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What to Know About Owner Financing

Buying a home often involves getting a mortgage to finance the home purchase. But if you can’t qualify for a loan through a mortgage lender, you may have another option, known as owner financing. In this scenario, a homebuyer gets a loan from the home seller, rather than jumping through the usual hoops of applying for a mortgage through a lender.

What is owner financing?

Owner financing, also called seller financing, is a mortgage funded by a home seller, rather than a mortgage lender.

In a typical homebuying transaction, the buyer applies for a home loan with a lender in order to purchase a home from the seller. Owner financing removes the lender from the equation, allowing the buyer to work directly with the seller to arrange financing and a repayment agreement.

Owner financing usually comes up as an alternative to a traditional mortgage when a buyer is having trouble getting approved because of their credit history or some other issue, said Sarah Bolling Mancini, an attorney with the National Consumer Law Center.

How owner financing works

In a seller-financed transaction, the seller signs a deed transferring the house to the buyer, and the buyer signs a promissory note and a mortgage note, Mancini explained. The notes state the buyer’s promise to repay the loan and give the seller the right to foreclose on the home if the buyer defaults on their mortgage payments.

Let’s walk through an example: A buyer with poor credit has their eyes on a $250,000 home for sale, but they don’t meet minimum mortgage requirements. They request that the seller consider an owner financing arrangement and commits to a 10% down payment, equaling $25,000.

The seller agrees to the arrangement at a 6% mortgage interest rate over a 15-year loan term. Using a mortgage payment calculator, here’s how the numbers would work:

Loan amount  $250,000
Down payment  $25,000
Interest rate  6%
Monthly payment (principal and interest)  $1,898.68
Total interest paid  $116,762.02

The buyer in the example would pay nearly $1,900 a month for their seller-financed mortgage, based on the 6% mortgage rate and 15-year repayment term.

What’s included in an owner financing contract?

At the very least, an owner financing contract should involve a property transfer and a promissory note. You also want to ensure the mortgage or deed of trust is recorded with the local county.

According to Anson Young, a Denver-based real estate investor and owner of Anson Property Group, the following details should be spelled out in the promissory note:

  • Loan term
  • Mortgage rate
  • Payment info (how, when and where to make payments)
  • Penalties for late payments
  • What happens if you default on your payments

Both the homebuyer and seller need to make sure they’re properly protected, so it’s best to work with a real estate attorney who’s versed in seller financing — no matter which side of the transaction you’re on.

“This is a mortgage instrument that big banks typically use and private parties [use] a whole lot less,” said Young. “You just want to really make sure that five years down the road you’re still protected if something were to happen.”

Pros and cons of owner financing

Pros

  • Bypass the mortgage lending process. There’s no need to apply for a mortgage to finance your home purchase, since you’re working directly with the home seller.
  • Fewer upfront costs. You won’t have the exhaustive list of closing costs that are characteristic of a traditional mortgage. You may also be able to negotiate a small down payment amount.
  • Get to the closing table faster. Since there’s no lengthy mortgage process to account for, there’s likely a shorter timeline to get from putting in an offer to closing the deal.

Cons

  • More interest costs. Because a seller is taking on considerable risk, you’ll likely pay a higher interest rate than you would for a traditional loan. A higher rate means you’ll pay more in interest over time — one of the key disadvantages of owner financing.
  • May have a short repayment term. Your seller-financed mortgage may have a repayment term similar to a traditional mortgage, but it could have a balloon payment due before the term ends (after five years, for instance).
  • Will likely need to qualify for a mortgage later. In the event there’s a balloon payment due a few years into your owner-financing agreement, you’ll need to get a mortgage or come up with the cash to repay the seller.
  • Risk of triggering due-on-sale clause. If the seller still has a mortgage on their home — ideally, they won’t — and it’s not an assumable mortgage, their lender could exercise the “due-on-sale” clause when they catch wind of the sale. That means the full outstanding loan amount would be due for repayment immediately. The lender can start foreclosure proceedings if the seller isn’t able to repay their loan, which puts you at risk of losing your new home and the money you’ve already invested.

Is owner financing a good idea?

If you’re a buyer who truly believes this is your best shot at buying a home, it’s wise to thoroughly vet the home before committing to an owner financing contract. Mancini suggests taking care of the following line items:

Still, it may be better to wait until you can work with a mortgage lender to buy a home. For assistance with getting your finances in shape, Mancini recommends enlisting the help of a housing counseling agency.

“The better option is to keep saving money and working on your income and your credit score until you can get qualified for a mortgage the regular way,” Mancini said.

 

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