Don't have the credit history or other formal credentials to get a traditional home loan?
No worries, there's an alternative way to get the home of your dreams: owner financing (aka seller financing).
Popularized in the 1980s when home buyers fled 20% mortgage rates in search of more affordable private deals, owner financing has grown in popularity again as mortgage lending standards have continued to tighten in a post-financial crisis world.
What is Owner Financing?
Owner financing is a private agreement where the seller agrees to sell their home to a buyer with an expectation that the buyer will repay the seller over time in regular installments.
While today’s diverse owner financing options are a far cry from their 1980 roots, the premise (and caveats) have remained the same. The concept behind owner financing (aka seller financing) is similar to what you would find with traditional mortgage lenders.
Here's how owner financing works: The buyer signs a promissory note and promises to pay the seller installment payments (typically monthly) that contain principal and interest. Just like a traditional loan, there will be a signed mortgage or a deed of trust -- a security agreement that allows the seller to foreclose if the buyer doesn't pay.
Currently, home buyers can choose from five different seller financing options:
Owner Financing Option #1: Free and Clear
The simplest seller financing option is when an owner sells a home free and clear of all liens. The buyer makes a down payment and pays the negotiated, monthly principal and interest payments to the seller who then carries the loan balance in a private note.
Owner Financing Option #2: Lease with an Option to Buy (Rent to Own)
In this scenario, the potential homeowner retains the option to buy the home but without the actual obligation. The borrower gains equitable interest in the home with a down payment while also making regular, monthly rent payments.
At the end of the lease term, he/she has the option to pay off the remaining balance through a refinance.
Kevin Amolsch, president of the Pine Financial Group, advises sellers pursuing this option to obtain a large enough, non-refundable down payment in case the person doesn’t opt to buy.
“But on the other hand, buyers can also protect their options by recording the lease which will cloud the title, thus making it difficult for the seller to sell it to someone else,” he says.
Owner Financing Option #3: The Second Lien Position
This where a seller carries a second mortgage lien behind the bank to either make a no, or small money down deal. The buyer will then make two payments each month -- one to the senior bank lien holder and a second to the private seller.
The seller risks with this option are obvious. If the buyer pays only the first lien holder, the seller must have enough equity or cash to foreclose and pay off the first, larger lien holder.
Likewise, if the buyer only pays the smaller second lien, the seller still risks losing the property if the senior lien holder forecloses.
Owner Financing Option #4: Wrap-Around Mortgage
Offered by those reluctant to take a riskier, second lien holder position, wrap-around mortgages are also an opportunity for sellers to earn a good rate of return.
“If I am a seller with a $100,000 mortgage loan at 4% and the property is worth $150,000, I’d sell it to the buyer with $10,000 down, carrying the entire difference [$140,000] at 7% on a wrap-around mortgage or all inclusive trust deed,” says Lance Churchill, an attorney with the Frontline Education Group. “I’d rather make 2% or 3% on the $100,000 rather than just 7% on the $40,000.”
Yet buyers should know the risks involved with wrap-arounds. “If you are going with a wrap-around mortgage, always go with an escrow company,” advises Amolsch. “You don’t know what the seller is doing with your money.”
Escrow companies will ensure that payments make it to both the seller and the senior bank lien holder.
Another risk involves the bank discovering this particular lien.
“This type of arrangement violates what's known as a due-on-sale clause that basically says the existing lender has to be paid off when the seller sells the property to a new buyer,” warns Bronstein.
“If the seller doesn't do this and the lender finds out, the lender could declare the note in default and ask to be paid off in full.”
However, Churchill counters that in a healthy real estate market, the risk of this happening is small. “Why bother risking a performing loan for a non-performing loan if it’s paying as agreed?"
The only reason why banks might call a loan is if interest rates rise, as they may want to make another loan at the higher rate.
Owner Financing Option #5: Installment Land Contract
Possibly the riskiest option few experts would recommend, an installment land contract gives the home buyer merely the equitable interest in the property while the legal, titled interest remains with the seller.
Final title ownership does not pass to the buyer until the last contracted loan payment has been received.
Last Tips for Before You Use Owner Financing
Seller financing creates a way for home buyers with the income to support a mortgage but having less than stellar credit, to finally own their own home. Yet with any business transaction, those opting for this method should keep the following caveats in mind.
- Don’t do it alone. The money saved on avoiding traditional bank closing costs should be applied toward getting expert guidance.
- Seller financing is a business deal and should be handled as such. Properly document everything through a deed (or mortgage), title insurance, inspections, appraisals, etc.
- Use an escrow company to close the deal and to properly remit mortgage payments.
- Remember that while sellers are great at cashing checks, getting the final deed release can be problematic. Have a provision for getting the signed release held in escrow for when the loan is finally paid off.