Are you having trouble qualifying for a traditional mortgage loan? Maybe you have a bad credit score, or you’re struggling to afford closing costs such as the home appraisal and inspection. In these instances, owner financing could be a solution to your problems.
Owner financing helps people who are ineligible for regular mortgages become homeowners. It’s crucial to understand the details if you’re considering this route because the rules usually differ from what you may have heard about other types of financing.
Read more: Closing costs — A guide to how they work and how much you’ll pay
In this article:
Owner financing — sometimes called seller financing, creative financing, or a purchase-money mortgage — refers to alternative lending arrangements in which home sellers opt to assist buyers who cannot purchase the home without their help.
In some cases, owner financing offers a substitute for traditional mortgage financing for homes being transferred within an extended family. In other cases, the sellers provide financing to buyers with credit or cash challenges who want to buy a house. Other scenarios include when a home appraisal comes back lower than what the buyers offered and when sellers may be more interested in a stream of income than immediate cash.
Like traditional mortgage financing, buyers who purchase property using homeowner financing must sign a purchase agreement with the sellers and a promissory note, a legal document obligating them to repay the debt.
However, owner financing is different from traditional lending in several ways. First, these arrangements can be more flexible than mortgage loans. With owner financing, buyers can pay for all or part of the home purchase up front. They may choose to take out a traditional mortgage in addition to relying on owner financing.
The specifics of owner financing are negotiable between the buyer and the seller. Legal advice is recommended for owner financing arrangements, particularly because some state regulations may impact how much interest the seller can charge, disclosure of property information, and foreclosure procedures.
Learn more: Do you need a real estate attorney, and how much do they cost?
Since owner financing terms are flexible, buyers and sellers can negotiate many options. Some of the more common owner financing arrangements include:
-
Second mortgage. With owner financing, you may also hear a second mortgage called “carry-back financing” or a “junior mortgage.” This is an option when a buyer has a traditional first mortgage but needs additional financing to make up the difference between their approved loan amount and the sales price. The sellers can take out a second mortgage and offer the funds to the buyers. Then, the two parties work out a repayment plan.
-
Rent-to-own. With a rent-to-own agreement, also called a lease-purchase agreement, the seller rents out the property, and both parties understand that the ultimate goal is for the renter to buy the house. The tenant pays rent, and a portion of those payments go toward their down payment when they buy the house. If the renters decide not to buy at the end of the lease, the owners will keep the accumulated funds.
-
Wraparound loan. With this type of financing, the seller continues to make monthly payments on their mortgage loan, but the buyer also makes monthly payments. The seller often charges a higher interest rate that generates additional income. The seller must get permission from their mortgage lender for this type of arrangement.
-
Land contract. With land contracts, the sellers keep the deed to the property while the buyer pays them in monthly installments. Once the buyer completes all payments in full according to the loan agreement, they receive the deed to the house.
Dig deeper: How a rent-to-own contract works
Let’s say an owner wants to accept an offer from a prospective home buyer — but the buyer doesn’t have the credit or income to qualify for a mortgage loan that covers the amount they need. In this case, the sellers may consider owner financing.
For example, if the agreed sales price is $450,000 and the buyers can only borrow a maximum of $300,000 and make a down payment of $45,000, the owners could offer to finance the remaining $105,000.
The sellers would get a legal agreement with a written promissory note from the buyers that states the loan terms, including the balance to be paid, the interest rate, the loan length, whether a balloon payment is required, and the consequences of a default. The buyers then make monthly payments to their mortgage company and the sellers.
Learn more: Can you buy a house with no credit score? Yes — here’s how.
While owner financing benefits sellers and can solve some real estate transaction problems, it also has some risks.
-
It could attract a larger pool of buyers, even resulting in a higher purchase price.
-
You’ll receive an income stream from the mortgage principal and interest payments.
-
The house may sell faster if no traditional mortgage lender is involved.
-
Less work and preparation involved due to the possibility of an as-is sale without an appraisal or inspection.
-
You may retain the title to the house for longer, which is more convenient if the buyer defaults on monthly payments.
-
It’s risky to essentially become the lender, especially to a buyer who might already be considered a risky borrower.
-
You’ll receive little to no cash up front like you would with a traditional sale.
-
There’s potential for the legal complexities that come with a foreclosure.
-
You must understand the laws in the property’s jurisdiction.
-
Sellers must do more work to make sure the buyers can make payments and that all legal requirements are met.
-
You may need to pay off the mortgage or get approval from your lender before offering owner financing to a buyer.
Keep learning: How to sell a house fast
For buyers, particularly if they can’t qualify for a traditional mortgage, owner financing may seem like a lifeline to becoming a homeowner. But there are risks associated with creative financing for buyers.
-
It grants access to homeownership for those who may not otherwise qualify for a loan.
-
The closing process is faster.
-
The closing costs are lower if you don’t pay for an appraisal, inspection, or lender fees.
-
You could have negotiable terms with more flexibility.
-
There are fewer regulatory protections than traditional financing.
-
Higher interest rates are typical.
-
You could face a balloon payment at the end of your term — and if you can’t afford this large lump-sum payment, you risk losing the home.
-
Possible higher down payment required by owners.
-
You might encounter title issues if a title search is not completed before the transaction.
Read more: What are mortgage lender fees?
So, who stands to benefit most from selling via owner financing? It could be a good idea if you want to sell to someone within your extended family and prefer to handle the arrangement privately.
Also, homeowners who don’t need the cash from the sale of their home immediately to buy another property or move are more likely to have the means to offer owner financing. Some sellers, particularly if they own multiple properties or are retiring, may want the cash flow that comes with receiving mortgage payments from a buyer.
Sellers concerned about a high capital gains tax may want to investigate the tax implications of offering owner financing to see if it mitigates a significant increase in home values. If taxes are your reason for considering this type of financing, consult a tax professional beforehand.
In a slow housing market, sellers may want to offer owner financing to attract buyers. Similarly, if you’re selling an expensive or unusual property that may be difficult to appraise, you may want to bypass that process by offering owner financing. Sellers looking for a faster closing may also want to consider owner financing since it generally takes less time than a traditionally financed transaction.
Learn more: How much does it cost to sell your house?
The most common pool of buyers looking for owner financing are those who can’t qualify for traditional mortgage financing due to poor credit, a lack of credit history, limited cash for a down payment, or nontraditional sources of income. In addition, buyers who want to purchase a home quickly because they are relocating or need to move immediately may be interested in bypassing the traditional financing process.
Those looking to buy a house from a family member might prefer this method. Buyers looking for flexibility in how they purchase a home are also likely candidates for owner financing.
Dive deeper: How much down payment do you need for a house?
Possibly. By spreading the payment schedule out over months or years instead of receiving the full amount all at once, owners may be able to avoid capital gains tax from the sale of their home. Buyers could deduct the interest paid on their mortgage if they itemize their deductions rather than take the standard deduction.
With owner financing, the consequences of defaulting are similar to a traditional loan and are guided by the terms of the written owner financing agreement. Generally, a default will allow the owner to initiate foreclosure proceedings per the rules in their state.
In some cases, owners can sell the loan they offered to their buyers to a real estate investor.
While the option of owner financing isn’t always advertised, sometimes sites that advertise FSBO (for sale by owner) properties include that information. Many real estate listing websites offer the option of searching for properties that mention owner financing. You can always ask your real estate agent for help identifying properties with owner financing and have your agent ask sellers about that possibility.
This article was edited by Laura Grace Tarpley.
