In most real estate transactions, properties are bought or sold with bank financing or cash. If the buyer doesn't have enough money to purchase it outright, he or she will undergo intense bank underwriting to qualify for a loan.
Most people don't know that there's another way to buy and sell homes: owner financing. Let's explore what owner financing is, how it works, why a buyer or seller would want to use it, and important things to know about it.
What is owner financing and how does it work?
Owner financing, also referred to as seller financing, is a method of financing a property in which the owner of the property holds the buyer's loan. Owner financing can also be called seller financing, seller carryback financing or seller carryback (because the owner "carries back," or holds, the financing). It works like bank financing, but the buyer repays the seller by making monthly payments over an agreed-upon period with a specified interest rate and terms. Seller financing is commonly used by investors to buy or sell properties, but it can be used by anyone.
While this way of financing properties is less common than traditional methods, it's a viable option and more common than you might think. According to Advanced Seller Data Services, $25.9 billion of owner-financed loans were created in 2018 throughout the United States.
There are no restrictions on who can use owner financing or what type of property can be bought or sold with it. I have experience with offering owner-financing deals and buying with owner financing on a fourplex, a single-family home, an apartment complex, and a self-storage facility. Seller financing is used frequently by real estate investors, but can also be used if a buyer doesn't qualify for traditional financing because of employment, previous bankruptcy or foreclosure, or economic factors that tighten lending guidelines.
Available Seller Financing Structures
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.
Owner financing example
Let's say a seller lists a property for $200,000. A potential buyer cannot qualify for traditional financing because he's self-employed. He makes a full-price offer and requests owner financing with 15% ($30,000) down.
The seller has no mortgage on the property and decides to accept the offer, creating a mortgage note that requires the buyer to pay her back over 10 years at 8% interest with a balloon payment at the end. The buyer makes a monthly payment of $1,247.40 to the seller and the seller makes an 8% return, collecting $224,532 over the entire 10-year period.