Low interest rates and stock market uncertainty have set the real estate market sizzling in most of the US. With borrowers flooding lenders to take advantage of those low rates, and lingering economic weakness in the wake of the coronavirus pandemic, many lenders have tightened their loan standards.
Which has left many homebuyers and real estate investors struggling to find financing. But do you have to go through a bank or traditional lender?
Enter: owner financing.
What Is Owner Financing?
Owner financing, also known as seller financing, occurs when the person selling the home finances the purchase for the buyer. The seller lends the mortgage to the buyer, who pays it back in monthly installments just like a bank mortgage.
It could replace the first mortgage entirely, cutting the bank out of the equation. Or the seller could lend a second mortgage, on top of a bank’s first mortgage. Known as a seller-held second, the seller takes second lien position after the bank’s first mortgage lien.
When the seller takes on the role of a bank or mortgage lender, it eliminates the risk of the buyer’s financing falling through. But the seller also assumes the risk of the borrower defaulting.
How Does Owner Financing Work?
It happens all the time: the buyer struggles to find adequate financing, putting the contract in jeopardy. Rather than let the deal fall through, the seller agrees to lend the buyer either a first or second mortgage.
In the case of a second mortgage, the seller lends some or all of the down payment. That minimizes the down payment the buyer has to come up with, and the buyer then makes payments both to the bank and to the seller. It proves a particular help to buyers with solid income but who lack the cash to put 20% down, and potentially even lets them buy a property with no money down.
No matter how they go about it, however, the buyer will have to pay the loan back to the seller at an agreed upon rate.
Seller Financing Loan Terms
The loan terms are completely negotiable between the two parties. Interest rate, points, loan term: the buyer and seller can work out any arrangement they like.
Most sellers don’t want to hold a mortgage for the next 30 years, so they typically issue the loan with a balloon term. The monthly payments may be amortized like a 30-year mortgage, but the seller imposes a time limit to repay them in full, such as five years. The buyer can make monthly payments like a normal 30-year mortgage for those first five years, but then they have to either refinance the mortgage to pay the remaining balance off in full, or sell the property, or pay it off early out of their own pocket.
Advantages to Seller Financing
Owner financing offers perks for both the buyer and seller. Consider the following benefits as you explore seller financing, on either side of the transaction.
For the Seller
- Passive Income & Cash Flow: If the buyer reliably pays on time, the seller benefits from consistent cash flow – both from interest and principal, that can be put towards other investments.
- Higher Interest: You can often secure an interest rate that will be higher than what you can expect on the market, so your money will be working harder and more efficiently without you putting in any extra work.
- No Landlord Headaches: The seller doesn’t have to manage tenants, fix toilets, hassle with contractors. They just collect their payment each month.
- Quicker Sale: If you are having trouble finding a buyer, giving the option of seller financing may entice potential suitors. While a slimmer advantage in a seller’s market such as today’s, it still allows more flexibility.
- Collateral: You can foreclose to take the property back if the buyer defaults on their monthly payments.
For the Buyer
- Low or No Down Payment: Buyers can potentially secure a larger loan from the seller than they might from a bank. Or you could negotiate a second mortgage, as a creative way to come up with a down payment. You may not have to come up with a down payment at all, depending on what you negotiate.
- Avoid PMI: If you take out a conventional mortgage and borrow more than 80% LTV (loan-to-value ratio, or the percentage of the property value that you borrow), you’ll have to pay PMI each month. Short for private mortgage insurance, the insurance covers your lender against default – it doesn’t protect you in the slightest, and is effectively lost money. By using seller financing, either for your first or second mortgage, you can avoid PMI.
- More Room for Negotiation: Banks aren’t known for their flexibility. But when you borrow a mortgage from the seller, you can potentially negotiate lower fees and interest rates.
Drawbacks to Seller Financing
While owner financing comes with plenty of perks, it still comes with its own risks and downsides. Make sure you weigh the pros and cons before committing!
- Risk of Default: Needless to say, sellers don’t generally have as deep of pockets as the banks. This means they are taking on the risk of lending money as individuals rather than institutions – and without the systems in place to qualify and underwrite borrowers.
- Expensive, Lengthy Foreclosure Process to Enforce Loan: If the buyer defaults on payments, they may just walk away from the home, but if they don’t, the seller will be responsible for going through the foreclosure process. This can be a time-consuming, expensive task.
- Existing Mortgage Still Due in Full: If you still hold a mortgage, you must pay it off upon selling the property.
- Complicated Taxes: Tax payments based around the sale can be complex and will likely require the assistance of a CPA. There are tax benefits that can be had but it can take quite a bit of time to work them out.
- Higher Interest Rates: Because sellers don’t have the financial backing of the bank, they might hold out for a higher interest rate based on the amount of risk they are taking.
- Risk: It’s not only the seller who takes on more risk. The buyer can be making a risky choice too, especially if a balloon payment will be due within five years. If the buyer can’t come up with the payment by the due date, they could face foreclosure and lose the property.
- Fickle Approval: Sellers don’t follow the rules and regulations of the banking industry and can decide that they simply don’t want to lend to you for a variety of reasons. If you are rejected for a bank loan you will at least know why – a seller doesn’t necessarily have to provide you with a reason.
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Sample Seller Financing Deal
To help you understand more about seller financing, consider the sample deal below.
In this example, the home price is $500,000, and the buyer is able to put a down payment of $100,000 (20%) but has only been approved for a loan of $350,000 for a traditional mortgage. This means that the seller will have to finance the additional $50,000 for the cost of the house.
Loan Amount: $350,000
Interest Rate: 2.85%
Term: 30-year mortgage
Monthly Payment: $2,386
Seller Financed Mortgage:
Loan Amount: $50,000
Interest Rate: 6%
Term: 10 Years
Monthly Payment: $740
As you can see, there are two legally binding payments, one to the bank for $2,386 and one to the seller for $740, making for a total monthly payment of $3,126. That might seem high, but keep in mind that the seller and buyer came to an agreement of a 6% interest rate on the $50,000 loan. It’s possible that this could be negotiated to a lower rate, but it is rare that a seller-financed loan will have an interest rate lower than one from the bank.
Considerations for Landlords and Investors
If you are looking to buy a home as an investment property, you can benefit from seller-financing by limiting the amount of cash that you have to part with up front. If you can negotiate a lower down payment, you might be able to make up for the higher interest rate in rental revenue.
In a multifamily property, you can house hack to have your tenants actually pay for your mortgage. This means that you are essentially living for free and gaining equity in the property every month. With your higher savings rate, you can pay off a seller-held second quickly, or even pay off your first mortgage.
If, however, you are flush with cash and can afford to put a substantial down payment on a house, it might not make sense to consider seller financing. You’ll benefit from lower interest rates and monthly payments if you go the traditional route, but you will have to come up with more cash up front.
There is no universally right or wrong answer when it comes to owner financing. There are a variety of factors at play if you go this route, and you’ll have to evaluate your current financial situation as well as your plans for the future. Even if seller financing is not currently on your radar, it’s nice to know that it is a viable option for potential investment properties.♦
Have you ever borrowed owner financing? What were your experiences with it?