Owner financing: What it is and how it works

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If your credit is fair or poor, you might not be able to qualify for a mortgage to buy a home. If you’re selling your home, you might not want to deal with the financing process that can sometimes add hassle to a sale. One solution could be owner financing, also known as a purchase-money mortgage.

What is owner financing?

Owner financing occurs when the owner of a property for sale provides partial or complete financing to the buyer directly, after the buyer makes a down payment, says Michael Foguth, founder and president of Foguth Financial Group in Howell, Michigan.

“The agreement here is very similar to a mortgage loan, except the owner of the home owns the debt instead of a bank or other lender,” Foguth says.

Owner financing is usually not reported on the buyer’s credit report. There is typically a substantial down payment required (usually 10 percent to 15 percent) that makes up for the fact that the financing isn’t dependent on the buyer’s income or credit history — although sellers are advised to perform a credit check regardless.

Chris McDermott, real estate investor and broker of Jax Nurses Buy Houses in Jacksonville, Florida, has offered owner financing himself on investment properties he’s sold. McDermott says it can be a common practice in some areas, “specifically for rural land or homes that a seller owns free and clear.”

Owner financing can be beneficial to buyers who aren’t eligible for a loan from a mortgage lender, or if the lender only qualifies the buyer for a portion of the purchase price. In the latter scenario, the buyer might be able to take out a first mortgage from the lender for that portion, and then obtain owner financing for the shortfall. Keep in mind: If you’re otherwise qualified but can’t get the full loan amount you need from a lender, you could be overpaying for the home.

This arrangement can also have benefits for sellers seeking income. It likely won’t be an option if the seller needs the proceeds from a sale to buy another home.

How does owner financing work?

In most owner financing arrangements, the owner (seller) records a mortgage against the property, which is sold via deed transfer to the buyer. In land contract arrangements (more on that below), the owner might instead retain the title as leverage.

“Typically, the owner lets the buyer take over and move into the house without a mortgage, but after the buyer makes a down payment,” says Andrew Swain, co-founder and president of Sundae, a San Francisco-headquartered residential real estate marketplace that helps sellers of distressed properties.

“The buyer makes mortgage payments to the seller over an agreed-upon amortization schedule at a specified fixed interest rate,” says McDermott. “Typically, the seller will not hold that mortgage for longer than five or 10 years. After that time, the mortgage commonly comes due in the form of a balloon payment owed by the buyer.”

To make that balloon payment, the buyer needs to qualify for and obtain a mortgage refinance. Note that this is the ideal outcome — there’s no guarantee the buyer would be able to qualify, especially if their credit and financial circumstances haven’t improved.

Alternatively, the buyer can get a first mortgage from a bank or other lender while the seller takes a second interest in lieu of some of the down payment, says John Kilpatrick, managing director of Greenfield Advisors in Seattle.

“Say you want to buy a $200,000 house,” Kilpatrick says. “The bank will only loan you $160,000. If the seller will take back a second mortgage for $40,000, the deal may be able to close.”

With this kind of arrangement, though, you’ll likely need the lender’s approval. Some might not agree to it. Be wary of the seller’s motivation here, too. Are they struggling to find other buyers? Could the home be overpriced?

Just because a seller is providing the funds doesn’t mean the buyer won’t pay closing costs, however. According to McDermott, these charges can include deed recording and title fees.

The good news is that the costs “are usually substantially less than you’d pay with bank financing,” says Bruce Ailion, a real estate attorney, investor and Realtor in Atlanta.

Types of owner financing

There are many different forms of owner financing. Each has unique benefits and drawbacks:

Second mortgage – If the homebuyer can’t qualify for a traditional mortgage for the full purchase price of the home, the seller can offer a second mortgage to the buyer to make up the difference. Typically, the second mortgage has a shorter term and higher interest rate than the first mortgage obtained from the lender. With a shorter term, you’ll need to be prepared to pay it off when the time comes — if not, you’ll be forced to refinance.
Land contract – In a land contract agreement, the homebuyer makes payments to the seller on an agreed-upon basis. When the buyer finishes the payment schedule, they get the deed to the property. A land contract typically doesn’t involve a bank or mortgage lender, so it can be a much faster way to secure financing for a home. Many states allow sellers to foreclose if you miss a payment, however, so there’s also considerable risk.
Lease-purchase – With a lease-purchase agreement, the homebuyer agrees to rent the property from the owner for a period of time. At the end of that time, the buyer has the option to purchase the home, usually at a prearranged price. Typically, the buyer needs to make an upfront deposit before moving in and will lose the deposit if they choose not to buy the home. If you’re the buyer in this situation, negotiate the price of the option and make it subject to financing, clear title and other contingencies, just as if you were buying a home the traditional way.
Wraparound mortgage – Home sellers can use wraparound financing when they still have an outstanding mortgage on their home. In this situation, the owner agrees to sell the home to the buyer, who makes a down payment plus monthly loan payments to the owner. The seller uses those payments to pay down their existing mortgage. Often, the buyer pays a higher interest rate than the interest rate on the seller’s existing mortgage. The risk: If the seller defaults on the underlying loan, you could lose the home. For this arrangement, it’s imperative to have an experienced attorney in your corner.

