What Is Owner Financing?
Owner financing refers to a transaction between individuals or companies for selling a property or business without using a bank. The seller of the property or business is financing the sale to the buyer. In most cases, the property or the business becomes the collateral for the financing. Although it is not technically a loan, the seller of the property is in a similar position to a bank in that they hold a mortgage note, collect the payments, make sure that taxes and insurance are collected, etc. In order to increase clarity in this article, we will mostly talk about real estate notes and mortgage note buyers. Most of what is written also applies to business notes. Although most people are not familiar with the term of owner financing, it is actually quite common in real estate.
Types of Owner Financing
Owner financing can take various forms, each with its own unique characteristics and benefits. Here are some common types of owner financing:
Lease-Purchase Agreement: This type of owner financing allows the buyer to lease the property from the seller with the option to purchase it in the future. During the lease period, the buyer pays rent, and a portion of this rent may be applied to the down payment. This arrangement is particularly beneficial for buyers who need time to improve their credit score or save for a larger down payment. This note is not marketable until the property is actually sold and a mortgage or deed of trust are created.
Land Contract: In a land contract, the buyer makes payments directly to the seller for the property, but the seller retains ownership until all payments are made. This type of owner financing is often used when traditional financing is not an option. It provides the buyer with immediate possession and use of the property while the seller retains legal title as security.
Wraparound Mortgage: A wraparound mortgage involves the seller’s existing mortgage being “wrapped around” by a new mortgage. The buyer makes payments to the seller, who then uses a portion of these payments to pay off the original mortgage. This type of owner financing can be advantageous when the existing mortgage has a lower interest rate than current market rates.
First Mortgage: The seller does not have any underlying loans, and sells the property to the buyer as part of a mortgage or deed of trust. This type of mortgage is the most common type of mortgage to sell to mortgage note buyers.
Second Mortgage: In this arrangement, the seller provides a second mortgage to the buyer in addition to the buyer’s primary mortgage. This can help the buyer cover the down payment or other costs associated with purchasing the property. The second mortgage typically carries a higher interest rate and shorter term than the primary mortgage.
When To Use Owner Financing and Down Payment Considerations
Owner financing is appropriate in many situations, including:
- Both individuals want to close quickly and avoid the hassles and expense of a bank.
- For non-conforming properties, mobile homes, or land, where a bank may be resistant to making a loan
- If the payer on the eventual note does not have a credit score or sufficient credit history to qualify with a traditional lender such as a bank or credit union.
- The seller of the property prefers to receive ongoing payments rather than a lump sum. This could be because they like receiving passive income or for tax purposes.
- Both parties can agree on terms that work best for them.
- The buyer of the property is an investor who has used up his or her allowed number of bank loans.
Owner financing may not be appropriate if:
- There is a large underlying loan on the property that the seller is paying on.
- The seller is skeptical that the buyer will be able to make timely payments, thus increasing the risk of default on the mortgage note.
- The parties cannot reach an agreement that conforms to the Dodd-Frank Act or local laws.
Owner Financing Example
Sally has lived in her house on Main Street for many years and now owns the property free and clear (meaning no mortgage note exists). She wants to move to another state and does not want to mess with renting out the Main Street property. Beth really likes the house and tells Sally that she would like to buy it. Unfortunately, Beth had some past medical bills that negatively affected her credit, so she could not get a bank loan. She asks Sally whether she would agree to owner finance the house, and Sally agrees to do so. The two negotiate the terms of the sale and decide upon these terms, including the monthly payments Beth will make.
| SALE PRICE | $250,000 |
| DOWN PAYMENT | $50,000 |
| ORIGINAL NOTE AMOUNT | $200,000 |
| TERMS OF NOTE | 5% over 20 years |
| MONTHLY PAYMENT AMOUNT | $1319.91 |
| 1ST PAYMENT DUE DATE | July 1 |
Sally has her attorney create the real estate note, which includes the above terms, any grace period for payments, what happens in case of default, paying for insurance and property taxes, etc. The attorney would also create the deed of trust or mortgage, prepare a closing statement, and set up other related documents. Sally and Beth would be wise to also have a title company prepare a title policy and record the mortgage.
Once all of the documents are completed and signed, Beth would be able to move into the house. She would make her first payment on July 1, and on the first of every month thereafter until the note is completely paid off. Once those payments have started coming in, Sally would have the option of trying to sell her note to a note buyer.
Common Mortgage Note Terms
Below is a list of some commonly used terms in owner financing, and the optimal use of each.
SALES PRICE is self-descriptive, and is simply the price of the property that the two parties agreed to. This amount would usually be close to the property value that an independent appraiser would come up with.
DOWN PAYMENT is the amount in cash that the property buyer gives the seller. Ideally, the amount would be at least 10% of the sales price for an owner-occupied house. For other property types or for payers with poor credit, the seller should try to get at least 15-20%.
ORIGINAL NOTE is the original amount owed and, unless there are multiple liens, equals the sales price minus the down payment. For an amortizing note (not interest-only), the note balance would decrease with each payment made.
