How Does Owner Financing Work

Have you been trying to sell yourself, and people keep asking you about “owner financing” or “seller financing”?

Or, are you just out of money right now and the only way to get the deal done is to buy it with owner financing?

Chances are, you will fall into one of these two categories.

It seems kind of scary for both people involved…primarily because it just isn’t that common.

Regardless if you are the buyer or seller, it’s not something you should fear. So, let’s dive in!

What is Owner Financing?

Owner financing is when a property owner finances the deal directly to the buyer. This often occurs when the buyer cannot afford the property, obtain financing, or is unwilling to pay the current interest rates. It also occurs when the seller cannot sell due to property condition or if the seller wants to generate long-term passive income.

Owner Financing vs Conventional Financing

Conventional loans are structured and highly regulated (especially if the lender intends to sell the note). Many self-employed buyers may not qualify for financing and many properties may not qualify as well. Additionally, most of the terms are non-negotiable and your only option is to shop for a new lender which can be time consuming and expensive.

Owner financing has a lot fewer regulations and everything is negotiable. It’s a lot easier to adjust price, interest, loan term, amortization and other terms with the seller since they are one in the same. Please seek legal advice as there are some laws and state-specific regulations involved.

How Seller Financing is Structured

There are different types of seller financing which include land contracts, lease-purchase agreement, and the typical promissory note and mortgage. In this article, we’ll focus on the most common type of seller financing structure – the promissory note and mortgage.

With this setup, the seller gives the title to the buyer and receives a mortgage and promissory note in return.

Think of it this way:

Traditionally, the seller and buyer trade the property while the bank provides the cash for the purchase and the buyer promises to pay the bank back.

With owner-financing, the seller and buyer trade the property, but instead of promising to pay the bank back, the buyer promises to pay the seller.

That’s it. That’s how seller financing works. Pretty easy, right?

The concept and structure are very easy, but it’s not the entire story. There are some risks and benefits to both the seller and buyer.

How Seller Financing Benefits the Seller

There are countless reasons why someone might choose owner financing, but here are the top 6

1. Higher sales price
2. Can sell an unmarketable property
3. Tax benefits
4. Monthly income
5. No agent fees
6. Higher interest rate

Higher Sales Price

Investors are purchasing a property and making offers based on the cash on cash return. You can read the article I just linked to for more information about it, but in general, it works like this:

In this example, the buyer invests $100,000 and gets $10k per year for income. That is 10% return.

Every investor has a goal for their returns and they make offers based on this. Here’s why owner financing lets you get a higher price.

The less the buyer invests for a down payment the higher their return!

This is why you can get full price or even higher if you seller finance.

You Can Sell an Unmarketable Property

Listing agents work on commission. Cheap properties require MORE work than expensive properties and pay less. If you were an agent, would you want to do that?

Of course not. So, if you’re having a hard time listing your property, you may want to consider seller financing.

Tax Benefits

I’m not a CPA, so please consult one.

But, typically you are taxed on capital gains the year you receive them. So, if you earn back the principal over several years, your tax burden is deferred.

Monthly Income

Many older sellers will choose owner financing because it’s kind of like getting an annuity or bond dividends but backed by the value of the property.

If you sell your property and finance it yourself, you may get…say $1000/month. You will receive this every month until the loan is paid off. It’s very stable and you don’t have to worry about market fluctuations destroying your nest-egg.

Higher Interest Rate

You can often charge above market interest rates. Since the buyers are earning more, you can charge a higher price up front and get a higher interest rate throughout the life of the loan.

How Owner Financing Benefits the Buyer

There are a lot of benefits to the buyer, but here are the top 5:

1. Flexible financing
2. Easy to qualify
3. Lower down payment
4. Lower closing costs
5. Quicker close

Flexible Financing When Financed Through the Seller

Do you want a 10-year term with 40-year amortization? Or, perhaps you want a 2-year interest only period with a 5-year term with a balloon payment at the end.

The ways to structure a private loan are endless. In fact, the seller may make adjustments on the price if the terms are favorable – for example a lower price in exchange for a higher interest rate.

Easy to Qualify

Banks are highly regulated and need to show regulators all of the risk and how they are mitigating it. Additionally, most loans need to conform to Fannie Mae lending guidelines. So, the requirements are the requirements and there is simply no way around it.

With owner financing, they may look deeper and take into account the whole picture. For example, a bank doesn’t care if your business is doing well if you took too many tax deductions you still won’t qualify. An individual can take all of this into consideration.

Lower Down Payment

Sellers often require no, or very little down payment that covers their closing costs. Typically, a seller-financed deal needs some improvements, so the new owner will do those repairs and create the equity that normally would be required when purchasing conventionally.

Cheaper Closing Costs

There will be no points, brokers fees, etc. Need I say more?

Quicker Close

Since there is no qualification period the bank can’t drag its feet. After title search and inspection, you’re ready to close.

What Are the Risks of Owner Financing?

Everything sounds so amazing, so why doesn’t everyone do it?

Well, the #1 reason most people don’t do this is that the seller needs to own it free and clear (or have a very small loan the buyer can pay off).

This eliminates 90%+ of people right away.

Of the remaining 10%, things need to work out a certain way. The seller should want long-term stable income rather than a pile of cash. Or, the seller must have a property that is not maintained well and will have a hard time selling on the open market.

On the reverse side, that seller who might be only 1 or 2% of sellers needs to find a buyer that wants to pay above market price and above market interest rates. Buyers typically only do this if they are aggressively pursuing deals and have run out of funds. Also, some newer investors will pursue this option.

If you do find the right buyer and the right seller, there are still a couple of risks. They are:

Buyer Default

The biggest risk to the seller is if a buyer defaults on the loan.

You can mitigate this risk by doing a solid background and credit check. Also, it helps to hire a 3rd party payment processor to collect and disperse payments. This way, there is less incentive to default as they know there will be a quick foreclosure if there is a problem.

Also, I think the risk of default is lower because the seller and buyer can easily renegotiate the terms should the economy collapse again. Your goal is to keep the income flowing, not repossess the property.

Illiquid capital

The biggest risk is the fact that your capital is not liquid – you cannot just sell some stock and have your cash back.

The fortunate thing is there are markets where you can trade your notes. You may have to sell it at a discount, but you should only use.

Should I Seller Finance?

Only you can answer that question. If you want to get a higher price and higher return over a long period of time, it seems like a no-brainer. If you want your cash now, then it doesn’t make sense at all.

If you’re a buyer, you should seek owner financing if you don’t have the cash available to purchase the deal, or if the seller is asking more than the value of the property.