How does owner financing work in real estate
If you’re looking to buy a house, but you’re an average citizen who cannot pay in cash, you will need a mortgage loan from the bank, as the most common type of residential purchase financing. However, in order to get a mortgage, you have to fulfill a long list of requirements, including an impeccable credit record, steady employment history, and predictable monthly income.
On the other hand, if you want to sell your house, you might come across an obstacle finding a buyer, precisely because they are unable to meet all the requirements for the mortgage. Well, owner financing is the way get around those requirements.
So, what is owner financing?
In short, owner finance (also called “owner carry “, “creative financing” or “seller financing” throughout the states) is a direct financing of the purchase by the seller. It leaves out the bank as a middleman and enables the seller to secure the deal by extending sufficient credit to the buyer in order to cover the purchase price of the real estate. Then, the buyer returns the loan to the seller by making regular payments until the whole amount is paid, usually finalized with a balloon payment after a certain period of time.
Sellers keep the owner financed homes’ title in their name and dictate the terms of the deal, which include the interest rate and consequences in case the buyer defaults.
What does owner financing mean and how does it work?
Instead of taking a loan from the bank, buyer borrows finances for the purchase directly from the seller. The buyer signs a promissory note that binds them to follow through the terms of an owner financing contract, which will protect the seller in the event of default. The buyer makes monthly payments with interest decided by the seller, which is usually higher than what the bank’s interest rate would be.
These deals are commonly a short-term solution, for a period of no more than five years, and should help the buyer until they manage to get back on track financially and apply for a mortgage loan from the bank. However, these deals can be risky, as sometimes things don’t go as planned.
If the seller struggles with finding a buyer, they can advertise owner financing as an option for the purchase of their property.
Advantages for sellers
With seller financing, there will always be a risk of buyer default. However, sellers often go for this option because the promissory note protects them in those instances. The title remains in their name, while they receive monthly payments from the buyer with the included interest rate. In addition, they also usually get a down payment of up to 25%, or even more. Since both interest and down payments are higher than in traditional mortgage loan deals, sellers can get noticeably higher money influx than they would otherwise.
Should the buyer default, the seller would keep the house and the money received until then, so the risks for sellers are rather lower than they are for buyers.
What does owner financing mean for buyers?
Buyers often choose owner financing because, unlike with the mortgage lender, they can negotiate with the seller. Sometimes, a realtor agent or a lawyer is involved to assist with drafting a seller financing contract and take the needs of both parties into consideration.
A seller-financed mortgage gives buyers time to come up with a way to refinance and switch to the traditional mortgage loan, which will thus enable them to transfer the title to their name.
Which terms to expect with Owner Financing?
Although, the strict middleman, i.e. mortgage lender, is left out of the picture, there are numerous conditions imposed on the buyer. They include down payments, amortization periods, and balloon payments that the seller will request after a certain period of time. Here is more information on each:
Higher down payments
As we already mentioned, sellers can request a substantially higher down payment (about 25%) than the mortgage lender, who usually impose between 8% and 11%. There has been a word about the convenience of not paying a down payment, or “no money down”, but in reality, it hasn’t been the case often enough. Rarely do sellers want to risk events of default.
However, you will have a benefit to negotiate the numbers with the seller, which wouldn’t be possible with the bank.
Shorter Loan Amortization period
With seller financing, you can expect a shorter amortization period than the traditional one of 30 years that mortgage lenders provide. The reason is that sellers typically don’t want to receive their money over a 3-decade stretch. They usually determine in owner carry contract the amortization period between 5 and 20 years, after which they wind up the loan return with a balloon payment.
After a determined period, the buyer is to pay the remainder of the price in form of a balloon payment. For example, the seller and the buyer agree to split the real estate price into monthly payments over a period of 30 years with interest rate included, but after 15 years, the buyer is required to send a balloon payment, i.e. pay the leftover amount at once. They can pay in cash, or take a loan from the mortgage lender.
There are typically 2 papers needed to close the seller financing deal. First is a promissory note which comprises seller’s conditions and consequences if buyer defaults. The second one is either a mortgage document or a deed of trust which has the same function, i.e. to secure the loan that seller provides.
A promissory note
By signing the promissory note, the buyer promises to return the loan under the owner’s terms. Promissory notes comprise:
- The loan amount
- Repayment terms
- Interest rate
- Repayment schedule (usually the payments are to be made monthly, but they can be requested weekly, biweekly, quarterly, etc.)
- The terms of balloon payment if it’s requested
Besides these specifics, promissory notes also define penalties in case the buyer falls behind on payments or any additional costs in case of an early payoff. Also, if you sell the property, the note states whether the loan should be paid in full, which is included in the due-on-sale clause.
Should either side need any help with the promissory note, they can engage an attorney to assist with the draft. Another option is to find a legal service online. Some provide consultations with an attorney who can write you draft.
A deed of trust
This document also protects the seller and involves 3 parties – the seller (lender), the buyer (borrower) and a trustee. It describes the terms of the loan, much like the promissory note, but also includes a lien on the borrower’s real estate, which serves as a collateral. A trustee is usually an attorney who is in charge of executing the deal’s terms out of court in case of foreclosure.
Ending thoughts on owner financing
Owner financing can be a good option for both sellers and buyers. It bypasses the mortgage lender and finalizes the sale quicker. Sellers can get a substantial additional income with the interest rate and keep the seller financed homes in their possession in case buyers default.
On the other hand, buyers can negotiate the terms of the loan and give themselves more time to refinance. However, both parties should be aware of the risks that this kind of deal carries, especially buyers, whose losses will be greater in case the deal doesn’t end well.