Owner Financing: The Ultimate Guide to Seller Financing
What Owner Financing Is & How It Works
Owner financing also called seller financing is a tool you can use to purchase real estate when you otherwise can’t use a traditional mortgage. With a traditional mortgage, you borrow money from a bank to pay for the property. Then, you make payments back to the bank to pay off the loan. With owner financing, you make arrangements to pay the owner in installments, typically of principal and interest, until you’ve paid off the purchase price of the property.
An owner financed transaction involves a certain amount of legal paperwork. Below, we’ll talk about promissory notes along with mortgages and trust deeds. This paperwork is fairly standard; more important, it protects everyone involved.
Throughout the country, owner financing goes by many names. You may hear it referred to by any of the following terms:
Owner carried financing
Owner will carry (OWC)
These all mean basically the same thing; they are just regional differences in what owner financing is referred to.
Let’s look at a basic example of how owner financing works.
An Example of Seller Financing
Let’s say you’ve found a seller of a $100,000 investment property that they own outright. You could go to the bank and borrow some or all of that $100,000. However, let’s say that you can’t do that. Perhaps your credit is not stellar, you are self-employed and have difficulty verifying your income, or you already have a lot of investment mortgages and have topped out what you can borrow. Whatever the reason, let’s say you just can’t borrow traditionally. Let’s also assume you don’t have $100,000 in cash to buy this investment.
In this case, you could offer to the seller the following: instead of buying the property for cash or from the proceeds of a bank loan, you propose making monthly installments. Those installments will include principal, 7% interest and will be for the typical 30 years. The numbers would look like this:
Seller Financing Example
Amount Financed $100,000
Interest Rate 7%
Number of Payments 360 (30 years worth of monthly payments)
Monthly Payment (Principal and Interest) $665.30
Total of All Payments to Seller $239,508
Typical Owner Financing Terms
The above example is a very simplified one. However, it isn’t what typically happens with most owner financed deals. In real life, you’ll probably need a down payment, loan periods (amortization periods) will not likely be the typical 30 years, and balloon payments will often be involved.
Here’s what to expect with each:
While there’s been a lot of discussion over the past 3 or 4 decades about “nothing down” or “no money down” that is not a common occurrence. To the seller, a down payment is your “skin in the game”; it’s what you stand to lose if you default. So, you can expect sellers to ask for 5% – 25% (and more) for down payments.
While a seller may ask for a hefty down payment, be aware that it’s not always written in stone. Unlike working with a bank, when you do seller financing, there’s often room for negotiation.
The public is used to a 30-year mortgage, and it’s only been recently, with historically low interest rates, that segments of the public have gone with 15-year payback periods (15-year amortization) to pay off their homes more quickly.
With owner financing, you won’t typically get 30-year amortization periods because sellers normally won’t want payments dribbling in over 3 decades. While a 30-year amortization schedule is possible, expect the loan to be wrapped up earlier with a balloon (see below). Otherwise, expect to amortization periods normally in the 15 to 20-year range.
When a longer amortization period is offered, it is usually truncated with something called a balloon payment. With a balloon payment, either a large chunk of principal is due – or, more commonly, the entire remaining balance is due in full at some period of time before the end of the normal payback period.
Let’s use the example from the table above. Instead of accepting payments for 30 years, perhaps the seller agrees to set up the 30-year payment schedule but wants a balloon payment at the end of 10 years. That means the seller is not interested in dragging out those monthly payments past the 10-year mark. Instead, you must pay off any remaining balance with cash or by getting a new loan.
In our example above, a balloon for the remaining principal balance at 10 years would be about an $85,000 lump sum payment.
More Realistic Owner Financing Terms
Let’s look at a more realistic owner financed scenario that involves both a down payment of 10%, a 30-year amortization period, but a balloon for the remaining balance due in year 15.
More Realistic Seller Financing Example
Asking Price $100,000
Down Payment (10%) $10,000
Amount Financed $90,000
Interest Rate 7%
Amortization 30 year repayment schedule
Balloon At 15 years
Monthly Payment (principal and interest) $598.77
Balance Due at Time of Balloon $73,785
Total of All Payments to Seller (down payment + monthly payments for 15 years + balloon payment) $191,563
Keep in mind that when the balloon comes due, you either have to come up with $73,785 in cash to pay off the balance or otherwise borrow that money to pay off the seller. If you end up borrowing the funds, then you will acquire a new loan payment to make on that $73,785 even after paying off the seller.
Typical Owner Financing Documents
In order to set up an owner financed situation, either you or the seller will need to have two forms of paperwork. One is called a promissory note which spells out the loan terms and expectations for repayment. The other will be either a mortgage document or something called a deed of trust which provides security for the loan.
Promissory notes are not difficult to understand. They are your promise to repay the debt. A promissory note will specify:
Amount of debt
Term of repayment
The repayment schedule
How payments are made (i.e whether they are monthly, quarterly, etc.),
Payment amount and whether it is principal and interest or takes another form
Whether a balloon payment is involved and what those specifics are
Promissory notes will also typically provide for penalties if you are late paying, if early payoff involves any additional costs, and whether the loan balance may be due in full if you sell the property (called a due-on-sale clause).