Example of owner financing

Say “a seller advertises a home for sale with owner financing offered,” says McDermott. “The buyer and seller agree to a purchase price of $175,000. The seller requires a down payment of 15 percent — $26,250. The seller agrees to finance the outstanding $148,750 at an 8 percent fixed interest rate over a 30-year amortization, with a balloon payment due after five years.”

In this example, the buyer agrees to make monthly payments of $1,091 to the seller for 59 months (excluding property taxes and homeowners insurance that the buyer will pay for separately).

At month 60, a balloon payment of $141,451.27 will be due. The seller will end up collecting $233,161.27 after 60 months, broken down as:

$26,250 for the down payment
$58,161.27 in total interest payments
Total principal balance of $148,750

Pros and cons of owner financing

Buyer pros

Faster closing
Lower closing costs
Flexible down payment requirement
Less strict credit requirements

Buyer cons

Higher interest rate
Not all sellers are willing
Many deals involve large balloon payments
Many lenders won’t allow unless seller pays remaining balance

Seller pros

Potential for a good return if you find a good buyer
Faster sale
Receive monthly income

Seller cons

Agreements can be complex and limiting
Many lenders won’t allow unless you own home free and clear
Need to thoroughly vet the buyer and their finances
Potential for buyer to default or damage home, meaning you’ll have to initiate foreclosure, make repairs and/or find a new buyer
Tax implications to consider

Owner financing offers advantages and disadvantages to both homebuyers and sellers.

“The buyer can get a loan they otherwise could not get approved for from a bank, which can be especially beneficial to borrowers who are self-employed or have bad credit,” says Ailion.

However, “the interest rate charged by a seller is usually much higher than a traditional mortgage lender would charge,” says McDermott, “and the balloon payment that comes due after a few years will be significant.”

The advantages to the seller are manifold. Owner financing allows the seller to sell the property as-is, without any repairs needed that a traditional lender could require.

“Additionally, sellers can obtain tax benefits by deferring any realized capital gains over many years, if they qualify,” says McDermott, adding that “depending on the interest rate they charge, sellers can get a better rate of return on the money they lend than they would get on many other types of investments.”

The seller is taking a risk, though. If the buyer stops making loan payments, the seller might have to foreclose, and if the buyer didn’t properly maintain and improve the home, the seller could end up repossessing a property that’s in worse shape than when it was sold.

How to buy a home with owner financing or offer it

If you can’t get the financing you need from a bank or mortgage lender, a skilled real estate agent can help you find properties with owner financing.

“Just be sure the promissory note you sign is legally compliant and clearly lays out the terms of the deal,” says Swain. “It’s also a good idea to revisit a seller financing agreement after a few years, especially if interest rates have dropped or your credit score improves — in which case you can refinance with a traditional mortgage and pay off the seller earlier than expected.”

If you want to offer owner financing as a seller, you can mention the arrangement in the listing description for your home.

“Be sure to require a substantial down payment — 15 percent if possible,” says McDermott. “Find out the buyer’s position and exit strategy, and determine what their plan and timeline is. Ultimately, you want to know the buyer will be in the position to pay you off and refinance once your balloon payment is due.”

It’s important to have a real estate attorney prepare and carefully review all the documents involved, as well, to protect each party’s interests.

Written by:

Erik J. Martin

Contributing writer

Read more From Erik J.

Erik J. Martin is a Chicago area-based freelance writer/editor whose articles have been featured in AARP The Magazine, Reader's Digest, The Costco Connection, The Motley Fool and other publications. He often writes on topics related to real estate, business, technology, health care, insurance and entertainment.