Have you ever been turned down for a mortgage home loan because you cannot meet the strict lending guidelines? Some of the reasons why a buyer may be turned down for traditional lender financing include:
- Poor credit
- Insufficient work history
- High debt-to-income ratios
- Recent divorce
- Past bankruptcy
- Short sale history
Have you heard people talk about "owner financing" but were not quite sure about it? Keep reading to find out what owner financing is and the pros and cons of owner financing for buyers.
What Is Owner Financing?
Owner financing, also referred to as seller financing, is where the owner of the house finances the purchase of the house for the buyer. A house can cost a lot of money, right? Some say it is the largest single investment a person will ever make. However, not everyone can qualify for a traditional mortgage home loan with a traditional mortgage broker or lender due to the strict lending guidelines.
Because there are no restrictions on who can use owner financing or what type of property can be bought or sold with it, many investors use owner financing to buy or sell properties. Although owner financing is used frequently by real estate investors, it can also be used if a buyer doesn't qualify for traditional financing because of poor credit, insufficient work history, self-employment, previous bankruptcy or foreclosure, or various other economic factors that do not meet the strict guidelines of a traditional mortgage lender.
How Does Owner Financing Work?
When the owner finances the house for the buyer, the owner is essentially extending credit to the buyer to cover the purchase of the house minus the down payment which is typically around 10 percent or more. There are several types of owner-financing structures that can be used, and it is very important that the buyer understands the difference. Here are a few of them.
- Promissory note and deed of trust
- Contract for deed
- Lease option
Promissory Note and Deed of Trust
A promissory note and deed of trust is considered the most secure form of owner financing for both the seller and buyer as it is the same structure a bank would use to lend on a property. The buyer signs a promissory note to the owner-seller that defines the terms of the loan such as the interest rate, the repayment schedule, and the consequences of defaulting on the loan. The buyer then makes regular periodic payments as defined in the installment agreement until the loan amount is paid in full. The buyer is recorded on the deed. The deed of trust secures the loan for the seller. The promissory note and the deed of trust are recorded in public records.
Contract for Deed
A contract for deed is a contract between an owner-seller and a buyer whereby the owner of property retains the title or deed of the property until the buyer finishes making the installment payments of the agreed-upon purchase price. There is no promissory note in a contract for deed. There are some owner-sellers who prefer the structure of a contract for deed because it can be quicker and less costly to regain the property in the event that the buyer defaults.
Sometimes referred to as "rent-to-own", a lease option begins with the buyer leasing the house for a period of time with the option to buy in the future. Before the lease starts, the buyer and owner-seller agree on the purchase price of the house. When the lease expires, the buyer can then choose to buy the house or forfeit the option fee and any other fees the buyer may have paid to enter into the lease-option agreement. If the buyer does choose to buy the house, the option fee is usually applied like a down payment towards the purchase price of the house. However, the lease payments made before the option was exercised DO NOT typically apply towards the purchase price of the house.
Contracts for deed and lease option agreements are heavily regulated by the State of Texas because they are viewed as potentially predatory. All buyers should seek legal advice when using owner financing.
Owner Financing Terms
The owner and the buyer determine the terms of the deal. This includes the amount of the down payment, the interest rate, the length of the loan, and if there will be a balloon payment at the end of the term. Most owners already have specific terms in mind, so there is not necessarily much negotiation. However, the terms do need to be defined, discussed, and decided upon by both parties. It is very important that the buyer thoroughly understands the terms of the agreement especially when there is a balloon payment involved.
The down payment is the amount of money the buyer pays up front to the owner, and it is typically around 10 to 20 percent of the purchase price. A higher down payment shows that the buyer has "skin in the game" meaning the buyer is less likely to default on the loan.
The interest rates for owner-financed loans are almost always much higher than what traditional lenders would offer. Because the owner takes on risk by financing the house for the buyer, the owner offsets the risk by charging a higher interest rate.
