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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.
|Number of payments||180|
|Balloon payment due at the end of year 10||$130,528.65|
|Total paid to seller||$224,532.00|
While this is one example of owner financing, many variables can alter how a seller finances a property.
Owner financing terms
It's up to the buyer and seller to determine the terms of the deal, such as the length of the loan, the amount of the down payment, the interest rate, and if there's a balloon payment. Some sellers have specific terms in mind, while others are open to negotiating. However, you need to decide on four main factors.
Length of the loan
This is the period over which the buyer will repay the loan. It can be five, 10, 15, 20, or 30 years -- or anything in between. While 30-year mortgages are sometimes used in seller financing, it's more common to see shorter terms, such as five to 10 years, with a balloon payment at the end. Even if a balloon payment is agreed upon in year 10, the loan can be amortized for 30 years to keep the buyer's monthly payment low and increase the interest collected by the seller.
A down payment is the amount of money the buyer pays to the seller to show their investment and interest in the home. This money is applied toward the purchase price and the remainder of that price is financed. The average down payment for residential properties on seller-financed loans in 2018 was 19%.
While there are ways to buy or sell a property with zero or very little money down, this is rare. In most circumstances, sellers require 10% to 20% down, although there's no minimum requirement. A study conducted in 2017 by Black Knight and the U.S. Department of Urban Housing and Development found that higher down payments reduced delinquency and default risk. A higher down payment shows that the buyer has "skin in the game," meaning they're less likely to walk away or stop paying.
It's important to note that a high down payment isn't the only factor that contributes to lower default risk.
Interest rates for seller-financed loans are typically higher than what traditional lenders would offer. The seller takes on some risk by holding financing, and he or she may charge a higher interest rate to offset this risk.
It's not uncommon to see interest rates from 4% to 10%. They could be higher, too. However, each state has usury laws, which are regulations governing the maximum interest rate that can be charged on a loan. In addition to the varying interest rate, there are several repayment terms available:
- Fixed-rate loan: The interest rate and payment stay the same throughout the entire term. The principal balance of the loan is gradually paid down with regular payments.
- Adjustable-rate mortgage (ARM): The interest rate adjusts periodically.
- Interest-only loan: The buyer only pays interest for a set period, then usually makes a large balloon payment toward the principal.
Fixed-rate interest loans are most common because of the ease in record keeping. Adjustable-rate mortgages fluctuate over time and, if not actively monitored, can lead to changes in the principal and interest being miscalculated or missed altogether. Interest-only loans are most commonly used with investors, especially for fix-and-flip loans.
A balloon payment is a one-time lump sum payment at the end of a loan.
Loans with balloon payments usually require monthly payments for a short period before the payment of the rest of the principal balance at the end of the loan. This payment can be made from savings, by selling the property, or refinancing.
Balloon payments are fairly common with seller-financed notes because lenders seldom want to wait 20 or 30 years to get their money back. These payments can also increase the return for the investor, so savvy real estate investors may elect this as a term.
How to structure a seller-financing deal
Various owner-financing structures can affect the buyer's security in the property and the process for regaining title if the buyer defaults.
Promissory note and mortgage or deed of trust
A promissory note and mortgage (or deed of trust, depending on the state) is the most common form of owner financing. This is the same structure a bank would use and is what people think of when they think mortgage.
The note outlines the amount the buyer borrowed and terms for repayment to the seller. The mortgage is a separate document that 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 promissory note isn't recorded and the original should be held by the seller.
A note and mortgage is the most secure form of financing for the buyer and the seller.
Contract for deed
A contract for deed can also be called an agreement for deed or land contract installment, depending on the state of issuance. It's structured like a note and mortgage, but instead of the buyer receiving a deed and being placed on title, the seller remains on title until the debt is repaid in full.
Some sellers may choose this structure because it's less time-consuming and more cost-effective to regain marketable title of the property if the borrower stops paying. Many states allow eviction or forfeiture, which are faster and cheaper than a full foreclosure. The procedures for this vary from state to state and contracts for deed aren't recognized in some states.
A contract for deed is a less secure form of financing for both the buyer and seller. Since the seller remains on the title while the buyer lives in and is responsible for the property, any liens or violations that become attached to the property during that period could negatively affect the seller.
A lease option is a form of owner financing where the buyer agrees to lease the home with the option to buy it at the end of the agreement term.
The buyer and seller agree on the purchase price of the home before the lease starts and the seller typically receives a down payment. At the end of the lease term, the buyer can buy the home or forfeit their lease option. If the buyer buys the home, payments made during the lease period can be used toward the purchase price.
Owner financing lien position
All loans are categorized by position, such as a first lien, second lien, and so on. The lien position distinguishes the priority a loan has in relation to other debts or encumbrances on the property. The first lien is the most secure position.
Seller financing can be used as a second-position note to help a buyer purchase the property when they may not have the full amount to buy the home. For example, let’s say a buyer finds a home for sale at $400,000 and has 20% ($80,000) to put down. She qualified for a $300,000 bank loan, so the seller decides to carry financing for the remaining $20,000, payable over five years. This owner-financed mortgage is secondary to the first mortgage from the bank, but is fully enforceable, like any regular mortgage. Here’s what those payments would look like.
The first mortgage, payable to the bank:
|Number of payments||360|
The second mortgage, payable to the seller:
|Number of payments (term)||60|
Owner financing documents and the Dodd-Frank Act
The documents used in owner financing vary depending on the type of structure used, but in most cases, there are two separate documents:
- The note, which outlines how much is to be repaid and the terms of the repayment.
