Owner Financing: Buy a House without a Bank

Is your debt to income ratio or short credit history keeping you from securing a conventional loan? Owner financing might be the solution for you. Though a viable financing strategy, owner/seller financing is often overlooked, misunderstood and mischaracterized. If you’ve read any other articles on this subject, it’s likely you don’t have the whole picture. Very few places online seem to have it right. To get the full story, we get the scoop from a real estate investor who has purchased 15 properties using this method, as well as a seller who has sold over 50 houses via owner financing.

What is Owner/ Seller Financing?

Owner financing is when the seller helps you finance the purchase of his property. Instead of getting a loan from a bank, the buyer instead makes monthly payments directly to the seller, paying gradually for the house over time. This is what typically happens in an owner-financed deal:

  1. The seller and buyer agree on financing terms such as the size of the downpayment, how much interest rate will be charged, etc. (We’ll cover the typical seller financing terms below.)
  2. The buyer works with a title insurance company to make sure the property doesn’t have debt
  3. The two parties sign a promissory note, a legally binding contract that says the buyer agrees to pay the seller the entire purchase price eventually. The buyer pledges property as security for the loan in case he fails to honor the terms of the promissory note
  4. The two parties also sign a Deed of Trust.
  5. The buyer wires over the downpayment and begins making monthly payments.

Notice that the seller isn’t actually loaning the buyer money. Instead, he is simply letting the buyer pay down the mortgage over time. Owner financing can go by a few other names. In fact, this has been a source of confusion for many readers. Owner financing is the same thing as seller carry-back financing. Rent to own is also a form of owner financing.

Owner Financing versus Rent to Own

  • What’s the difference between owner financing and rent to own?
  • In a rent to own situation, you pay rent with the understanding that at the end of the lease, you can purchase the house. However, you don’t get the deed upfront.
  • Typically, when you go to purchase the house, a portion of your rent payments can be credited to the purchase price.
  • In contrast, in an owner financed sale, you will be given the deed from the beginning. You own the house outright and only lose it if you fail to meet your payments.

Five Common Misconceptions about Owner Financing

Now that we’ve covered the basics of seller financing, let’s set the record straight and correct the most common myths that surround owner/ seller financing. All statements below can be true in some cases, but they’re not universally true. Keep this in mind. The seller can’t sell their property any other way There are lots of reasons to want to sell a property via owner financing (which we will get to shortly). This myth suggests that seller financing is the method of last resort; only properties that are otherwise unsellable are financed this way. In fact, there are many reasons a seller is incentivized to sell: it could be for tax reasons, or they want to receive interest payments, etc.

  • All owner financed properties come with balloon payments

With balloon payments, the buyer makes monthly payments for a few years. After five or seven years, the buyer must make one large payment that covers the entire value of the house. Some sellers will ask for balloon payments to quickly unlock the value of their property, but by no means is it normal or required. Many sellers prefer collecting interest on top of the principal payment. For these sellers, balloon payments defeat the entire purpose of owner financing.

  • Seller financing is offered because the buyer can’t get approved through a traditional lender

Some sellers do specifically care to buyers who can’t get bank loans. For example, Nick at Sell My San Antonio House caters exclusively to this type of buyer. Of course he makes money off of these types of transactions, but it’s more about fulfilling a need within his community: “There are a lot of good people out there who pay each and every bill on time every month, but lenders still don’t consider them creditworthy,” Nick says. “They’re stuck in rentals despite the fact that they have a stable source of income and they’re always up-to-date on all of their monthly obligations.” However, lots of creditworthy buyers choose seller financing because it enables them to truly negotiate every aspect of the loan terms.

  • Loans are short term

Many sellers finance the sale of their own property because they want to lock in a predictable income stream. As with balloon payments, a short repayment period would also defeat that purpose.

