Looking to get into a home but can’t qualify for a traditional mortgage? You may want to look at owner financing.
Owner-financed homes aren’t very common, but they have some benefits for unique buyer and seller situations. Owner financing bypasses a traditional mortgage when the seller takes on the role of lender, but seller financing comes with some risks.
Let’s take a deep dive into how owner financing works and when it could make sense.
What Is Owner Financing?
Owner financing, also known as seller financing, is a transaction in which the property owner takes on the role of lender by financing the sale to the buyer. Like the trading of homes, this type of transaction bypasses traditional mortgages (unless the purchase of the home is only partially owner-financed.)
The payments for buyers are typically amortized over 30 years for a smaller monthly payment, but there’s often a large balloon payment at the end of a shorter period of time (usually one to seven years). Owner-financed transactions operate on the belief that the buyer’s finances may improve over time or the property will appreciate to a point where the buyer can get a home loan from a traditional lender.
How Does Owner Financing Work?
Owner-financed homes work much like traditionally financed homes, but with the seller acting as the lender. The seller may require a credit check, loan application, a down payment, an appraisal of the home, and the right to foreclose should the buyer default. Buyers and sellers will need to agree on an interest rate and length of loan.
The buyer and seller sign a promissory note, which contains the loan terms. They also record a mortgage (or deed of trust), and the buyer pays the seller. The buyer should also pay for homeowner’s insurance, taxes, title insurance, and other loan costs. It is typical to hire real estate professionals or lawyers to get more into the details of how to use a home contract in owner financing.
Pros and Cons of Owner Financing
For Sellers
Owner financing isn’t nearly as beneficial for sellers as it is for buyers, but there are still some upsides to consider along with the increased debt load and assumed risk.
| Pros for Sellers | Cons for Sellers |
|---|---|
| Attract a larger buyer pool | Carry more debt |
| Saves money on selling costs | Assume more risk; buyers could default |
| May be able to sidestep inspections, especially if the home needs work or may not pass an inspection for FHA or VA loans | Not able to cash out for years |
| Can earn higher returns by acting as a lender | May need to act like a landlord; buyer may not keep up the property and the home may lose value |
| Faster closing occurs when buyers don’t have to go through the mortgage underwriting process | If the seller still has a fairly large mortgage on the property, the lender must agree to the transaction (many are not willing) |
For Buyers
There are advantages to buying a house for sale by owner, namely that a buyer can obtain housing sooner under owner financing. A buyer may also be able to lower the down payment needed and pay lower closing costs. But it’s also riskier than borrowing from a traditional mortgage lender. If, for example, buyers are unable to finance the balloon payment, they risk losing all the money they’ve spent during the loan term.
| Pros for Homebuyers | Cons for Homebuyers |
|---|---|
| Opportunity to gain equity | Sellers may ask for a hefty down payment to protect themselves against loss |
| Opportunity to improve finances | May pay a higher interest rate than the market rate |
| Can obtain housing and financing when traditional lenders would issue a denial | May pay too much for the home |
| No mandated credit check from a lender | Fewer consumer protections available when a homebuyer purchases from a seller |
| No mortgage insurance | Short loan terms |
| No minimum down payment | Sellers may not follow consumer protection laws |
| Lower closing costs | Buyers may not be protected by contingencies |
To reduce risk exposure in an owner-financed transaction, buyers may want to hire an attorney.
Example of Owner Financing
Bob and Vila want to purchase a large, forever home for their family. The purchase price of the home is $965,000, but Bob and Vila can only qualify for $815,000. Part of Bob’s income is from recent self-employment, which is not accounted for by the lender but will help the couple be able to afford the house.
For the remaining $150,000, the seller offers owner financing as a junior mortgage. The buyers will pay both a traditional mortgage lender as well as the seller in this type of owner financing.
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Types of Owner Financing
Land contracts, mortgages, and lease-purchase agreements are a few ways to look at owner financing. Here’s how they work and how they’re different from a traditional mortgage.
Land Contracts
Because the title cannot pass to the buyer in owner financing, a land contract creates a shared title for the buyer and seller until the buyer makes the final payment to the seller. The seller maintains the legal title, but the buyer gains an interest in the property.
Mortgages
These are the different ways to structure a mortgage with owner financing.
• All-inclusive mortgage. The seller carries the promissory note and the balance for the home purchase.
• Junior mortgage. When a buyer is unable to finance the entire purchase with a lender on one mortgage, the seller carries a junior mortgage (or second mortgage) for the buyer. The seller is put in second position if the buyer defaults, so there is risk to the seller by doing a second mortgage.
