What is owner financing and how does it work?

You don’t have to throw away your dreams of owning a home if you don’t meet a lender’s strict requirements. The alternative option, owner financing, allows the seller of the home to act as a lender. This option is not always possible, but when it is, it can benefit both the buyer and seller.

While this alternative financing can help a buyer bypass a lender’s approval and allow an owner to sell a property quicker, it can be a complicated process. Here’s what you need to know before pursuing this option.

Key insights

• Owner financing can be beneficial for buyers who may not qualify for traditional mortgages due to a low credit score or other financial reasons.
• The buyer and seller negotiate the terms of the financing agreement, including the interest rate, length of the loan and other conditions.
• Owner financing can be risky, since buyers may have less protection in the event of default.

What is owner financing?

Owner financing, also known as seller financing, is an alternative financing method that allows the owner to act as a lender when selling a house.

Since very few homebuyers have the cash on hand to purchase a home outright, financing options are needed. Typically, buyers seek financing through banks, credit unions and other lenders to buy their homes. The catch is that these lenders need to protect themselves from financial risk and therefore have strict financial and credit requirements.

What’s a buyer to do when they don’t qualify for traditional financing but need to buy a home? Owner financing. It is a lesser-known alternative but sometimes a viable option.

Depending on the seller, both parties can enter into complete or partial owner financing. Complete financing involves little or no down payment. Partial owner financing occurs when you put a notable down payment on a property.

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How does owner financing work?

When you purchase a home with a traditional mortgage, the lender pays the seller. The buyer then makes monthly payments to the lender with interest. In contrast, owner financing is a more straightforward transaction that occurs directly between the buyer and seller.

Owners are likely to charge a higher interest rate than a financial institution would.

With owner financing, once a buyer and seller agree to the terms, the seller extends credit to the buyer. This amount is enough to cover the list price of the property, minus any down payment. The buyer will begin making monthly payments until the home is paid off. These payments usually begin within 30 days of closing the deal.

It's important to note that the seller may or may not require a down payment. This will be entirely up to the property owner.

Even though it's a simpler option, owner financing does not simply rely on a good-faith agreement between two parties. As part of the agreement, the buyer will sign a promissory note. This legal note will spell out specific details of the purchase, including repayment terms, interest rates and the consequences of defaulting.

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Pros and cons of owner financings

“Owner financing can be a great way for aspiring buyers to structure their purchase transactions. There are advantages and disadvantages to be mindful of, however,” said Shmuel Shayowitz, president and chief lending officer at Approved Funding in River Edge, New Jersey.

“The notion of seller financing, merely to avoid a bank, doesn't always mean the buyer is getting a better deal,” he said. “A buyer should do a proper analysis to see if the terms of the seller are more favorable than the terms of a lender for both their short- and long-term financial needs.”

Advantages and disadvantages for sellers

If owner financing were only beneficial for the buyers, no deals would ever get done — which is why this purchasing option has some significant advantages for sellers, too, though sellers need to know this isn’t a risk-free transaction.

Before opting for owner financing, you should familiarize yourself with the Dodd-Frank Wall Street Reform and Consumer Protection Act. This act sets forth specific rules for owner financing that sellers must adhere to.

Advantages and disadvantages for buyers

If you’re a buyer, owner financing can be a great option if you have little money to put down or subpar credit, but you need to know what you are getting into before signing any paperwork.

You should also ensure that the seller does not have a “due-on-sale” clause with their current lender. If they do, their lender can require immediate payment once they sell the home, and the bank can then foreclose. If the seller owns the home outright, a due-on-sale clause won't be an issue.

Additionally, Shayowitz, from Approved Funding, recommends that buyers have a plan when the terms of financing require that the loan be paid off. “The buyer should make sure that they will be in a position to refinance the loan at that time,” he said.

How to buy a house with owner financing

The first step to buying a home with owner financing is to find a property in your desired location and price range. Many real estate sites will clearly state whether a home is available for owner financing or not.

Remember: You can always contact the seller and request owner financing.

Once you've found a home, you can begin discussions with the seller. You can negotiate terms such as the interest rate, down payment amount, length of the loan, balloon payments (a large, lump-sum final payment) and monthly payment amount. You should also decide who will hold the title while you're paying the loan.

All this information should be outlined in a promissory note to protect you and the seller. Before signing anything, inquire about the due-on-sale clause, and ask for documentation verifying that the seller owns the property free and clear.

Some lenders will allow owner-financing sales. If the seller’s lender is granting them an exception, request documentation of this.

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Bottom line

Owner financing is certainly a good option for some homebuyers, but it's not a one-size-fits-all solution.

If you have poor credit or difficulty obtaining a traditional mortgage, owner financing might deserve your consideration. However, you'll have to take steps to protect yourself from balloon payments and restrictions such as due-on-sale clauses. As long as you do so, owner financing can be a worthwhile alternative to a traditional mortgage.