How Does Owner Financing Work?

Owner financing is an arrangement in which the seller agrees to act as the bank, accepting payments directly from the buyer, rather than the buyer taking out a bank loan. It helps the buyer in that qualifications are typically easier and helps the seller in that they’ll receive a monthly income.

Let’s look at it from both perspectives.

The Buyer Side of Owner Financing

In order to obtain financing from a bank, you have to have a good credit score. The Federal Reserve reports that the median credit score for mortgages taken out in 2019 is 759, whereas, the average score of US consumers is 695, which means many will not qualify. With owner financing, the owner is likely to be more flexible, providing a better opportunity for consumers with lower scores to buy. You’ll approach the homeowner and obtain credit from that person – he or she won’t give you a loan but provides credit minus any down payment that may be required. Monthly payments are made to the owner to pay off the interest and principal.

Something to keep in mind is that there is usually a fairly big down payment required as it shows that you’re a serious buyer – it’s what you stand to lose if you default. Sellers may ask anywhere from 5 to 25 percent, or even more. Of course, that’s not set in stone because unlike a bank, there is usually room for negotiation.

Buyers sign a promissory note which includes details like the total amount of the sale, the interest rate, term of the loan and schedule for repayment. The house will remain in the owner’s name, but once what is owed is completely paid off, it’s transferred to the buyer’s name. Typically it won’t be the standard 30 years, and balloon payments are often involved. With a balloon payment, either a significant chunk of the principal will be due, or more commonly, the full remaining balance will be due at some period of time before the end of the usual payback period. What that means is that when the balloon payment is due, the buyer will have to come up with a lot of cash to pay off the balance, or be eligible for a traditional mortgage loan to pay off the seller.

If you can prove to the seller that you’ll meet your obligation, owner financing can be ideal if you have financing issues like shaky credit or if you’re self-employed and have difficulty proving income.

The Seller Side of Owner Financing

Why would a seller want a buyer to make payments over time for the purchase of property rather than going the traditional route? They’ll have a much larger pool of prospective buyers, which means they’re likely to sell quicker and closing will be faster too, often in as little as two to three weeks, while closing involving conventional lenders can take as long as eight weeks. They may make significantly more money too as they collect interest rather than the bank.  If the buyer defaults, the seller keeps all the monies paid, including the down payment, as well as the home.

Some might wonder what will happen if circumstances change and the seller has owner-financed the mortgage but requires the full amount of the home price. The good news is that if you find yourself in this situation, provided the buyer has had sufficient payment history and some equity, you don’t have to continue acting as the bank, as you can sell your notes to get the money you need.