  • The interest rates are higher

It’s true that sometimes the interest rates will be higher. But Jeff, who has purchased over 15 owner financed rental properties, finds that owner financed homes are typically on par with lender financed homes. This means many buyers are only paying a 4-5% interest rate. Jeff says, “If you own a property in the middle of nowhere and an area that’s kind of a dump, high interest rates may happen. But if we’re talking about a reasonably high demand area that people actually want to live in than the assumption that you’ll pay a higher interest rate is just simply not true.”

Why It’s Good for Both Parties

If you’re willing to negotiate and compromise, owner financing can be a great fit for everyone.

Pros for Buyers:

Faster Than Working with a Bank

Banks can really hit the brakes on any real estate purchase. With them out of the equation, the process goes by more smoothly.

Qualification is Easier

In most cases, sellers are a lot easier to work with than lenders. “Sellers aren’t going to be going through your bank statements asking you about deposits,” explains Jeff. “Likewise they’re not going to ask you to fill out 700 pages of their own forms. Qualification is faster and easier with seller financing.” This is a boon to self-employed buyers or freelancers with volatile income streams. These people typically have an especially difficult getting conventional financing. Similarly, buyers with a short credit history might find that sellers are more willing to work with them than banks.

Flexible Down Payment and Loan Terms

If it’s an investment property, banks typically require 20% down. But, here again, that’s banks. With an owner financed property you can negotiate whatever down payment you want. There isn’t a norm. It is whatever the two of you can agree upon. It’s also the same with loan terms in general. Don’t want a 30 year mortgage? Rather have a 26 year one? It’s all on the table. Jeff, for example, doesn’t have a set repayment period he likes to have. It all depends on the property and what works best for him and the seller. As for Nick, he likes for the maturity date to be as long as possible because he wants the passive monthly income.

Pros for Sellers:

Passive Cash Flow

Owner financing creates consistent cash flow similar to a rental property. Unlike rentals, owner financed properties come without the normal headaches associated with managing a rental property.  “When you sell the property,” says Nick, “you’re no longer the homeowner. If a toilet breaks or a tree falls down, that’s the owner’s responsibility. Owner financing allows the investor to be more passive and frees up more of his or her time.”  

Deferred Capital Gains Tax

When you sell a property, you have to pay capital gains tax. But when the seller finances the sale of the property, he can defer taxes until the property is paid off. This is another reason that many seller’s either defer balloon payments, or don’t do them at all.

No Realtor Fees

Typically sellers have to pay 6% of the sales price to cover realtor fees. Without getting middlemen like realtors and brokers involved, sellers can save quite a bit of commission.

Disadvantages of Owner Financing

  • The disadvantages of owner financing for a seller is: without a bank collecting mortgage payments, you have to take on the collection duties.

  • If the buyer stops his payments, you’re responsible for taking legal action. And it’s not just rent collection you have to enforce.

  • Until the house is paid off, you still need to make sure the buyer keeps up with property insurance, pays taxes on the property and doesn’t violate any other terms of your agreement. You might even still be liable for any accidents that happen on the property.

  • The disadvantages of owner financing for the buyer is that there’s some room for error when you don’t know what you’re doing. You won’t have a loan officer vetting the terms of the deal. You need to make sure you work with a real estate attorney and a title insurance agency.

How to Find Seller Financed Homes

If you want to target homes where the seller is likely to agree to finance the purchase, you’ll want to specifically seek out a certain seller profile. The most important trait you are looking for is: you want to find sellers who own their house outright. According to data analytics provider ATTOM Data Solutions, over one third of all the properties in the US have no debt. We’d advise you to avoid trying to get seller-finance on properties that still have a mortgage. It ends up being riskier and more complex, for reasons we’ll cover below. Sellers who are open to owner financing are usually older, close to retirement, and (most importantly) are tired of managing properties. After decades of chasing down and doing small repairs, many people are simply burnt out of being landlords. However, they haven’t sold yet for several reasons. One reason is simply inertia. Even though they are open to selling their rental properties, they just haven’t been proactive about listing it. After all, they are collecting checks every month. Another common reason sellers don’t list their properties is because they’re not keen on paying a capital gains tax. To spot these burnt out sellers, you’ll have to get on the phone with them. Don’t jump the gun by immediately asking for seller financing. Instead, build up to the conversation by learning about the sellers. Jeff suggests to keep an ear out for the following when talking to them:

  • “I’d miss the income I get off this place.”
  • “I’m just tired of running everything.”
  • “I’m done with this property.”
  • “I’m not looking forward to the capital gains tax on this one.”
  • “If I sold I’d just be trading one responsibility for another.”
    • Or, “I’d need to do a 1031 exchange and buy something else.”