It is not uncommon to see interest rates of 8% or higher. Texas, like most states, has usury laws which regulate the maximum interest rate that may be charged on a loan. Loans can have an adjustable interest rate, a fixed interest rate, and some loans can be interest-only loans. Again, it is very important for a buyer to understand the terms of the agreement.
Adjustable-rate mortgage (ARM) loan
The interest rate of the loan may change periodically, as the rate is often tied to the prime rate or other index rate. There are also occasions where the owner-seller and buyer agree to specific step up rates which will occur during the life of the loan.
Fixed rate loans have an interest rate that does not change over the life of a loan, meaning it does not go up or down with the prime rate or other index rate. You pay the same amount each month, and the principal balance of the loan is paid down gradually with regular periodic payments.
For a set period of time, the buyer pays interest only then makes a large balloon payment toward the principal at the end of the set term. Interest-only loans mean lower payments for a period of time, but they also mean you are not building equity by paying down principal. There can be a big jump in payment amount when the interest-only period ends. Interest-only loans are often used by investors for fixing and flipping properties.
Length of Loan
The length of the loan is the time over which the buyer will repay the loan. It can be five, 10, 15, 20, or 30 years or anything really. In owner financing, it is not uncommon to see shorter terms such as five or 10 years with a balloon payment at the end of the term. Owners often finance properties for buyers with the expectation that the buyer will refinance the house with a traditional lending product. Sometimes, an owner-financed loan can be amortized over a longer period of say 30 years but the length of the loan term is set to 10 years. This keeps the buyer's monthly payment low, but it also means less principal is being paid down during that time.
A balloon payment is a LARGE, one-time lump sum payment made at the end of a loan. It is very important that a buyer understands whether or not a balloon payment is part of the loan agreement. If the buyer cannot make the balloon payment, he or she may be forced to sell the house quickly (potentially at a loss) or default on the loan if he or she is still not qualified to refinance with a traditional mortgage home loan.
Balloon payments are not uncommon with owner-financed loans. Owner-sellers very seldom want to wait a full 20 or 30 years to get their money back. Also, these payments can increase the return for the owner-seller.
Owner financing can be a good and only option for a buyer who cannot qualify for a mortgage home loan with a conventional lender. However, it is important to weigh the pros and cons of owner financing.
Owner Financing is Often a Short-Term Scenario
Many owner-financing deals are short term, because most owners are not willing to wait decades to get their money back. A typical arrangement is to amortize the loan over 30 years to keep the monthly payments low with a final balloon payment due after about five or 10 years. The assumption is that after five or 10 years the buyer will have enough equity in the house or enough time to improve their financial situation to qualify for a traditional mortgage home loan.
Owner Financing Example With a Balloon Payment
Let's say a seller owns a house outright. The seller lists the house for sale for $200,000 and is willing to owner finance a buyer. The owner-seller and buyer define, discuss, and decide on the terms of the agreement. While the owner is willing to finance the buyer, the owner does not want to wait 30 years for repayment, and the buyer is trying to keep the monthly payments low to pay down other debts. So, the owner offers a 15-year note based on a 30-year amortization with a balloon payment due at the end of the 15th year. Remember, this means lower monthly payments but a sizeable balloon payment will be due at the end of the installment term.
Owner Financing Example With Numbers
Let’s look at a realistic traditional owner finance example with a promissory note and deed of trust. There is a down payment of 10%, a 30-year amortization period and a balloon payment due for the remaining balance due in year 15. Here is what a balloon mortgage calculator shows. (Note: the terms mortgage and note are used interchangeably here.)
