated payments for a period of time (5 to 10 years is common). Similar to a lease option, it allows the buyer to control the property and price until other financing can be arranged.

The real caution is that with a “land contract” the buyer has no vested interest in the title to the real estate. If they default on even one payment, the contract is terminated and the seller gets the property back without any need to foreclose.

The Dodd-Frank Act of 2010 Affects Owner Financing:

In the aftermath of the subprime mortgage meltdown and all the predatory loans that had been issued prior to 2007, Congress enacted legislation that eventually became known as Dodd-Frank.

The details are beyond the scope of this post, but for the average seller, with a property or two for sale, the Dodd-Frank is of no real concern. It’s not until a person is attempting to sell 3 or more properties with owner financing that Dodd-Frank applies, and among other expectations, they will need to obtain a mortgage originator’s license. For that reason, a lot of owner financing has disappeared from the market.

Advantages & Disadvantages: 

Seller financing offers benefits to both the purchaser and seller. Still, there are some pitfalls to be aware of. Here is a list of the advantages and disadvantages for each party:

Buyer Advantages

• Easier qualification
• Can negotiate rate and terms
• Lower closing costs
• Faster closing

Buyer Disadvantages

• Sellers may be unwilling to carry financing
• Flexibility of owner financing may come with a price tag
• Difficulty if there are underlying mortgages

Seller Advantages

• Can get a property sold faster
• Can get a higher price
• Generates monthly interest income
• Can get the property back if it forecloses

Seller Disadvantages

• Don’t get all cash up front
• Problems collecting payments
• Can end up in foreclosure
• Sellers have to administer the loan
• The Dodd Frank Act of 2010 placed limits on owner carried mortgages

Bottom Line:

Owner financing is an arrangement in which buyers make payments directly to the seller rather than acquire a mortgage from a financial institution. Payments are usually in the form of monthly installments of principal and interest or interest only. Sellers benefit by getting monthly interest income along with a potentially higher selling price and a quicker sale.

Thanks for reading! Have more tips/thoughts? Comment below! 

~ Zain Hartman