If you’re struggling to qualify for a traditional mortgage loan, consider owner financing. Buying a home with owner financing is a relatively uncommon yet legitimate way to finance your home purchase.
With owner financing, you can work directly with the seller on a financing deal that benefits both of you.
What is owner financing?
Owner financing, also known as seller financing, is when a property owner finances a home purchase and collects loan payments like a traditional lender. With this arrangement, the buyer doesn’t need to take out a mortgage.
Seller’s financing standards are often more flexible than the home loan requirements for conventional or government-backed mortgages. However, your interest rate will likely be higher than what mortgage lenders are charging and you can expect a short-term repayment schedule (usually five to 10 years).
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How does owner financing work?
Owner financing is typically easier to obtain than a traditional mortgage. Most sellers will require you to make some kind of down payment, undergo a hard credit check, and have your income verified.
You’re free to work with the seller and negotiate the terms of the loan. For instance, if you want to purchase a $300,000 home but only have enough to cover a 10% down payment ($30,000), you can work with the seller on financing that will cover the remainder of the price.
Once you come to an agreement on the terms, you and the seller will sign a legally binding document — a promissory note — to finalize the agreement. The promissory note states that you intend to pay the seller back along with the terms of the repayment plan.
Good to know: You’ll need to make a final balloon payment — or secure a mortgage loan— at the end of your term to pay off the remaining balance of the loan and take possession of the title.
This is a significant cost that can run you tens of thousands of dollars, and if you can’t pay it off, you risk losing the home.
Different types of owner financing
There are several different contract options available when buying a home with owner financing:
- Free and clear: In this situation, the seller owns the property mortgage-free and there are zero liens on the home title. This is the ideal arrangement as it allows you to avoid many potential legal and financial troubles.
- Junior mortgage: If your first mortgage doesn’t cover the entire sales price, the seller can get a second mortgage and use the funds to help you close the financing gap. You would then pay back the seller directly.
- Wraparound mortgage: If a seller still has a mortgage balance on the home for sale, they might be able to get a wraparound mortgage. This is when a seller gets a second mortgage that covers the cost of both their new home and the remaining mortgage balance on their home for sale. Like a junior mortgage, you’ll make direct payments to the seller.
- Land contract: During the payment period of a land contract, you’ll make payments and be given “equitable title”. Equitable title allows you to enjoy the property for the time being and obtain full ownership rights in the future. Once you make the final payment, you’ll receive the legal title of the property.
- Lease-purchase agreement: A lease-purchase agreement is a rent-to-own contract that allows you to rent the property for a period of time and buy it at a later date when you qualify for a mortgage or have sufficient cash. All or part of each rental payment may apply towards the final purchase price.
Pros and cons of owner financing
Here are some of the advantages and disadvantages of pursuing owner financing for your home purchase.
Pros
- Less stringent qualifications: The credit and income requirements can be more lenient if you are a first-time homebuyer, self-employed, or don’t have enough credit.
- Lower down payment and closing costs: You might be able to put less than 20% down by opting for owner financing. And since you aren’t going through a traditional mortgage lender, you won’t have to worry about paying lender-specific costs like an origination fee or appraisal fee.
- Quick closing process: You may be able to move in sooner by forgoing the traditional mortgage process. Closing on a house can take up to seven weeks due to lender processing times, home appraisals, and more paperwork. With owner financing, you avoid all of that.
Cons
- Potentially higher interest rate: Seller financing loans may charge a higher interest rate due to the more lenient qualifications.
- Shorter repayment schedule: Most owner-financing arrangements have shorter terms — between five to 10 years — resulting in high monthly payments. On top of that, you’ll need to make a lump-sum balloon payment at the end of the term or secure a mortgage to cover the remaining balance.
- Risk of foreclosure: The seller is responsible for making payments if the home title has a mortgage lien. If the seller defaults on their mortgage, the lender can foreclose on the property, and you risk losing your home.
Steps to take before opting for owner financing
Owner financing can be easier to qualify for and lead to a cheaper and faster closing, but you’ll need to do your due diligence to ensure it’s a good option for you. Here are the steps you should take before settling on an owner-financing arrangement.
Do your research
With owner financing, buyers may have fewer protections than with a traditional lender. As such, you’ll want to do as much research as possible before entering an owner-financing agreement.
Here are a few things you’ll want to do as a homebuyer:
- Research the neighborhood and comparable home values
- Perform a property title search to verify there are no errors or liens
- Vet the seller by performing a background check
- Perform a home inspection for necessary and future repairs
- Compare traditional mortgage rates to the owner financing rates and terms
Hire an attorney
A real estate lawyer can offer guidance throughout the seller financing process and help you resolve any legal issues you might encounter along the way. Several states even require a real estate attorney to be present at closing or review the contract before it becomes legally binding.
Your attorney can review the promissory note that the seller’s attorney drafts and verify that the terms of the loan comply with state usury laws. They can also perform a title search to look for errors and unreported liens.
Agree on a payment plan
In an owner-financing deal, you and the seller are free to negotiate the terms of the loan. These will be set out in the promissory note.
The promissory note should specify the following:
- Total loan amount
- Interest rate
- The monthly mortgage payment amount
- Schedule of payments, including the final payment due date
- Missed payment penalties
- Incidental fees (e.g., property taxes)
A written contract lets you calculate your total home loan expenses and can also help you decide if using a mortgage lender is a better option, assuming you’re able to qualify for traditional financing.
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