Owner Financing: What It Is & How It Works

Owner financing allows a buyer to purchase real estate without taking out a mortgage from a lender to buy it. The owner and buyer work out an arrangement to make installment payments directly to the owner. The payments continue until the debt is satisfied, or the buyer can secure a mortgage and complete the purchase.

In most cases, owner financing is used when the buyer is unable to secure financing for a mortgage, either due to the financial or credit history of the buyer or the condition of the property. Owner financing can be used to purchase any type of commercial real estate, from an apartment to raw land.

Like a traditional mortgage, owner financing requires legal paperwork, including promissory notes, mortgages, and trust deeds. The paperwork is standard and protects all parties involved in the transaction.

The mortgage or deed in trust provides security to the owner. They place a lien on the property and provide remedies to the owner if you default on payments. They’re filed with the local courthouse and contain a detailed description of the lien and the expectation of repayment. The filed document provides the basis for foreclosure if necessary.

Owner financing may go by other terms, including seller financing, owner carried financing, owner carryback, and owner will carry (OWC).

Potential Problem With Seller Financing

One of the biggest concerns for buyers in a seller-financing situation is if the owner has an existing loan on the property. Most mortgages are no longer assumable, such as if the buyer could just take over the obligation of paying the mortgage to the lender.

Most mortgages now have a due-on-sale clause, which means the remaining loan balance must be paid when the property is sold. If there’s an existing mortgage, you won’t receive the full title until that mortgage is satisfied.

There are some ways around this problem, using one of the types of owner financing below. However, it is strongly recommended that you consult your legal advisor before pursuing owner financing with an existing mortgage on the property.

Types of Owner Financing

The four most common types of owner financing are buying “subject to” the existing loan, wraparound mortgage, lease-purchase agreements, and land contracts.

Buying ‘Subject to’ the Existing Loan:

Buying “subject to” the existing loan is similar to assuming a mortgage. However, instead of the buyer assuming the mortgage, the original owner is still responsible for the payments. Few sellers will agree to this because it puts their credit at risk if you don’t pay.

Wraparound Mortgage

Creates a loan big enough to pay the existing loan and any additional equity in the property. The buyer makes a larger payment to the seller, who then, in turn, pays the underlying mortgage. The risk is you could be held responsible if the seller doesn’t pay the underlying loan. In some states, this is referred to as an all-inclusive trust deed.

Lease-Purchase Agreements

A lease-purchase agreement allows the buyer to make payments to the owner until the buyer can secure a mortgage to satisfy the remaining amount of the purchase. It is a rent-to-own scenario where the owner will offer an equitable title to the buyer until the buyer can get a mortgage to pay off the remaining balance owed. Then, the owner will transfer the full title to the buyer.

Land Contracts

A land contract is an agreement that requires the buyer to make installment payments to the seller for the use of the land. As in a lease-purchase agreement, an equitable title is given to the buyer, with the full title transferred once the land contract is satisfied. This happens when the final payment is made to the owner or when the buyer can get a mortgage to pay off the rest of what is owed to the owner.

Buyer Pros and Cons to Owner Financing

Pros:

• Helps buyers who can’t get a mortgage: Whether due to the credit and financial history of the buyer or the condition of the property, seller financing can allow a buyer to purchase a property without qualifying for a traditional mortgage.
• Terms can be more flexible: Since this is an agreement with the seller and not with a lender, the terms of the agreement can be more flexible than a traditional mortgage.
• Lower closing costs and faster closing: This is especially true if the seller wants to sell the property quickly. A seller is likely to require far less in fees for closing than a lender would, and the deal can be done in a matter of days instead of weeks.

Cons:

• Foreclosure risk: If there’s an existing mortgage, the owner is responsible for making payments on the mortgage. If the owner stops paying, the lender can foreclose on the owner even if the buyer is current.
• Terms may be expensive: The seller may charge higher interest rates or shorter repayment terms because they know you can’t get financing from a lender. Be familiar with the current commercial real estate rates before beginning negotiations.
• Seller may be unwilling: In the end, the seller might decide they would rather sell to someone who can get financing to purchase the property outright instead of dealing with seller financing.

Owner Pros and Cons to Owner Financing

Pros:

• Can get the property sold faster: The process of selling through an agent and a traditional lender can take 60 days or more. An owner financing arrangement can be closed in a matter of days.
• Can get a higher price: Since you have leverage on the buyer because you’re financing the sale yourself, you can get a higher asking price.
• Can generate interest income: You’ll likely charge a higher interest rate than a lender would, so you can generate interest income.

Cons:

• You don’t get all the cash upfront: Because the sale includes the buyer making payments toward the purchase instead of getting a loan to pay you a lump sum, you don’t get that instant influx of cash.
• You’re responsible for existing mortgages: If the buyer decides to stop paying, the owner is still responsible for paying the mortgage. The owner’s credit can be damaged if the buyer stops paying.
• Could risk having too many mortgages: If you attempt to sell three or more properties, you’ll be expected to obtain a mortgage originator’s license due to the Dodd-Frank Act. This limits the number of owner financing opportunities available.

Example of Seller Financing Terms

Not only will the terms above need to be negotiated, but also which party is going to pay property taxes. Typically, the seller will pay property taxes monthly to the buyer, who will then pay them either annually or semi-annually. Also, if there’s an existing mortgage on the property, it’s possible that part of the monthly mortgage payment is an escrow that covers taxes and insurance.

This is why it’s critical to work with your legal advisor when going through the negotiation process. It’s also good to know the steps involved with getting any small business loan. Many of those same steps will be needed in owner financing.

Bottom Line

Any type of investment property financing can be complicated and sometimes difficult to obtain. Owner financing can be a good option for buyers who cannot qualify for a traditional commercial mortgage loan due to financial or credit issues or because of the type of property being purchased. Owner financing can be very complicated, and it shouldn’t be attempted without legal advice on both sides of the transaction. We strongly recommend that you explore every possible commercial real estate loan option before settling for owner financing.