Owner financing, should you consider it?
With banks lending practices becoming more stringent, successful investors looking to sell a home are turning to owner financing. Selling a property with owner financing is best for an investors whose goals are to collect monthly cash flow.
Owner Financing | How does it work?
Owner financing is when the seller agrees to sell the property in exchange for a note where the buyer promises to pay back according to the agreed upon terms and pledges the property as collateral for the loan. Since only two parties are involved, the terms are generally more flexible and the closings much quicker than with a conventional loan. The following would be an example of a typical owner finance terms:
- 1-5% owner finance fee
- Initial down payment of at least 10% of the sale price
- Fully amortized 30 year loan
- term with balloon in 24 -120 months
- Interest rate of 8 to 12%.
As you can see by the balloon period, the ultimate goal of owner financing for the owner is to be able to get the end buyer short term financing until the end buyer is able to refinance, paying out the seller in ful. The combination of a considerable down payment, a balloon, and a higher than average interest rate should motivate the end buyer to refinance as quickly as they are able.
Seller Financing | Advantages & Disadvantages to the Seller
As stated above, this strategy is beneficial to a seller who can afford to wait 5 years for their equity and is looking to looking to earn a monthly positive return on their money (8-12% is better than any bank account) without the hassle and responsibilities of becoming a landlord. When owner financing, the seller is paid 3 times: the down payment, the monthly cash flow, and the equity when the property is refinanced. Owner financing properties is much easier to manage. Since the buyer has invested a down payment much greater than a deposit for a rental and since they do have the deed to the property, they will take care of the much better than a renter would. Plus they are responsible for all repairs. Finally, the end buyer pays all taxes & insurance on the property. As such, with owner financing, the seller is able to charge a collect monthly income with less costs, risk, and hassle than a typical landlord.
The disadvantages of this strategy for the seller is that they are not paid the equity up front. Also, there is still a chance that the end buyer may still default on the loan, during which time no income is collected. Plus other costs of foreclosures can become expensive as well. Finally, if the buyer defaults and left the property in need of repairs, it will be the seller’s responsibility to repair, which again, could be expensive.
Owner Financing Notes| Advantages & Disadvantages to the Seller
Purchasing a property with owner financing in place may be the only way an end buyer is able to achieve the dream of home ownership. Plus, it is ultimately easier to refinance a property that they have been living in and making payments on than it is to obtain new financing. In fact, this is a good reason to be paying the higher than market average on an interest rate. If you can show 2 years worth of payment history on an 8% loan, it stands to reason that you could pay back a 5% loan to the bank even easier, improving your chances on a refinance. Plus, the closing costs of both the original owner financed transaction plus the eventual refinance will still be lower than the closing costs of obtaining a conventional loan. Finally, since there is a note with a fixed price in place, should the property value appreciate over the course of 5 years, then that equity belongs to the end buyer.
The disadvantages of owner financing for the end buyer is that the interest rates are higher than conventional loans in order for the owner to offset the risks. However, if this transaction eliminates the need for Private Mortgage Insurance, then monthly payments may end up about the same anyways. As an end buyer, you will need to make the determination as to whether or not a higher monthly payment for 1-3 years is worth the ability to own your dream home. Finally, if you unable to improve your credit score or refinance for whatever reason within the balloon period, then you will lose the property and as well as the non-refundable down payment you invested. Therefore, it is important that you work with a credit repair agency or avoid changing jobs during the time you are owner financing the property.
Owner Financing Contracts| Conclusion
Owner financing is gaining popularity in todays economy because this strategy offers a larger buyer pool for sellers and give buyers who are otherwise ‘un-loanable’ in the eyes of the banks a chance at a piece of the American dream of home ownership. The seller considering this strategy should make sure that they can afford to wait for the equity and are comfortable collecting only monthly cash flow for the period of the note. The end buyer should see how close they are to being able to qualify for conventional financing and commit to a plan to improve whatever deficiency is preventing them from bank financing. While this strategy has some risks for both parties, overall, owner financing can lead to a mutually beneficial real estate transaction that otherwise would not have occurred.