NOTE TERM is the amount of time from when the first payment is made until the note should be paid off. For instance, the mortgage note could have a 15-year or 30-year term, or there could be a balloon payment due after a certain number of years. Everything else being equal, a note buyer would value a note with a shorter remaining term to be more valuable.
INTEREST RATE is the rate charged by the seller to the buyer. The rate is often higher than a bank rate to reflect the risk being taken on by the seller. Depending on the property type, normal rates at the time of this writing would be 4-9%.
MONTHLY PAYMENT AMOUNT reflects the combined principal and interest payment that is due each month. As with most loan types, the majority of the initial payments go toward interest, though that mix changes over time. If the seller is escrowing taxes and insurance for the buyer, that incremental amount would also get paid each month by the buyer.
THE SELLER is the person that previously owned the property and is now selling it. This person is also referred to as the mortgagee.
THE BUYER is the person acquiring the property and who will be making the payments each month. This person is the mortgagor.
DEED OF TRUST OR MORTGAGE are the documents that make the property collateral for the note. Although the buyer owns the property when the initial documents are signed, the seller has the right to take the property back in case the buyer defaults. The seller would take back the property via a deed in lieu or through the legal proceedings of foreclosure. For the latter, the seller must go through specific steps and timelines to conform to state laws.
THE MORTGAGE NOTE is known by various names such as the real estate note, deed of trust note, promissory note, installment note, straight note, or simply the note. As stated above, it documents the requirements for the buyer to make the payments.
CONTRACT FOR DEED is allowed in certain states but is used less than in the past. It is similar to a mortgage or deed of trust except that title to the property does not pass from the seller to the buyer until the note is completely paid off.
Structuring a Seller Financing Deal
Structuring a seller financing deal requires careful consideration of several factors to ensure a fair and beneficial arrangement for both parties. Here are some key considerations:
Purchase Price: The purchase price should reflect the fair market value of the property. Both parties should agree on a price that is competitive and reasonable, taking into account the property’s condition, location, and market trends.
Down Payment: A substantial down payment is crucial as it demonstrates the buyer’s commitment to the purchase and provides a financial cushion in case of default. Typically, a down payment of at least 10-20% of the purchase price is recommended, depending on the buyer’s creditworthiness and the property type.
Interest Rate: The interest rate should be competitive with traditional financing options while also reflecting the seller’s risk. It’s common for the interest rate in a seller financing deal to be slightly higher than that of a traditional mortgage, compensating the seller for the increased risk and lack of liquidity.
Repayment Terms: Clear and detailed repayment terms are essential. These should include the monthly payment amount, due dates, grace periods, and any penalties for late payments. Additionally, provisions for default and prepayment should be outlined to protect both parties. For instance, the agreement might specify what happens if the buyer defaults, such as the seller’s right to foreclose on the property.
Owner Financing vs Traditional Loans
Owner financing and traditional loans each have their own set of advantages and disadvantages. Understanding these differences can help buyers and sellers make informed decisions.
Owner Financing:
Advantages: Owner financing offers flexibility in terms, which can be tailored to meet the needs of both parties. It can attract a wider pool of buyers, especially those who may not qualify for traditional loans. Additionally, sellers can potentially earn higher interest rates compared to traditional investments.
Disadvantages: There is a risk of buyer default, which can lead to foreclosure and potential legal complications. Sellers are also responsible for ensuring that property taxes and insurance payments are up to date. Moreover, sellers need to be familiar with and comply with relevant laws and regulations.
Traditional Loans:
Advantages: Traditional loans typically offer lower interest rates and more predictable repayment terms. They also pose less risk to the seller, as the lender assumes the risk of default. Additionally, traditional loans often come with professional oversight and regulatory compliance.
Disadvantages: These loans have stricter qualification requirements, which can exclude some buyers. They also involve higher fees and closing costs and offer less flexibility in terms.
Owner Financing – Advantages and Disadvantages
Owner financing is an excellent method of financing when used correctly and in the right situations. Below are general advantages and disadvantages for each person:
Seller Advantages
- Opens up the pool of potential buyers to a higher level.
- Quicker and cheaper than using banks.
- Beyond the sales price, the seller can collect passive income over a period of time.
- The seller may be able to defer some capital gains.
- The seller has future options to sell all or part of the note if a lump sum is needed fast.
- The transaction can be set up the way that the seller wants rather than bending to bank guidelines.
Seller Disadvantages
The highest risk to the seller is the buyer defaulting on the note. In addition, there is some risk in whether the payer maintains the property and keeps up with the obligations shown below.
At least annually, the seller will need to check to make sure that the property taxes and insurance are kept up to date. Defaulted property taxes can result in the mortgage or deed of trust being put in a junior lien position. Except for land sales, fire insurance is needed to make sure that the seller is protected in case the house or building burns down. Other types of insurance may be needed, depending on the type of property and where it is located.
The seller will need to understand and conform to the Dodd-Frank Act and other laws to ensure that the lien in enforceable.
