Are you looking to purchase a new home but struggling to get a bank loan? An owner financing agreement might be your path to homeownership. It’s a financing deal that doesn’t rely on traditional lenders.
Key takeaways:
- Owner financing offers a path to homeownership for those who may not meet the qualifications of conventional financing.
- Owner financing requires sellers to assume greater financial risk and responsibility.
- There are three ways to structure owner financing agreements: promissory note and deed of trust, land contract, and lease purchase agreement.
- Talk to a real estate attorney when drafting the terms of your owner financing agreement.
What is owner financing?
According to Investopedia, owner financing is “a transaction in which a property’s seller finances the purchase directly with the person or entity buying it, either in whole or in part.”
Essentially, owner financing, or seller financing, lets homebuyers purchase a new home without relying on a bank to secure a traditional mortgage because the homeowner, or seller, finances the purchase. Owner financing also eliminates the need for a home inspection and appraisal.
An owner-financing agreement can be very beneficial for buyers but can pose a greater financial risk for sellers.
Who is owner financing for?
Owner financing is an excellent option for anyone looking to purchase a home but cannot secure a traditional loan, like homebuyers with no or bad credit.
However, it’s important to note that not all sellers will be willing to accept the risk that comes with an owner-financing agreement.
How does owner financing work?
In many ways, owner financing is like a traditional loan. For example, the process involves the homebuyer making a down payment on the property and paying off the rest of the purchase price over time. But there are some critical differences between owner financing and conventional mortgages. Owner financing is usually more expensive and quicker.
Here’s how it works.
Let’s say you’re interested in purchasing a home that’s listed for $250,000. You have enough money to pay a 20% down payment ($50,000). This means you’d have to finance $200,000, but your mortgage lender only approved you for a $150,000 traditional mortgage.
You approach the seller and present two owner financing agreements to them. The first one is that they agree to loan you the $50,000 difference, and you end up with two mortgage payments, one to the lender and one to the seller. The second option is that they agree to finance the entire $200,000. The seller agrees to the second option.
You work with a real estate attorney to draft the financing terms for the loan agreement.
3 types of owner financing arrangements
There are a few ways to structure an owner-financing agreement. Below is a high-level overview of them. Use it as a guide to determine which option is best for you.
Promissory note and deed of trust
The first step of the owner financing process is for the buyer and seller to agree on the terms of the promissory note and deed of trust. The promissory note includes key financing terms like the loan amount, interest rate, and monthly payments. The deed of trust is an agreement between the buyer and seller that states the seller will hold the legal title of the property until the loan is paid.
Land contract
A land contract is like a traditional mortgage. It’s a legal document that states the seller agrees to finance the property for the buyer and that the seller will hold the title until the loan is paid.
There are two types of land contracts: traditional land contracts and wrap-around land contracts.
In a traditional land contract, the seller keeps the title on the property until the loan is paid in full, and the buyer can build up equity on the property. This ultimately allows the buyer to convert and refinance the land contract with a traditional mortgage if they choose.
In a wrap-around land contract, the seller keeps paying the existing mortgage on the property but pockets the difference between it and the monthly payments made by the buyer. The buyer gets the warrant deed immediately and essentially owns the home. The seller’s lender must agree to this type of land contract.
Lease purchase agreement
A lease-purchase agreement, or rent-to-own, is a purchase contract between a tenant and landlord. It’s often confused with a lease option, but the two are very different. A lease option obligates the seller to sell. A lease purchase agreement obligates the seller to sell to the tenant.
A lease purchase agreement gives the tenant exclusive rights to buy a property at a set time. Lease purchase agreements contain two contracts. The first is for the lease agreement, and the second is for the end-of-lease sale. The lease agreement is just like a traditional lease but with a few key differences. Namely, in a lease-purchase agreement, the tenant-buyer is responsible for all maintenance, property taxes, and insurance. The contract of sale outlines the purchasing process and terms once the lease period is over.