Asking Price $200,000
Down Payment $20,000
Amount Financed $180,000
Interest Rate 9%
Amortization 30 years
Balloon at 15 years
Monthly Payment (principal & interest) $1448.32
Balance due at time of balloon $142,794.80
Total of All Payments to Seller (down payment + monthly payments
for 15 years + balloon payment) $423,492.40
Owner Financing Documents
To set up an agreement for owner financing, either the owner-seller or the buyer will have several forms of paperwork drafted by a real estate attorney. The three documents that will be drafted and signed in this example are the promissory note, a deed of trust and a warranty deed. Because this scenario involves a promissory note and deed of trust, the buyer will receive the title at closing.
A promissory note is the promise to pay for the property and spells out the loan terms and expectations for repayment. It includes the following information about the agreement:
- Amount of debt
- Term of repayment
- Interest rate
- The repayment schedule
- Frequency of payments like monthly or quarterly
- Payment amount which may be principal and interest or if it takes another form
- Tax and insurance payment responsibilities
- Balloon payment if one is involved and what the specifics are
A promissory note will also detail the penalties for late payments, any prepayment penalties, and whether the loan balance may be due in full if you sell the property (called a due-on-sale clause).
Deed of Trust
A deed of trust is the instrument that creates a lien on the house to secure a promissory note.
The warranty deed is the instrument that transfers the property to the Buyer.
After five years of timely monthly payments, the buyer makes the final LARGE balloon payment to the seller, and the lien is released. The deed of trust provides security for the seller. In effect, it places a lien on the property and provides for remedies if the buyer default on payments.
The documents 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 the seller finds it necessary.
Pros and Cons of Owner Financing
Owner financing can be a good option for buyers who cannot otherwise secure a loan to purchase a house.
Pros for Buyers
Easier qualification: A good option for buyers who cannot qualify for a traditional mortgage home loan due to strict lending guidelines
Faster closing: No waiting for a bank loan officer, underwriter, and legal department to process and approve the buyer's application
Cheaper closing costs: No bank fees, inspection, or appraisal costs (unless the buyer chooses to have an inspection and appraisal)
Cons for Buyers
Larger down payment: Most owner finance deals require at least a 10% down payment
Higher interest: The loan interest rate will be higher that what would be paid to a bank
Need owner approval: Even if an owner is willing to owner finance the house, the owner will still have to qualify the buyer
Balloon payment: The owner may not be willing to hold the note for more than five or 10 years. If not, the note commonly comes due in the form of a balloon payment. The buyer must pay the balloon payment in cash or by refinancing the property. Otherwise the buyer risks losing all the money paid thus far including the initial down payment plus the property itself.
Taxes and Insurance: Unlike a traditional mortgage home loan, property taxes and insurance may not be rolled into monthly payment. If they are not, the buyer must pay those bills outside of but in addition to the monthly installment payment.
Due-on-sale clause: If the seller still has a mortgage home loan on the property, then the sellers lender can demand immediate payment of the debt in full if the house is sold to someone else (to you). Most mortgage home loans have a due-on-sale clause. If the lender isn’t paid, then the seller's bank can foreclose. To avoid this risk, make sure that the seller owns the house free and clear or that the seller’s lender agree in writing to owner financing.
Before Considering Owner Financing
Before considering owner financing it is important that a buyer consider the pros and cons. The process can be complex so working with a licensed attorney who specializes in real estate is highly advisable. A licensed attorney who specializes in real estate will consider your best interests when drafting or reviewing the necessary documents. A REALTOR® may help you in finding a house, but a REALTOR® cannot give legal advice.
About the author: The above real estate information on the Advantages of a Buyer Representation Agreement was provided by Krista Jenkins, a Lubbock, Texas REALTOR®. Krista can be reached via call or text at 806-928-4359. Krista has helped people move in and around the Lubbock, Texas area for the last 7+ Years.
Are you thinking of buying or selling a house in Lubbock, Texas or the surrounding area? I have a passion for real estate and would love to share my buying, selling, and investing expertise with you!
I practice real estate in the following West Texas towns: Lubbock, Idalou, New Deal, New Home, Ransom Canyon, Shallowater, Slaton, and Wolfforth TX.