Owner financing, also called seller financing, is when a property owner provides financing for a buyer. Instead of the buyer getting a loan from a bank, they get a loan from the seller of the property. Payments are made to the seller over a specific period of time with a specified interest rate and terms.
Owner financing can also be called a seller carry-back or owner carry-back. The seller "carries" or "holds" the financing on the property.
Advanced Seller Data Services found that 91,605 first-lien-position, owner-financed loans were created and recorded in public records in 2018. They totaled over $25.9 billion in owner-financed loans across 2,137 counties in the United States.
Seller financing is commonly used by investors to buy or sell properties, but it can be used by anyone.
How does owner financing work?
When a seller carries financing for a buyer, there's a contract that outlines specific terms for repayment. There are several types of seller financing structures available:
- Note and mortgage.
- Land contract, which can also be called a contract for deed or agreement for deed.
- Lease option.
A note and mortgage is the most secure form of financing and is the same structure banks use when lending on a property. The seller creates a note outlining the amount borrowed and terms for repayment. The mortgage securitizes the seller with the property in the event of default. The buyer is put on the title with a deed and the mortgage is typically recorded in public records.
A land contract can also be called a contract for deed or agreement for deed and works similarly to a note and mortgage. However, instead of the buyer gaining title to the property, the seller remains on title until the debt is repaid in full.
Some sellers prefer the structure of a contract for deed because it can be faster and more cost-effective to regain title in the event of default. Many states allow eviction or forfeiture, which are faster and cheaper than a full foreclosure. The procedures in the event of non-payment vary from state to state.
A lease option is a slightly different structure -- it starts with the buyer leasing the home for a period of time with the option to buy. The buyer and seller agree on the purchase price of the home before the lease starts. When it expires, the buyer can buy the home or forfeit their lease option and any fees paid to enter into the lease option agreement. If the buyer buys the home, payments made during that lease period can be used toward the purchase of the home.
Repayment terms vary, and in most circumstances, they're determined by the seller but can be negotiated by the buyer. It's not uncommon for interest rates to be higher than a traditional bank loan. The seller carries some risk by lending to someone who may not qualify for a bank loan.
It's important to know the state usury laws that outline the maximum interest you can charge on a loan. In addition to the varying interest rate percentage, there are several repayment terms available:
- Fixed-rate: The interest rate and payment stay the same throughout the entire term. The principal balance of the loan is gradually paid down with regular payments.
- Adjustable: The interest rate adjusts periodically.
- Interest-only: The buyer only pays interest or a set period of time, then usually makes a large principal payment in the form of a balloon.
- Balloon: The loan is repaid with monthly payments for a short period of time and the remaining principal is paid as a one-time payment at the end of the loan
What are the benefits of owner financing?
Owner financing can be beneficial for a buyer or a seller. A seller may offer owner financing to reduce capital gains taxes from selling the property. A seller-financed loan breaks up the gains over a period of time.
Some investors offer financing on properties when they're ready to retire to reduce taxes and create residual income. If the buyer performs on the loan as agreed, the seller has created a passive income stream for many years.
Owner financing may also be a good option if the seller has trouble selling the property because it doesn't qualify for financing from a bank. Using owner financing gives prospective buyers the opportunity to buy a property they may not have had access to without it.
Seller financing is an appealing option for buyers because it lets them purchase a property without having to borrow money from a bank. There's typically less paperwork, fewer fees, and fewer qualifications to meet to be approved. Not all buyers who request or use owner financing to buy a home are unqualified. It may be that they don’t qualify for a bank loan because they're self-employed or lending has tightened in the current market.
What are the risks of owner financing?
There are risks of owner financing that both buyers and sellers need to know before entering into a seller financing arrangement.
The most substantial risk for the seller is the buyer not repaying the loan as agreed. There's no way to guarantee a buyer can pay or will continue to pay. But there are measures that reduce this possibility. For example, a seller might review a borrower’s credit score and credit history. You might also:
- look at the buyer's payment history on other accounts,
- identify potential outstanding debts that could jeopardize their ability to pay, and
- confirm that their income would cover their monthly expenses with the new payment.
Additionally, getting a larger down payment from the borrower may help mitigate risk. In 2018, the average down payment for residential properties on seller-financed loans was 19% compared to a median of 13% down on non-seller-financed mortgages. The more money the buyer puts down, the more equitable interest they have in the home, which could reduce the likelihood of default.
If the buyer defaults, the seller always has the ability to regain title through legal action, such as a foreclosure or forfeiture. But this takes time and can be costly. Weighing the risk of default is important for anyone considering selling a property with owner financing.
The most considerable risk a buyer has when purchasing a home with seller financing is the owner's process for record-keeping.
Every seller tracks payments in different ways. They might record them by hand or pay a third-party servicing company to keep payment records. Buyers should keep a record of each payment made over the life of the loan so payments and the remaining balance due can be verified in the event an issue arises.
It’s also important for the buyer to have a firm understanding of the terms of the loan agreement. The buyer and seller both have rights and responsibilities to be aware of.
How are owner-financing documents created?
The Dodd-Frank Act made several changes to the seller-finance industry. The most notable change restricted who can create an owner-financed mortgage.
Before 2014, the seller could create the note and mortgage themselves or have an attorney or a title company do it. However, the Dodd-Frank Act says that residential seller-financed mortgages for homes in which the buyer intends to reside should be created by a licensed mortgage loan originator (LMLO) unless they qualify for one of the two exceptions.
If the seller isn't an LMLO, they should hire one to originate and underwrite the mortgage note. Using an LMLO is an additional cost on top of the traditional title and closing fees associated with selling a property. But it's required by law.
Owner financing offers advantages for both parties. Some sellers openly advertise seller financing, while other times the buyer may have to request this structuring.
If you're entering into a seller-financed agreement, consult an attorney who specializes in real estate contract law. They'll ensure the transaction follows state and national laws while protecting both parties.