When buying or selling a home, it’s always suggested to know all of the options that might be available to you. Especially for buyers or sellers looking to minimize closing costs and bank fees, knowing what owner financing is can help them consider alternative methods for purchase and payment. Owner financing has established itself as one of the most valuable tools in a prospective buyer’s skillset. In offering buyers an additional means to an end, owner financing simultaneously increases the odds of buying a home and reduces the risk of finances derailing an impending deal. That said, owner financing isn’t without its flaws, nor is it meant for every situation. As a result, buyers must learn exactly when (and when not) to use this particular acquisition strategy. Understanding the nuances that have become synonymous with owner financing homes is of the utmost importance, and investors can better understand the concept below.
In this article, we’ll explore what owner financing is, how owner financing works, as well as some of the pros and cons of owner financing. Understanding the nuances that have become synonymous with owner financing homes is of the utmost importance. With FortuneBuilders’ helpful guide, investors, buyers, and sellers can all gain a better knowledge of how owner financing works.
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What Is Owner Financing?
Owner financing is an alternative way for buyers to fund the purchase of a home that doesn’t include a traditional lender or excessive involvement with a bank or financial entity. Instead, the homeowner will play the bank’s role and finance the impending purchase themselves, perhaps to minimize closing fees or streamline the sale for a prospective buyer. The buyer will then be expected to repay the owner/seller by making monthly payments based on predetermined timeframes, interest rates, and terms.
When wrapping your head around what owner financing is, it’s important to understand that the process isn’t all that different from a traditionally financed mortgage. The main difference is that instead of repaying an institutional lender, the borrower is making payments directly to the homeowner. Each owner financing scenario will have a unique arrangement, and there are numerous types of owner financing. To be clear, there’s more nuance to the concept of owner financing, but we will break down exactly how it works in the next section.
Who Owns The Deed In Owner Financing?
When making any form of real estate transaction, it’s natural to consider the matter of deed and title. Owner financing works differently than a typical mortgage or real estate sale. The seller will technically hold on to the deed until the buyer has fully paid off the amount of the financing. During this interim repayment period, the buyer possesses equitable title in the property but full technical ownership until the payment is complete and the deed is transferred.
As far as payment of property taxes during this period, all insurance and property tax payments should be decided upon within the initial owner financing agreement (something we will explore in the section below). In most scenarios, it’s common for the buyer to pay these fees directly to the seller as a part of their monthly payment while the seller will continue to pay the costs directly to the respective parties as they did when they still occupied the property. This can save buyers money from avoiding escrow payments each month.
How Does Owner Financing Work?
In its simplest form, owner financing is an agreement between a homeowner and a prospective buyer, which states the owner’s willingness to finance the next buyer’s purchase. It is worth noting, however, that not every homeowner is allowed to conduct their own seller financing. Certain criteria must be met for the owner to pursue this particular strategy:
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The seller will need to make sure their current mortgage is paid in full, or
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The seller will need to pay off their entire balance before making an agreement with the next buyer. In other words, the home must be owned free and clear for the seller to consider using owner financing.
In the event the home is owned free and clear, buyers and sellers will negotiate several terms: loan amount, monthly payments, who is in charge of maintaining the property, interest rate, loan duration, repayment schedule, default consequences, and anything else either side finds necessary for inclusion. All of the agreed-upon terms will be included in a promissory note which everyone signs. The homeowner will hold onto the promissory note for the duration of the loan’s repayment and will serve as the guideline moving forward.
Once each side has agreed to terms and given their consent by signing a promissory note, the rest of the transaction will be carried out like a traditional loan. The borrower will receive financing from the homeowner and make monthly payments until it’s paid in full by the agreed-upon date.
Sellers willing to finance the sale of their own property may forgo a large-sum, immediate payment, but their patience will be rewarded with more profits in the long run. In addition to receiving monthly installments, the seller will capitalize on the agreed-upon interest rate. As a result, the seller will receive the full price of the home, plus interest.
Buyers, on the other hand, will be able to step around any unnecessary institutional involvement. In doing so, borrowers most likely won’t be subjected to strict lending criteria or endless “hoops” to jump through. Owner financing may also enable borrowers with bad credit to receive a loan they would have otherwise been unqualified for.
Types Of Owner Financing
Owner financing agreements may be negotiated between buyers and sellers, making them very flexible for everyone involved. While owner financing strategies will be subject to unique laws in each state, buyers and sellers should be able to find something that works for them within their legal rights in most places. At the very least, owner financing can take several forms, not the least of which include:
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Land Contracts: Owner financing can play a role in land contracts, providing buyers with an equitable title to the property despite claiming the full legal title. This allows the buyer to still have use of the property and land without total ownership, receiving the deed when the property has been fully paid or been refinanced.
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Mortgages: For a mortgage, the seller carries the mortgage balance for the purchase price, minus the down payment paid by the buyer (which may or may not be an underlying loan). It’s common for the seller to receive an override of interest incurring on that underlying loan.
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Lease-Purchase Agreements: A lease-purchase owner financing agreement, otherwise known as a “rent-to-own” arrangement, allows the seller to lease a property to a buyer by providing the equitable title. The buyer will obtain the full title upon fulfillment of the lease-purchase agreement, and typically receives a loan to pay the seller to receive credit for all or part of the rent payments that we’re made toward the purchase.
