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Jeffrey L. Beal, president of Real Estate Solutions, has 40 years' experience in multiple phases of the real estate industry.
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If you have few assets, a short or shaky credit history, or low credit score, you might find qualifying for a mortgage difficult — if not impossible. One solution could be owner financing, a unique arrangement that allows you to buy a home without needing to qualify for a traditional mortgage. Here’s what to know.
Owner financing, also known as creative financing, typically involves a private arrangement or agreement between the home seller and the buyer. The home seller will provide some or all of the financing directly to the buyer. Most common in transactions involving family members or parties that know each other, the arrangement can involve the full purchase price or just a portion of it.
Say a buyer is interested in a home priced at $380,000 and plans to put down $38,000, or 10 percent. Due to credit or financial circumstances, the buyer can only qualify for a mortgage up to $100,000. The seller agrees to finance the outstanding $242,000 at a fixed interest rate for 10 years, with a balloon payment (calculated at a 30-year amortization rate) for the remaining balance due after a decade.
Owner financing can take a variety of forms, including second mortgages, land contracts, rent-to-own agreements and wraparound mortgages. Each of these options has its own specific structure, but all of them involve the property owner acting as the lender.
Rather than giving the buyer a large sum of money to make the purchase, however, the seller usually extends credit, allowing the buyer to make installment payments to the owner to purchase the property. In this scenario, the seller typically retains the deed to the property until the buyer pays for it in full. However, in other cases, the buyer signs a promissory note (the promise to repay the loan) and either a mortgage or a deed of trust (which gives the seller the right to foreclose if the buyer defaults on payments). In exchange, the seller signs a deed transferring title to the buyer.
In most cases, owner financing is a short-term arrangement, lasting five to 10 years (compared to 30 years for a traditional mortgage). And in some cases, the buyer may need to make an upfront deposit.
There isn’t just one way to establish an owner financing agreement. Here are some common setups.
If the buyer only qualifies for a portion of the funds through a traditional mortgage, the seller could extend a second mortgage for the remaining financing, typically with a higher interest rate, a shorter loan term and a lump-sum balloon payment. “Typically, the seller will not hold that mortgage for longer than five or 10 years,” says Chris McDermott, real estate investor, broker and co-founder of Jax Nurses Buy Houses in Jacksonville, Fla. “After that time, the mortgage commonly comes due in the form of a balloon payment owed by the buyer.”
Learn more: What is a second mortgage?In a land contract agreement, the buyer pays the seller directly in installments and receives the deed to the property once they’ve paid the purchase price in full. This approach eliminates the expenses of closing costs and loan-related fees, making it a faster and cheaper option than a traditional mortgage.
Learn more: What is a land contract?In this arrangement, the buyer rents the home with an option to buy at a set price after a certain period of time. When using this approach, some of the monthly rent payments will be applied to the property’s final purchase price. In addition, the buyer typically needs to make an upfront deposit, which will be forfeited if they ultimately decide not to buy.
Learn more: What is rent-to-own?If a seller still has a mortgage on the home, they could offer a wraparound loan, meaning the buyer’s mortgage “wraps around” theirs. In effect, the buyer makes payments toward the seller’s mortgage. The seller can charge a higher interest rate on the wraparound and pocket the difference. In this type of arrangement, the seller must first obtain permission from their lender before proceeding.
Learn more: What is a wraparound mortgage?Owner financing can benefit buyers who aren’t eligible for a mortgage from a lender, or those who only qualify for some of the financing needed for the purchase. It also gives sellers the opportunity to earn income via interest and, in a buyer’s market, attract more offers.
Here are some scenarios when owner financing can make sense:
Owner financing offers much more flexibility for both the buyer and seller, but it’s not without risks.
For a buyer, the main advantage is they “can get a loan they otherwise could not get approved for from a bank, which can be especially beneficial to borrowers who are self-employed or have bad credit,” says Bruce Ailion, a real estate attorney, investor and Realtor with RE/MAX Town & Country in Alpharetta, Georgia.
The big downside: The terms for borrowing the funds might be less advantageous than for a mortgage. And your taking title to the property and building equity in it could be delayed.