Basically, you’re listening for owner fatigue and a reluctance to part ways with the monthly income as well as pay a capital gains tax. Owner financing can assuage every one of those fears.

Owner Financed Houses for Sale

You’ll need to be proactive in sourcing and reaching out to seller. Many sellers don’t even know seller financing is an option until you ask. Great, so you know what type of seller you want to target: how do you actually go about finding them?

Craigslist

Oftentimes it’s as easy as searching on Craigslist or even noticing a yard sign. Using a combination of both is how Nick has sold most of his 50+ properties . While you’re on Craigslist, don’t forget to check out the “For Rent” section. Reaching a seller when his rental is vacant or his is in the process turnover is the peak time to reach out.

Zillow

You can also run a search on Zillow for homes sold by the owner. ‘For Sale by Owner’ is not synonymous with owner financing, but it’s a good place to start.

Use a Realtor

If you’re stumped finding owner-financed properties, you could engage a realtor to help you. You’ll likely realtor’s fee, which in turn would reduce the buyer's negotiation power. Work with a realtor to search for homes that have the following traits:

  • Homes that are currently listed for rent, but were previously listed for sale.
  • Conversely, look for homes that are listed for sale, but were previously listed for rent.
  • Homes with expired listings.
  • Homes listed for sale that aren’t occupied.
  • Homes where the owners do not live in the neighborhood

There’s a new platform called Open Listings, a competitor to Zillow, that also has a section for owner-financed deals.

Eviction Records

When better to reach a potential seller than right after he’s had to go through the onerous process of evicting a tenant. Eviction records are available through public records at your local county courthouse. Anyone can search these records. With that info, you can reach out to owners and see if they are willing to sell.

Escrow Agent

Another option is to befriend an escrow officer at a title company and ask them to run a search for you that includes such things as:

  • Zip code
  • Single-family
  • Non-owner occupied
  • Length of ownership

You’d be surprised at how willing to help you title companies are. After all, it is in their best interest because ultimately you’re bringing them business.

Direct Mail

Once an escrow officer hands you a list, it’s direct mail time.This is how Jeff makes contact with most sellers. It’s not foolproof, but you might be surprised at the hit rate. He has his own unique formula, but insists that it’s not so much about what you say as it is about what you don’t say. Do not say:

    • You’re looking for motivated sellers
    • Can offer fast closing
    • That you would buy the property ‘as-is’
    • Can give an all-cash offer
    • That there would be zero closing costs

This makes most people think you’re running a scam, and will consequently cause them to throw your letter right in the trash.

How to Structure a Seller Financed Deal

How you structure the deal depends on what you and the seller are looking for. That said, here are some benchmarks for “typical” seller-financed deals. Typical Owner Financing Terms

  • Payment Structure

    • You need to agree on financing terms. This includes deciding on whether you’ll use fixed or adjustable interest rates, fully amortized loans (where your payments would eventually pay for the house), or balloon payments.

  • Seller Financed Down Payment

    • It’s going to be difficult to negotiate the downpayment to be less than 15%. Sellers wants to see skin in the game so they are reassured you won’t walk away from payments after closing.

