What Is Owner Financing?
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. This type of arrangement can be advantageous for both sellers and buyers because it eliminates the costs of a bank intermediary. Owner financing can create much greater risk and responsibilities for the owner, however.
Key Takeaways
- Owner financing is sometimes referred to as “creative financing” or“seller financing.”
- Typically, this type of financing is disclosed in the advertising of a property when owner financing is an option.
- Owner financing requires that the seller take on the default risk of the buyer, but owners are often more willing to negotiate than traditional lenders.
- Owner financing can provide extra income to the seller in the form of interest.
- Sometimes, owner financing is known to help a property sell more quickly in a buyer's market.
Understanding Owner Financing
A buyer might be very interested in purchasing a property, but the seller won't budge from a $350,000 asking price. The buyer is willing to pay that amount and can put 20% down—$70,000 that they gained from the sale of their prior home. They would have to finance $280,000, but they can only get approved for a traditional mortgage in the amount of $250,000.
The seller might agree to loan them the $30,000 to make up the difference, or they might agree to finance the entire $280,000. In either case, the buyer would pay the seller monthly, principal plus interest on the loan. These loans are somewhat common when the buyer and seller are family or friends or are associated in some other way outside the deal.
In many cases, owner financing is for just a short period of time until the buyer is able to refinance to pay the owner in full.
Owner Financing Situations
There are often a number of specific situations that arise that cause a buyer and seller to agree to owner financing. These situations may include but often aren't limited to the following cases.
- The buyer has poor credit. A potential buyer may be deemed a high-risk borrower and not be eligible for a traditional mortgage if they have a poor credit score or a history of financial problems.
- The buyer has limited down payment funds. To approve a mortgage, many lenders need a reasonable down payment to reduce the amount of debt and protect against fluctuating property values. Not every buyer has the means to pay so much in advance.
- Both sides want to move fast. Due to the substantial documentation, underwriting, and appraisal procedures required for traditional mortgage processes, traditional loans can be time-consuming compared to owner financing.
- The property has a high selling price. Buyers may be unable to obtain traditional financing due to the high cost of a property. Though one could argue this means the property is potentially financially inadvisable, the prospective buyer could simply seek other forms of borrowing funds.
- The seller wants the passive income stream. Owner financing turns the seller into the lender in the deal, creating an income stream. They get consistent payments from the buyer, which might be a reliable source of revenue. They may also benefit from being able to generate interest revenue over time.
- There may be tax benefits. Both buyers and sellers may benefit from tax advantages. Mortgage interest deductions may be available to buyers which can lower their taxable income through specific tax deductions. On the other hand, if the transaction is set up as an installment sale, spreading the tax burden over the payment period, sellers may profit from capital gains tax deferral.
- The property is unique. Some properties may have special characteristics or be situated in remote locations, making it difficult to finance them through conventional lenders. As lenders may evaluate a property as too risky to finance, the buyer may elect owner financing.
- The buyer wants different terms. Owner financing enables more customizability of the agreement's terms. Depending on their unique requirements and preferences, sellers and purchasers might bargain over interest rates, payment plans, and other terms. This level of adaptability may not be possible with traditional mortgage lenders.
Advantages and Disadvantages of Owner Financing (for Buyers)
Pros of Owner Financing (for Buyers)
Owner financing offers several advantages over traditional lenders. Borrowers may find it easier to qualify for and to make it through the entire approval process. Due to more fluid underwriting constraints, borrowers may find they are able to put less money down. Because there is less rigidity in owner financing as compared to corporate lending, borrowers may find they have greater flexibility on terms when opting for owner financing.
Because lenders may be resistant to financing certain riskier types of properties, owner financing may be the only option a buyer has to secure capital for a purchase. Traditional lenders often have strict credit score requirements which may scrutinize a buyer's financial history, debt-to-income ratio, and employment stability. Owner financing may not take those into consideration.
Cons of Owner Financing (for Buyers)
Owner financing involves greater risk for sellers compared to traditional lenders. This means that buyers often have to pay higher interest rates and make higher loan payments over the life of the loan. Though there may be some upfront fees that the borrower does not need to pay, they may still need to pay more over time.
Some owner financing agreements may include balloon payments, which can be challenging for buyers to manage and potentially lead to financial strain or default. Balloon payments stipulate periodic one-time larger payments, which helps mitigate risk on the seller's side. These types of payments are not as typical with traditional mortgages.