Buyer Advantages
- The buyer is able to acquire a property that might otherwise not be an option
- The buyer has some say in the terms of the note so that it works in with their financial situation
- Also gets to enjoy fewer closing costs and a quicker close to the transaction
- In case of financial problems, the seller may be more lenient with late or missed payments
Buyer Disadvantages
- The interest rate may be higher than that of a conventional bank loan
- If the seller owes money on the property, the buyer will need to make sure that those loans are kept current in order to protect the property from other lienholders.
Regulatory Compliance and Disclosure
Owner financing is subject to various regulations and disclosure requirements to protect both parties involved. Here are some key regulations to be aware of:
Truth in Lending Act (TILA): This federal law requires lenders to disclose the terms and conditions of the loan, including the interest rate, fees, and repayment terms. The goal is to ensure that borrowers are fully informed about the cost of credit.
Real Estate Settlement Procedures Act (RESPA): RESPA mandates that lenders provide clear and detailed information about the costs and terms of the loan. This includes disclosing any fees, the interest rate, and the repayment schedule. RESPA aims to protect consumers by eliminating kickbacks and referral fees that can increase the cost of settlement services.
State and Local Regulations: In addition to federal laws, state and local regulations may impose additional disclosure requirements and compliance obligations. These can include usury laws, which cap the interest rate that can be charged, and consumer protection laws that safeguard against predatory lending practices.
It is essential for both buyers and sellers to understand these regulations and ensure compliance when structuring an owner financing deal. Consulting with a real estate attorney or financial advisor can help navigate these legal requirements and avoid potential pitfalls.
When To Sell A Note
People use owner financing to sell properties for a variety of reasons. Sometimes, they had preferred to use owner financing in order to get passive income and enjoy some of the other advantages shown earlier in this article. More often, they would have preferred to get all cash, but owner financing was the best way to sell the property. In either event, life’s circumstances can change, and the note holder (seller) may have different needs after a few months or years.
A good reason for the seller to keep the note is if he or she likes getting the monthly passive income and has the time and knowledge to check on property taxes, insurance, property upkeep, and late payments.
The note holder could decide to sell the mortgage note for any number of reasons, including:
- Paying off debts
- New business or investment opportunities
- Elderly note holders recognize that it is easier for their heirs to share a lump sum rather than sharing payments each month
- Putting kids through college
- Tired of chasing down the buyer to collect payments each month or to meet their other obligations
- A desire to simplify their life
Choosing a Note Buyer
Once the decision has been made to sell the mortgage note, the note holder will want to choose the best note buyer. Because there is a lot of money involved and because most people don’t sell more than one note in their lifetime, it is critically important to select the right note buyer.
Here are some key items to look for in order to get the best note buyer:
- They should have been working full time in the note buying business for at least five years. This assures you that they have the experience and competence to help you.
- Check with the Better Business Bureau (bbb.org), Google, or other reputable sites to be sure that the note buyer has a high score and positive reviews.
- Do an online search of the company to see if they have been accused of fraud or any unethical behaviors.
- Find out whether the mortgage note buyer is a licensed real estate broker in at least one state. While most states don’t require a license to buy or broker notes, the license indicates a higher level of competence and commitment to the industry.
- Trust your own gut. When you talk with the other person on the phone, do they seem to know what they are talking about, do you feel like you can trust them, and do they seem customer-service oriente
The Process For Selling A Note
The two toughest decisions have now been made – you made the decision to sell the note and you chose an excellent note buyer. That note buyer should explain the note selling process and the normal steps.
- First, you will provide the note buying company information about the property and the note, as well as a copy of the note.
- The note buyer will tell you their offer price to buy the note. Be aware that notes are almost always purchased at a discount – meaning that you will receive less than the current note balance. The amount of the discount depends upon their perceived risk of the note. Factors that enter into the risk calculation are the property type, the payer’s credit score, the terms of the note, and the payment history.
- Once you have agreed to the price, the mortgage note buyer will ask for copies of some other documents and your signature on a written agreement. Do not send originals of any document at this point. If a note buyer demands the originals, find a different company.
- The underwriter at the note buying company will quickly review the documents, and order a drive-by appraisal by a company that is local to the property. This step generally takes 1-2 weeks.
- Once the appraisal is received and approved, the note buying company will ask a title company to provide a title search. This also takes 1-2 weeks. In most cases, the note buyer pays for the appraisal, title, and any normal closing costs.
- Once the title commitment is received and approved, the note buyer will ask you to sign documents for assigning the note. Generally, this is either done at a title company or through the mail. At this point, you will be asked to provide the original note and either the original mortgage or deed of trust.
- Once the signed documents are received, the note buyer will record the assignment with the county and wire the funds to your bank account.
From the time that you send copies of the documents (Step 3) until you receive the funds usually takes 4-5 weeks. Since the appraiser and title company are independent entities that are not controlled by the note buyer, the process can sometimes be quicker or require more time.
Alan Noblitt is the President of Seascape Capital, and has been buying notes since 2002. Mr. Noblitt is well respected in the industry, and his articles have been frequently published in numerous national and local publications. Seascape has always had an A+ rating and had positive reviews with the Better Business Bureau and other entities.