• Assumable mortgage. Some FHA, VA, and conventional adjustable-rate mortgages are assumable, meaning the buyer is able to take the seller’s place on the mortgage.
A mortgage calculator can help you get an idea of what purchase price you may be able to afford.
Lease-Purchase
In a lease-purchase arrangement, both parties agree on a purchase price. The potential buyer leases from the owner for an amount of time, usually one to three years, until a set date, when the renter has the option to purchase the property. In addition to paying rent, the tenant pays an additional fee, known as the rent premium.
It’s typical to see options that credit a percentage of the purchase price (often between 1% and 5%), rents, and rent premiums toward the purchase price. If the option to buy is not used, the buyer will lose the option fee and rent premiums.
They are also known as rent-to-own, lease-to-own, or lease with an option to purchase. They can be used when an aspiring buyer has a lower credit score and needs some time to qualify for traditional financing.
Steps to Structuring a Seller Financing Deal
If you’re thinking about finding a property with owner financing, consider taking these steps to help get you through the process.
1. Hire a professional. Because owner financing bypasses traditional lending institutions, there’s a lot more risk involved. Hiring a real estate professional and an attorney can help you structure the deal to protect your interests.
2. Find a property where the owner offers financing. An owner must be willing and able to offer seller financing to make this type of transaction happen. It’s difficult, which is why owner financing is more common between parties that know each other very well. It’s usually required that the property is owned free and clear of any mortgage. A few other ways to look for seller-financed properties:
◦ Asking your current landlord if they’re open to selling their property to you.
◦ Looking for real estate listings with phrases like “seller financing available.”
◦ Contacting the real estate agent for a home you’re interested in. If the home has been on the market a while and the conditions are right, the sellers may be open to this option.
◦ Finding a personal connection who is able to offer owner financing.
3. Agree to terms. Because seller financing terms are so flexible, there are a lot of details that buyers and sellers need to work out, including:
◦ Sales price
◦ Amount of down payment
◦ Length of the loan
◦ Balloon payment amount
◦ Interest rate
◦ Structure of the contract (land contract, mortgage, or lease-purchase, as described above)
◦ Any late fees, prepayment penalties, and other costs the buyer is responsible for
4. Complete due diligence. Buyers and sellers would be wise to do their due diligence as if it were a regular purchase. Sellers may want to examine a buyer’s credit, complete a background check, and confirm that buyers have obtained homeowner’s insurance and title insurance to move forward with the transaction. On the buyer’s end, a home inspection and appraisal may be warranted.
5. Sign and file paperwork. Much like a real estate transaction, the contracts involved in owner financing arrangements can be pretty involved. Depending on how your financing is structured, you may have a promissory note, owner financing contract and addendums, and title paperwork. You’ll also want to be sure your promissory note and deed of trust are filed with the county recorder’s office. An attorney, if you hired one, should be able to complete this process for you.
Alternatives to Owner Financing
Traditional mortgage financing may work better for your individual situation.
• FHA loans. FHA loans have a low down payment requirement and low closing costs and maybe approved for homebuyers with lower credit scores. They are underwritten by the Federal Housing Administration. Even if you’ve had a bankruptcy, you may be able to get an FHA loan.
• USDA loans. USDA loans are backed by the Department of Agriculture. Income must meet certain guidelines (as determined by geographic region), and the home purchased must be in an eligible rural area.
• VA loans. Loans guaranteed by the Department of Veteran Affairs are geared toward military members, veterans, and eligible spouses. The favorable terms include a low or no down payment, lower closing costs, low interest rate, and the ability to use the VA for a home loan multiple times.
• Conventional loans. A conventional loan simply means the financing is not insured by the federal government as it is with FHA, VA, or USDA loans. Fannie Mae and Freddie Mac provide the backing for conforming loans: those that have maximum loan amounts that are set by the government.
It’s a good idea to not take interest rates at face value but to compare APRs instead. The annual percentage rate represents the interest rate and loan fees, so even if, for instance, an FHA loan looks better than a conventional mortgage, based on just the rates, an APR comparison may tell a different story.
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The Takeaway
With owner financing, the seller is the lender. Both buyers and sellers face upsides and downsides when the transaction involves owner-financed homes.
No matter who you buy your home from, SoFi’s help center for mortgages can be a great resource for navigating the mortgage and home buying process.
It might pay off to view SoFi home loans to help you get into the house that’s right for you.
Photo credit: iStock/KTStock
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