Defaulting on owner financing can result in property loss and damage to the buyer's credit score. Additionally, buyer financing may face uncertain market conditions, such as negative equity. Negative equity may occur where the property's value is lower than the outstanding loan balance, making it difficult to sell or refinance at favorable terms.
Pros and Cons, Owner Financing (for Buyers)
Pros
May be easier to qualify for compared to traditional loans
Loan approval processes may be faster
Down payment requirement may be smaller
More flexibility in negotiating loan terms
Cons
May incur higher interest rate compared to traditional loans
May include a balloon payment clause, requiring substantial capital at one time
Often has limited legal protection compared to other types of loans
Advantages and Disadvantages of Owner Financing (for Sellers)
Pros of Owner Financing (for Sellers)
Offering owner financing can open up a broader buyer pool. Some candidates may be naturally excluded because they can't secure a traditional loan. However, they may still be able to make a competitive bid and make all appropriate payments in the future.
Owner financing can be especially advantageous in slow real estate markets or unique properties, as it attracts more buyers. In these cases, sellers may be able to command a higher selling price for their property by providing a financing option, making the property more accessible. As lenders, sellers can receive regular principal and interest payments from the buyer. This creates a stable and predictable income stream and can be beneficial for sellers seeking reliable cash flow.
Owner financing can expedite the sale process, eliminating the need for the buyer to go through the lengthy mortgage approval process, which is particularly advantageous in competitive real estate markets. This may help buyers close on the property faster, taking the property off of the market sooner than if the deal should stall out due to traditional financing.
Cons of Owner Financing (for Sellers)
Sellers who finance property sales face various risks they wouldn't otherwise experience if the buyer used traditional financing. The buyer may default, delaying payments and putting the seller at risk of not capturing all payments agreed to in the sale.
If the buyer defaults on the loan, the seller may need to go through the foreclosure process to reclaim the property. This process can be time-consuming, emotionally draining, and costly. Though the seller may make more money over time, there may be non-financial costs to also consider.
The extended payment schedule of owner financing means sellers receive the purchase price over time rather than in a lump sum. This limits their ability to use funds for other purposes or investments. In some ways, this erodes their purchasing power as money today tends to be more valuable than money received in the future (for the same amount).
Pros and Cons, Owner Financing (for Sellers)
Pros
May result in more prospective buyers
May yield higher prices due to broader buyer pools
Steady income stream of principal and interest
Sale may be faster due to faster close processes
Cons
Risk of the buyer defaulting
No cash for the property upfront
May result in foreclosure process should buyer stop making payments
Requirements for Owner Financing
An owner-financing deal should be facilitated through a promissory note. The promissory note outlines the terms of the arrangement, including but not limited to the interest rate, repayment schedule, and the consequences of default. The owners also typically keep the property title until all the payments have been made to protect themselves against default.
Some do-it-yourself transactions can be fully managed by the owner, but assistance from an attorney is generally advisable to ensure all of the bases are covered. Paying for a title search can be beneficial as well to establish that the owner/seller is, in fact, in a position to sell the property and that they can eventually release the title in exchange for financing some portion or all of the deal.
Can Owner Financing Be Used for Commercial Properties?
Yes, owner financing can be used for commercial properties as well. It offers similar benefits to both buyers and sellers in the commercial real estate market.
Are There Tax Implications for Owner Financing?
Both buyers and sellers should be aware of the tax implications of owner financing. Sellers may need to report interest income, while buyers might be eligible for certain tax deductions related to mortgage interest. If you are considering entering an owner financing engagement, consult your tax advisor.
Can Owner Financing Include a Down Payment?
Yes, owner financing often includes a down payment, typically negotiated between the buyer and seller. The down payment helps reduce the amount financed and provides security for the seller.
Can Owner Financing Be Transferred to a Third Party?
In some cases, owner financing can be transferred to a third party, subject to the terms of the original agreement and approval from the seller.
The Bottom Line
Owner financing is a real estate arrangement where the property seller acts as the lender, offering direct financing to the buyer. Instead of obtaining a mortgage from a bank, the buyer makes regular payments to the seller until the property is fully paid off. This alternative financing option can benefit buyers with limited access to traditional mortgages and sellers seeking a broader pool of potential buyers.
