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What is owner financing and how does it work?

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When it comes to buying a home, you have several purchasing options. The most common, of course, is financing with a mortgage. However, strict lending requirements mean that this may not be the ideal solution for everyone.

An alternative option is owner financing. Simply put, owner financing is a transaction that occurs directly between a buyer and a seller. The seller finances the purchase for the person buying the home.

Before you can select the best purchasing option for you, it's important to understand the ins and outs of owner financing. Below, we will cover owner financing in greater detail. We will also provide some of the pros and cons of this purchasing option so you can make an informed decision.

What is owner financing?

Very few homebuyers have the cash on hand to purchase a home outright. This is understandable, as a home is often the largest purchase the average person will make. Because buying a home requires such a large investment, there's almost always some type of financing required.

Owner financing is a lesser-known alternative to a traditional mortgage. Instead of financing a property purchase through a bank or other lender, the buyer finances the purchase through the seller. Owner financing is appealing to some buyers because it helps them to avoid navigating the complex mortgage process and does not include strict lending regulations. It's also a money-saving measure, as buyers can avoid paying thousands of dollars in closing fees to a financial institution.

The seller of a property can agree to complete or partial owner financing. Partial owner financing occurs when you put a notable down payment on a property. Complete financing involves little or no down payment.

How does owner financing work?

With owner financing, the buyer finances the home purchase directly through the seller — with no traditional lender involved.

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.

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. They're also likely to charge a higher interest rate than a financial institution would.

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. The note will spell out specific details of the purchase, including repayment terms, interest rates and the consequences of defaulting on the note.

What is a promissory note?

A promissory note is a financial instrument that's used as a legal means of closing a deal between two parties. This note lays out all repayment terms of the deal. While these notes can be issued by financial institutions, they're typically used by individuals or companies employing alternative financing options. Promissory notes protect the seller in an owner-financed home purchase.

Who holds the title in owner financing?

There are no set rules as to who holds the title in an owner-financed home purchase. In some cases, the seller will keep the title to a property until the buyer makes the final payment. However, it's not uncommon for the seller to provide the buyer with the title after the promissory note is signed. These terms can be laid out in the promissory note to protect the interest of both parties.

Are banks involved at all?

The primary purpose of owner financing is to circumvent traditional financial institutions. Banks are seldom involved in owner financing. However, if the seller requires a down payment, the buyer could pursue a personal loan from a financial institution to close the deal. This would still prevent the bank from having a substantive stake in the property.

With that being said, many sellers will opt to conduct a credit check on a potential buyer. While owner financing does not have any hard and fast rules as to creditworthiness, the seller will be able to use their discretion in extending financing. If an interested buyer has a history of defaulting on loans or rental agreements, the seller is more likely to decline an offer.

Does “For sale by owner” mean owner financing?

When you’re shopping for a home, you may encounter the phrase “For sale by owner.” While this verbiage may sound enticing, it's important to understand that this is not the same thing as owner financing.

The words “For sale by owner” simply mean the seller is foregoing the services of a listing agent. This allows them to avoid paying various fees to a real estate agent and can improve their profit margins. They may still want to receive a lump-sum payment for their home via a traditional mortgage. However, this shouldn't stop you from inquiring about their preferred purchasing methods.

Pros and cons of owner financing

Owner financing has pros and cons for both homebuyers and sellers. When you’re making a final decision on financing options, weigh the potential benefits against any possible negatives. Doing so will help you to choose the best option for your current financial situation.

Advantages for sellers

If owner financing were only beneficial for the buyers, no deals would ever get done. Fortunately, this purchasing option has some significant advantages for sellers too.

One of the most apparent advantages of owner financing is that it allows a seller to list the home “as is.” When a buyer is acquiring financing, the lender may require sellers to make significant repairs. Sellers can circumvent these requirements by working directly with the purchasing party.

Owner financing also allows a faster sale, since both parties avoid the mortgage process. The promissory note can be sold to an investor, which gives sellers a means of obtaining a lump-sum payment if needed. Lastly, it's important to remember that the seller will retain the title if the buyer defaults. They would keep any payments already made, the money down and the home.

Disadvantages for sellers

Owner financing is not a danger-free option for sellers. There are a few potential pitfalls to be aware of. Most important is the danger of default. If a buyer stops making payments but does not walk away from the property, you will have to navigate the foreclosure process.

In addition to going through foreclosure, you will likely be left with some costly repairs if the buyer defaults. Before opting for owner financing, you should familiarize yourself with the Dodd-Frank Act. This act sets forth specific rules for owner financing that sellers must adhere to.

Advantages 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. In addition, owner financing allows for a rapid closing because you don’t have to wait on a loan officer or underwriter for loan approval. Closing is cheaper, too, because you won't be subject to appraisal costs or financing fees.

Down payment options are also much more flexible with owner financing. There are no minimums set forth for this style of purchasing; any down payments can be negotiated between you and the seller.

Disadvantages for buyers

One of the primary disadvantages for buyers is that the interest rate is usually much higher with owner financing than with a traditional mortgage. There's also a good chance that the seller will request a balloon payment at the five- or 10-year mark. Fortunately, owner financing can give you the opportunity to build your credit and pursue traditional financing at a later time.

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 you 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.

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 and the 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: Is owner financing a good idea?

    Owner financing is certainly a good option for some homebuyers. However, 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 is a viable alternative to a traditional mortgage.

    If you prefer concrete terms and the assistance of a financial professional, then you may want to opt for a traditional mortgage. While you will incur additional fees such as closing costs, the interest rate will be lower. You will also be required to complete a home inspection and appraisal, which protects you from buying a home that's overpriced or in disrepair.

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