- The security instrument, which could be the land contract, mortgage, or deed of trust.
The Dodd-Frank Act made several changes to the mortgage industry, including owner-financed residential loans. While much of the bill focuses on debt collection and servicing rights, there were also revisions to who can originate seller-financed loans.
Before 2014, the person holding the financing could create the note and mortgage themselves or have an attorney or a title company do it for them. But the Dodd-Frank Act requires a licensed mortgage loan originator (LMLO) to underwrite and create any loans in which the buyer intends to reside in the property. You can hire a third-party LMLO to handle all of the required loan underwriting, including:
- pulling credit,
- determining the debt-to-income ratio,
- verifying identity and income, and
- creating and executing all paperwork.
If you intend to write or create the loan yourself, you need a license unless you qualify for one of the two exceptions:
- You own the property you're holding financing for and only create a loan for one property (that you didn't construct or act as the contractor for) in a 12-month period.
- You're a trust, estate, or entity holding financing for three or fewer properties that you own in a 12-month period and didn't construct or act as the contractor for.
There are guidelines on specific terms such as balloon payments, interest rates, and vetting processes. For this reason, even if you're not required to be a licensed mortgage loan originator, you should work with a knowledgeable professional who can help you with the paperwork and underwriting.
It's important to note that the Dodd-Frank Act doesn't apply to:
- properties intended for investment purposes, such as rentals;
- vacant land;
- commercial properties; or
- non-consumer buyers, such as limited liability companies (LLCs), corporations, trusts, or limited partnerships (LPs).
Why buy with owner financing? What are the benefits of owner financing?
Owner financing can be beneficial for a buyer or a seller. A seller may offer owner financing to reduce capital gains taxes from selling the property. A seller-financed loan breaks up the gains over a period of time.
Some investors offer financing on properties when they're ready to retire to reduce taxes and create residual income. If the buyer performs on the loan as agreed, the seller has created a passive income stream for many years.
Owner financing may also be a good option if the seller has trouble selling the property because it doesn't qualify for financing from a bank. Using owner financing gives prospective buyers the opportunity to buy a property they may not have had access to without it.
Seller financing is an appealing option for buyers because it lets them purchase a property without having to borrow money from a bank. There's typically less paperwork, fewer fees, and fewer qualifications to meet to be approved. Not all buyers who request or use owner financing to buy a home are unqualified. It may be that they don’t qualify for a bank loan because they're self-employed or lending has tightened in the current market.
Why sell a property with owner financing?
Back in the '80s, when interest rates were in the high teens and low 20s, selling properties was difficult. Sellers were desperate to find buyers, so many offered owner financing with lower interest rates than banks were offering.
Luckily, interest rates have become far more favorable in the past decade, so sellers may not need to use owner financing, but certain tax advantages may incentivize sellers to offer it.
When a property is sold, it may be subject to capital gains taxes in addition to depreciation recapture. By creating a seller-financed loan, the tax hit from capital gains is broken up over the life of the loan rather than having it in one tax year. It can also be a form of passive income for the seller, who can use the monthly principal-and-interest payment to offset living expenses in their retirement or grow their investment portfolio.
Important things to know about seller financing
Most owner-financed loans are created by property owners or investors for the tax advantages and cash flow these loans generate. While these owners may be experienced investors, they may not know the current laws regarding loan documentation, underwriting guidelines, record keeping, or contacting a borrower.
I've seen owner-financed loans in which the seller had great records with proof of payments for every payment made by the buyer, and I've seen seller-financed loans in which the owner had no idea where the original loan documents were, what the balance of the loan was, or where tangible records of the payments were.
While seller-financed loans aren't regulated as heavily as banks or servicing companies, there are specific requirements. For this reason, anyone who owns or creates a loan should educate themselves on the proper procedures or use a licensed servicing company.
A servicing company can handle several important tasks:
- Payment collection, including recording payments with the balance due, paid-through date, and other important loan information. Servicing companies will report payment history to the credit bureaus, which is often beneficial for the buyer.
- Buyer outreach, which may include payment reminders, monthly statements, or delinquency notices.
- Loss mitigation, or efforts to collect on the loan if the buyer stops paying.
Servicing companies charge a nominal monthly fee depending on the status of the loan, such as paying or not-paying. A servicing company will keep you compliant with the current laws, which makes for a more passive, hands-off investment.
Owner financing risks
For sellers offering owner financing, the most substantial risk is the buyer not repaying the loan as agreed. You can take measures to reduce the likelihood of default, but there's no way to guarantee a buyer can or will continue to pay.
Some ways to decrease this risk are:
- running a credit report,
- verifying income,
- looking up past payment history,
- seeing the buyer's outstanding debts, and
- calculating a debt-to-income ratio.
The seller has the right to regain title through legal action, such as foreclosure or forfeiture, but this takes time and can be costly. Understand your state's laws and procedures for regaining title if the buyer defaults. Some sellers set the down payment aside in a separate account to cover any expenses in case the buyers stop paying.
For buyers entering into a seller-financing agreement, the most substantial risk is how payments are tracked. If the seller services the loan themselves, their recordkeeping may not accurately reflect the balance owed or the last payment made. Buyers should keep their own records of each payment made over the life of the loan so the remaining balance due can be verified.
Owner financing offers major advantages to both buyers and sellers. But before you enter an owner-financed agreement, weigh the risks and consult a real estate attorney to ensure you understand the consequences, terms, and responsibilities of the agreement. This method of financing is definitely not right for everyone, but it can be a useful tool when buying or selling real estate.
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