8 key financing terms to include in any real estate transaction
Whether you opt for a traditional loan or owner financing, there are several key terms to include in your real estate transaction agreement. They include:
- Purchase price. Always include the total purchase price for the property when drafting a seller financing agreement. It helps calculate the total loan amount.
- Down payment and/or earnest money deposit. This details how much money the buyer pays upfront.
- Loan amount. This is the purchase price minus any down payment or earnest money paid by the homebuyer. Use it when calculating monthly payments.
- Interest rate. Like a traditional mortgage, an owner financing agreement should include details about the loan’s interest rate. Seller financing agreements typically have higher interest rates than conventional loans.
- Loan term and amortization. The loan term is the period of time a homebuyer has to pay off the loan. Mortgage amortization refers to the home loan repayment process and schedule. It’s used to determine the monthly mortgage payments.
- Monthly payments. Owner financing terms should include very clear details about the number, amount, and due date of monthly mortgage payments.
- Property taxes and insurance payments. These are often rolled into traditional mortgages, so they must be accounted for in owner financing agreements. Homebuyers typically have to pay them directly to the government and insurance companies.
- Balloon payment details. Typical seller financing agreements are amortized for 20 to 30 years but have much shorter loan terms. The result? Homebuyers must pay a balloon payment or lump sum payment at the end of the loan term.
The above list is not comprehensive. Be sure to speak with a real estate attorney before you draft your owner financing agreement. They’ll help ensure everything is covered and legal.
The pros and cons of owner financing for homebuyers
Owner financing greatly benefits borrowers because it simplifies and expedites the home-buying process. As a result, it’s an excellent option for first-time homebuyers or those with poor credit scores who cannot secure a mortgage loan through a traditional lender. However, owner financing isn’t without risk. Let’s take a closer look at the pros and cons of owner financing for homebuyers.
Pros for homebuyers
- Provides access to homeownership for borrowers who may not meet the qualifications for a traditional mortgage.
- Shortens the due diligence period resulting in faster closing.
- Reduces closing costs by eliminating bank fees, home appraisals, and inspections.
- Seller may not require a down payment.
Cons for homebuyers
- Higher interest rates than conventional financing options.
- Often requires buyers to make a balloon payment.
- Sellers do not have to require owner financing.
- Some sellers may have mortgages that include a due-on-sale clause which requires them to pay off their existing mortgage when they sell their home. As a result, they cannot offer owner financing.
The pros and cons of owner financing for home sellers
Owner financing can be a great option for home sellers, as well. It helps expedite the closing process and allows them to collect interest during the loan term rather than a lump sum payment. However, owner financing does pose a greater financial risk to sellers. Let’s take a closer look at the pros and cons of owner financing for sellers.
Pros for home sellers
- A way for owners to sell their home as-is because they don’t need to meet a traditional lender’s appraisal and inspection requirements.
- Offers a way for homeowners to earn more money, through mortgage interest payments, on the sale of their home.
- Expedites the selling process by eliminating due diligence.
- Sellers can sell their promissory note to a real estate investor for a lump sum payment.
- Allows sellers to retain the title on their home if the buyer defaults.
Cons for home sellers
- Comes with greater financial risk and responsibility, especially if the borrower doesn’t make monthly payments and defaults.
- Risk of initiating the foreclosure process if the buyer defaults.
- Seller is responsible for any repairs and damages to the property if the buyer defaults.
- It may not be legal for the seller to offer owner financing.
The bottom line
Owner financing can be a viable option for buyers and sellers.
For buyers, it offers a path to homeownership for those who may not otherwise qualify for a conventional loan. It’s also faster and eliminates bank fees and lender requirements like home appraisals. However, owner financing typically comes with higher interest rates and balloon payments.
For sellers, owner financing offers a way to earn more money by selling their property. It also expedites the sales process by eliminating the due diligence period. However, the seller must take on greater financial risk and responsibility.
Everyone’s situation is unique. Talk to your financial advisor and a real estate attorney before deciding if an owner-financing agreement suits you.
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