Example Of Owner Financing
Let’s say, for example, someone wants to buy a home but lacks the credit score to qualify for a traditional home loan. Typically, the inability to secure a bank loan would suggest the buyer can’t proceed with receiving a loan. However, bank loans aren’t the only way to secure capital to buy a home in today’s market; there’s creative forms of financing that buyers need to look into.
Of the alternative options, owner financing can simultaneously get the buyer the loan they want and perhaps even better terms over a shorter period. Therefore, if the buyer intends to pursue owner financing, they will either need to locate a home that has already announced a willingness to work around traditional banks or persuade the owner to finance the deal.
Once the buyer has found a seller willing to finance a deal, they will need to negotiate terms. At this time each side will give their input and negotiate what they would like to see in an impending deal. Provided each side can come to terms, they will be documented on a promissory note. This note will serve as the “underwriting” for the loan and tell each side how to proceed.
Once the terms are agreed on and signed into existence, the transition will initiate. The seller will finance the purchase of their own home for the buyer. In return, the buyer will make payments to the seller based on the previously discussed terms. The buyer will continue to make payments until the interest and principal are paid in full and the terms of the promissory note are met. Once everything is paid in full, the seller will pass the deed to the buyer, and the transaction will be complete.
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Pros and Cons of Owner Financing
Now that we know what owner financing is and how it works within the context of a real estate scenario, it’s important to note that owner financing is not the perfect option for everyone. It’s common to see owner financing among buyers and sellers who already know one another, perhaps friends, family, or work colleagues that already have a firm understanding of what would be expected from both parties. Owner financing has many advantages as well as unique challenges that both buyers and sellers should consider before moving forward with an owner financing option.
Let’s explore some of the pros and cons of owner financing for buyers and sellers to better understand what is on the horizon for those interested in how owner financing works.
Advantages Of Owner Financing
Owner financing has established itself as a popular acquisition strategy in recent years. The ability to finance a home through alternative means opens up buyers to a whole new world of opportunities, like the following:
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Buyers require little to no pre-qualifications: The inherent lack of an institutional lender rids borrowers of the inconvenience of qualification requirements. That’s not to say the seller won’t have requirements of their own, but rather that they will most likely be less strict. As a result, more buyers will qualify for loans they would have otherwise been passed up on.
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Financing is entirely negotiable: Again, the lack of an institutional “middleman” leaves a lot of room for negotiation. Most notably, each party may negotiate their own terms, not the least of which will include the sales price, monthly payments, and down payment. However, since financing is negotiable, this benefit can quickly turn into a disadvantage if the negotiations go poorly. Therefore, to benefit from this “advantage,” buyers and sellers must enter into negotiations prepared.
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Down payments are flexible: Prospective buyers may negotiate down payment terms, which typically work in their favor. Depending on the situation, buyers may want to put down a lot of money upfront, which can save them a lot in interest over the loan term. On the other hand, buyers with little access to cash may also negotiate a lower down payment.
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Minimal to no closing costs: Since there’s no bank underwriting the loan or facilitating the process, closing costs are going to be significantly smaller than traditional loans.
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Expedited transition: The transition between the buyer and seller may be expedited without bank interference. In particular, buyers and sellers won’t have to wait the weeks (if not months) it usually takes to receive loan approval. Without a bank overseeing things, the process will most likely move along a lot faster.
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Tax sheltering: Paring down profits each year by claiming installment payments can reduce one’s taxable income. Instead of receiving one lump sum, receiving 12 smaller payments for several years can lower taxable obligations in a given year.
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Installment payments for sellers: Installment payments which help sellers mitigate taxes also serve as monthly cash flow, not unlike receiving rental payments. However, instead of only receiving principal payments, each installment includes interest payments. Over time, interest will generate more returns than a traditional sale.
Disadvantages Of Owner Financing
The biggest disadvantages associated with owner financing are directly correlated to the previously discussed advantages. If for nothing else, owner financing is a double-edged sword that must be respected. The same flexibility it offers both buyers and sellers can easily swing the other way and work against anyone at a moment’s notice. Some of the most notable challenges faced when owner financing include:
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High Risk For Sellers: Many causes might lead to a buyer not qualifying for a traditional mortgage, so buyers and sellers both need to understand how this might affect the sale. Buyers might be asked to pay high interest rates or place a higher percentage of the home value as a down payment to incentivize timely payments.
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Conflicting Causes: If the seller has an alienation clause or due-on-sale clause, it can kick in if there is a presence of an existing mortgage on the property. This might lead to buyers needing to pay these mortgage payments if the seller completes the transaction before the full repayment.
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Seller Control: As the party financing the sale, sellers might be privy to demanding terms that work in their favor most. This could include a balloon payment required after a certain period, which could lead to further loans needed down the line if they do not have that funding.
Summary
The true benefit of owner financing lies in its ability to create opportunities. If real estate is a numbers game; the more financing options you have at your disposal, the more likely you are to receive the leverage you require. It is as simple as that: those who can secure multiple streams of financing stand a better chance of closing on a deal. That said, owner financing is entirely hands-off; there isn’t a bank to hold your hand through the process.
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