What Is Owner Financing And Is It A Good Idea For Buyers And Sellers?

Bank financing is the traditional move, but it may not work for everyone. Sellers have to deal with appraisals, and buyers can struggle with the approval process. Whether they have poor credit or simply work in a self-employed career, it can sometimes be difficult to find accessible financing.

When traditional financing is not an option, there is also the owner financing method.

Owner finance arrangements are contracts between buyers and sellers that operate like mortgages but without a third-party lender. Essentially, the seller becomes the lender and earns interest on the borrowed principal, and the buyer enjoys homeownership and builds equity.

These types of agreements were used frequently after the 2008 Great Recession. During that time, lenders all but stopped approving mortgages. As a result, buyers needed alternative ways to pay off their property purchases.

While owner financing is one name for this type of agreement, you may also hear it referred to as seller financing, holding mortgages or purchase money mortgages.

Owner financing can be helpful to a range of buyers and sellers. Parts of the process may be familiar to anyone with experience in traditional lending, but it has its differences. Sellers and buyers should know how owner financing works for each party.

For Sellers

Foremost, always make sure that the seller you work with owns the property free and clear. Otherwise, if the seller tries to transfer the deed without their lender’s permission, they will violate the alienation clause. That could lead to property foreclosure.

In owner financing, the seller takes up a position similar to a lender. They extend a certain amount of credit that allows the buyer to afford the property’s purchase price. Once they do, the buyer has to pay them back. The seller earns a regular monthly income of principal and interest from this. And, just like a traditional lender, they must keep records of any transactions.

For Buyers

Owner financing is like traditional lending but gives buyers flexibility. They make monthly payments of principal and interest to the seller, rather than a typical lender like a bank. So, the buyer still enjoys homeownership and can build up equity. It also gives them the opportunity to fix their credit or make repairs to the house without worrying about applying for a mortgage.

Selling a home isn’t always easy – and neither is buying one. For buyers, having poor credit or self-employed status can make it hard to find a lender. Or, they might want to avoid as many costs as possible if they are real estate investors, like house flippers. Owner financing lets them fix and resell the place quickly with easier approval processes.

Sellers also benefit, though. For them, they can bypass some of the stress of navigating the traditional market. Owner financing makes it easier for them to sell in a buyer’s market or if they are struggling with home appraisals ordered by other buyers’ lenders.  

Sellers and buyers negotiate among themselves in an owner financing agreement. That gives them the freedom to structure their deal creatively. There are several formats that those interested in owner financing can refer to, though. Below are some of the variations you might see.

However, if you are considering an owner financing agreement, be sure to consult with a real estate attorney first. You want to make sure that the deal you draft is legal in the state where the property is located.

Note And Mortgage

A note and mortgage is generally the securest type of financing, and the type banks use when lending for a home. In it, a seller creates a note detailing the terms of the agreement and the amount borrowed. Also, like a traditional mortgage, it puts the buyer’s name on the deed, and the mortgage lien is recorded in public records.

Land Contracts

A land contract, otherwise called a contract for deed or agreement for deed, functions similarly to a note and mortgage. However, there is a crucial difference. With a land contract, the seller’s name stays on the deed until the buyer repays the mortgage in full.

Sellers may prefer this type of seller financing because it makes it easier to regain the property title if the buyer defaults on the mortgage. States vary in how they handle the defaulting buyer.

Lease-Purchase Agreement Or Rent-to-Own Option

Lease-purchase agreement and rent-to-own are actually interchangeable terms. They both describe an option where the buyer leases the home for a certain amount of time. At the end of it, they have the choice to purchase the property. The seller and buyer negotiate a purchase price before the latter starts renting.

Buyers also have an upfront cost in the form of an option fee, also known as option money or option consideration. It’s typically nonrefundable, but negotiable, and sits between 1% – 5% of the home’s purchase price.

When a buyer enters an owner financing agreement, they sign a private contract with their seller. This contract includes terms from the lender that the buyer must negotiate.

Repayment Term Length

Depending on the agreement, the buyer has a certain number of years to repay their loan. These time lengths vary between contracts, but most lenders aren’t interested in waiting 30 years for the buyer to repay them in full. So, owner financing agreements tend to have shorter terms – around 10 years or less.

Balloon Payment

Shorter terms can put a strain on buyers, though. Unless the buyer can afford large monthly payments, they’ll likely owe a balloon payment at the end of their repayment term.

However, it’s possible to qualify for refinancing. For example, a buyer with poor credit can improve their score during the intervening period and apply for refinancing,

Interest Rate

The interest rates in an owner financing agreement typically run higher than you would pay to a typical bank. Since the agreement requires more risk for the seller, they compensate with a higher interest rate. The actual amount varies, but each state upholds usury laws that cap the maximum rate a loan can charge.

Down Payment 

A down payment is the money a buyer puts toward the house outright to show their investment in the home. Parties must always negotiate the terms of the down payment, like its amount and what it’s used for, especially if the buyer takes on a rent-to-own option. Buyers who end their lease in a rent-to-own option without purchasing the property lose this money.

Record Keeping And Tax Issues

It’s important that the agreement clearly states both parties’ responsibilities. But even still, buyers should keep thorough records of all their payments. Sellers should also file any and all necessary tax documents, like a Form 1908, that report mortgage interest income. The documents need to identify who paid it as well so that buyers can take mortgage interest deductions.

Sellers who sell the estate outright may pay more in federal income taxes, making documentation vital. The proceeds are subject to capital gains tax, which can take a bite out of your earnings even after applying exemptions ($250,000 per individual and $500,000 per joint filers).

The procedure may depend on the state where the property is located and the structure of the owner financing agreement.

With a note and mortgage agreement, the past owner must take the same actions as a traditional mortgage lender. That requires them to pursue a judicial or nonjudicial foreclosure (which varies based on state law).

Because of their terms, sellers often prefer land contracts, though. They let the seller keep the deed in their name, so only the buyer gets evicted from the property.

Here are a few pros and cons to consider for buyers in an owner financing agreement:

Here are a few pros and cons to consider for sellers in an owner financing agreement:

Anyone thinking of entering an owner financing arrangement with a family member should be careful. Even if the ownership transfer is for estate or other tax purposes, the IRS is highly suspicious of sale arrangements among family members.

Parents should also be cautious when handing off ownership of a property to a future heir. It’s possible to give up too much control and create a tax liability for your children. They will not qualify for the step-up in basis that comes with inheritance.

Traditional mortgage lenders may work for many – but not everyone. With owner financing, buyers and sellers can make deals between themselves. That allows them to avoid typical problems common to traditional lending. If you are looking for alternative financing with flexible credit requirements, consider learning about FHA or VA loans.