You or the seller can hire an attorney to draft the promissory note and other documents, or you can use an online legal service.
Mortgages and Deeds of Trust
These two documents serve basically the same function; whether one is used over the other is mainly a function of where you are buying and what the customary form is in that area.
Both mortgage documents and deeds of trust provide security for the seller. In effect, they place a lien on the property and provide for remedies if you default on payments. Of importance to the seller, they are filed at the local courthouse to ensure there’s a legal record of the lien, expectation of repayment, and provide the basis for foreclosing if necessary. The method of foreclosure is specified (and varies depending on whether a mortgage or deed of trust is used) should the owner need to repossess the property.
Some Complications With Seller Financing Today
Owner financing used to be more common than it is today. Changes in lending practices related to existing mortgages have closed some doors on the possibility of owner financed deals and recent legislation known as Dodd-Frank has complicated the owner financing process.
Seller Financing Options with Existing Loan on the Property
One of the most common questions raised – and one of the most difficult situations to wrestle with in an owner-financed deal is if there’s an existing loan on the property.
Once upon a time, many existing mortgages were assumable, meaning a buyer could simply take over the obligation to pay on an existing mortgage. In effect, they would become the new payor for that loan. This worked exceedingly well with owner financed deals.
With very few exceptions, those days are behind us, and most mortgages today have what is called a due-on-sale clause which makes them un-assumable because any remaining loan balance has to be paid in full at the time of sale.
There are some tricky ways to try to subvert the due-on-sale clause and still set up an owner financed deal when the property has an underlying loan. All of these get into the realm of creative financing. It is recommended that you enlist the services of legal help if you attempt any of these.
Here’s a quick rundown on 5 techniques for putting together owner financing if there’s an existing mortgage present:
1. Buying “Subject To” the Existing Loan
This is remotely similar to assuming a mortgage. However, unlike an assumption, the original holder is still the one legally responsible for the payments. If you don’t pay, they are on the hook. Very few discerning sellers will agree to this.
2. Wraparound Mortgage
A wraparound mortgage creates one loan that is big enough to pay on the existing loan plus any additional equity in the property. With a “wrap” mortgage, you make this larger payment to the seller. In turn, you entrust the seller to pay the underlying mortgage. The difference between the two is the owner financing on the equity. Be aware – buyers can be on the hook if the seller doesn’t pay their underlying loan.
3. All-Inclusive Trust Deed
An all-inclusive trust deed is basically a wraparound mortgage. It’s a legal term used in many states to denote the same process.
4. Lease Option or Lease Purchase
With this approach, you actually lease the property from the seller with an option to buy, or a contract is already drawn up to buy, but at a later date. This allows you to control the property and selling price until you can arrange for outside financing. Again, buyers need to be wary in case the seller fails to make their payments while the lease option is in effect.
5. Land Installment Contract
This is, perhaps, the most complicated of all forms of creative financing. With this approach, a contract is set up for the buyer making stipulated payments for a period time (5 to 10 years is common). Similar to a lease option, it allows the buyer to control the property and price until other financing can be arranged.
The real caution is that with a “land contract” the buyer has no vested interest in the title to the real estate. If they default on even one payment, the contract is terminated and the seller gets the property back without any need to foreclose.
The Dodd-Frank Act of 2010 Affects Owner Financing
In the aftermath of the subprime mortgage meltdown and all the predatory loans that had been issued prior to 2007, Congress enacted legislation that eventually became known as Dodd-Frank. It was aimed mainly at Wall Street, but politics allowed its scope to also blanket private sellers on Main Street who offer owner financing.
The details are beyond the scope of this article, but for the average seller, with a property or two for sale, the Dodd-Frank is of no real concern. It’s not until a person is attempting to sell 3 or more properties with owner financing that Dodd-Frank applies, and among other expectations, they will need to obtain a mortgage originator’s license. For that reason, a lot of owner financing has disappeared from the market.
Advantages & Disadvantages of Owner Financing
Seller financing offers benefits to both the purchaser and seller. Still, there are some pitfalls to be aware of. Here is a list of the benefits and downsides for each party:
Can negotiate rate and terms
Lower closing costs
Sellers may be unwilling to carry financing
Flexibility of owner financing may come with a price tag
Difficulty if there are underlying mortgages
Can get a property sold faster
Can get a higher price
Generates monthly interest income
Can get the property back if it forecloses
Don’t get all cash up front
Problems collecting payments
Can end up in foreclosure
Sellers have to administer the loan
The Dodd Frank Act of 2010 placed limits on owner carried mortgages
Owner financing is a financial arrangement in which buyers make payments directly to the seller rather than acquire a mortgage from a financial institution. Payments are usually in the form of monthly installments of principal and interest. Sellers benefit by getting monthly interest income along with a potentially higher selling price and a quicker sale.
If you are looking for owner financing because you looking for a creative way to finance your real estate purchase, reach out to Davis Mortgage Notes and schedule an appointment today!!