  • Seller Financed Interest Rate

    • Whether the interest will be higher really depends on your circumstances. If you are not creditworthy or have foreclosures in your record, then you’ll likely have to pay a higher interest rate.
    • For context, interest rates for unconventional loans are 6%-8% in 2019.
    • Dawn Rickabaugh, a CA owner-financing consultant, says she often see interest rates in the 7% to 9% range. Sellers command a premium for the additional risk they take in extending credit to you.
    • However, if you have good credit and cannot qualify for a conventional loan because you just started a new business, you will likely be able to negotiate better terms.
    • In addition, if the sellers are motivated (for example if they are tired of paying property taxes, insurance and maintenance) then you can strike a much more favorable deal.

Seller Financing Contract

For your first transaction, you’ll want to sit down with a real estate transactions lawyer to draft up the promissory note and the deed of trust. For a newbie buyer, the biggest risk is, you don’t know what you don’t know, so it’s best to involve the pros until you’ve had a few deals under your belt.

  • Promissory Note

    • You’ll outline all the financing terms in the promissory note, such as repayment amount, interest rate, down payment, consequences of nonpayment and late payment fees, what happens in the event of default, etc.

  • Deed of Trust

    • You want to make sure the seller is protected if the buyer stops making payments. The Deed of Trust gives the buyer the right to own the property after he’s made all the payments, while the actual title is transferred to a trustee.
    • This means the trustee can foreclose on the property if the buyer defaults or violates any of the terms.

  • Power of Sale

    • Many states let the seller do non-judicial foreclosure. Adding a “Power of Sale” clause in the Deed of Trust protects the seller from a costly and lengthy foreclosure process if the buyer defaults.

  • First Right of Refusal

    • The seller can actually sell your promissory note to other investors. If they do, your monthly payments would go to the note investor instead of the person who originally sold the house to you.
    • Investors will want to buy notes at a discount to face value. For example, if you have a promissory note saying you owe $200,000 on the house, the note investor might buy that for $150,000.
    • You’d save lot of money buy buying that note yourself! It would essentially mean that you only owe $150,000 for the house, nabbing you a nifty $50k in savings.
    • That’s why you want to negotiate right of first refusal into your deal. This means that if the seller finds a buyer for the note, he has to offer you the chance to buy it first (at the same discount).

Seller Financing and Dodd-Frank

In 2010, Congress passed Dodd-Frank which put safeguards on the mortgage industry by regulating lending practices. Even though you aren’t going through a bank to finance the deal, you still need to stay compliant with Dodd-Frank. This means you should observe the following terms:

  • If the interest rate is fixed, it must remain so throughout the term of the agreement.
  • If the rate is to be adjusted for inflation, it must be fixed for the first five years and may not increase more than 2% over the start-rate in any given year after that.
  • There’s also a lifetime adjustment cap that may not exceed 6 percentage points over the original rate
  • The rate cannot violate usury laws (laws that limit the amount of interest that can be charged)

The rule allows qualified owners to complete up to three owner-financed transactions per year, none of which can include a balloon payment. If you are a seller who is financing more than one transaction a year, Dodd Frank requires you verify the buyer can afford the payments by running a credit and background check.

Is Owner Financing Safe?

  • Risks to the Seller

    • The biggest risk to the seller is you end up with a flaky buyer.
    • Without loan officers vetting buyers, sellers are responsible for thoroughly vetting the buyers themselves. Does the buyer have a steady job, does his income cover the payments with room to spare, how is his credit history, has he ever been evicted, how much debt does he have etc.

  • Biggest Risk to a Buyer

    • The biggest risk to the buyer is if the owner still owes money on the property. We highly recommend you avoid owner financing on properties that still have a mortgage for a few reasons.
    • First of all, when the owner tries to transfer the title to the buyer, it can trigger a “due on sale” provision in the mortgage.
    • The lender might ask for the full balance of the mortgage. In extreme circumstances, it will try to foreclose on the property if the buyer can’t come up with the balance.
    • That’s why it’s good to work with a title company to make sure the house is completely paid off.

Owner Financing Can Be a Win-Win for Everyone

Owner financing requires you to do your homework, but if you do everyone can leave the negotiating table happy. When you make the sale exactly what you want it to be, there aren’t any cons.