The Pros & Cons Of Seller Financing & Is Owner Financing Safe?
I was standing with Julie. We were in the living room of her 3-bedroom rental property, discussing options to help her sell this house. This was the house she thought would produce income to help her take care of her son. Her son had autism, and she decided to buy rentals to create income and flexibility to take care of him. She found that owning rentals was hard, and she was having trouble getting it to cash flow. She had other rentals, too, and thought she might start defaulting on loans if she did not sell them fast!
I ended up buying two rentals from her with owner financing. This strategy took much of the risk out of her rentals and provided some much-needed relief. I was able to add two rentals to my portfolio with nothing down and no bank qualifying. This was a perfect win-win situation.
What Is Owner Financing?
Owner financing can mean many different things, but at its core, it is simple. Owner financing is when the owner of a home participates in financing the buyer. It could be a free and clear home, and owner financing is the only financing in place. It could also be the owner carries a much smaller loan, and the buyer combines that with a new loan from a bank. In most cases, when a seller holds a loan, the buyer will make the payment to them to produce some much-needed cash flow, without the headache of owning the house. The beauty of owner financing is its flexibility. Anything is possible when a buyer and seller are both flexible and creative. It is this flexibility that makes owner financing attractive to buyers and sellers.
I was recently the seller on an owner financing deal in Branson, MO. It was a small hotel that I purchased with the intent to turn it into apartments. I ran into one snag after another and eventually gave up. The city was going to force me to operate it as a hotel, which in this case, was mostly a cash business with high taxes. Since I do not live in Branson, I had to hire property management. Trusting someone else to collect cash payments month after month seemed to be a mistake. Although I cannot prove anything, I have a good idea, and not all the rent was accounted for. Between that and sales tax charged to hotels, I was losing money. This is a deal for someone much more familiar with hotels and maybe someone local that can run it themselves. I ended up finding a buyer on Facebook of all places and financed it for them. This was a smaller deal, and I owned it free and clear. After some negotiations, I accepted a down payment, and we wrote a note at 8% interest for the balance. The note was interest only with monthly payments and a maturity of five years. I was able to turn a property that was losing me money into a cash flowing note. Oh, and the down payment? It was not cash; it was a vacant lot on a lake in New Mexico.
The Different Types Of Owner Financing
Because of its flexibility, there are many different ways an owner can finance a property. Here are a few of the more common.
This is by far the most common owner financing strategy that you will see. This is exactly what I did at the hotel in Branson. The buyer signed a note, and we secured the note with a mortgage. If, for some reason, the buyer defaults, the seller can foreclose on the property and repossess it. This helps keep the seller safe. I accepted a down payment in my specific example, and the buyer borrowed the rest from me. That means he did not need to go to a bank or traditional lender at all. And since he gave up his lot in New Mexico, he did not have any cash down payment.
Another example of a note and mortgage that you will come across is a seller-carry second. This is when the buyer gets a new loan from a bank or more traditional lender but does not have enough cash to cover the down payment balance. The seller can carry a much smaller loan in this example and secure it with a mortgage but would be in a second or junior position to the bank. If there is a default, the seller does have rights to the property but needs to be sure the bank is paid off. This situation is widespread with commercial real estate as banks are less concerned with down payments as long as their loan is safe. It is riskier for the seller because they would need to come up with a lot of cash to pay off the bank if they wanted to repossess the property.
Land Contracts are much more complicated but are creative, which can help buyers and sellers. Land Contracts, also known as Contracts for Deed, are often used to finance property when there is already a loan in place. The agreement’s concept is that the buyer will make regular payments on a contract, and at the end of the contract, will receive the deed to the house. Although not technically on the title, the buyer will have all the same rights as an owner. They will be able to make changes to the house, they can lease it out, they can sell it, and they will get the tax benefits of the owner. The Seller will be giving up all his or her ownership rights but will own the contract with regular payments. It is common in these agreements for the buyer to make payments on the contract directly to the seller, and then the seller is then responsible for making payments on any other loans in place.
Because there is no mortgage or deed of trust, the repossession process is more challenging. This creates more risk for the seller because it is harder to foreclose. The process to foreclose is litigation. The seller will most likely be successful, but it will take time and money. If the seller has their own loan, they would be expected to keep that loan current even if they do not get payments from the buyer on the deed contract. This can be a fantastic strategy both as a buyer and a seller, but be careful of the downside.
“Subject to” investing always gets a lot of buzz. Some of the most creative and successful investors I know choose to use this strategy when they buy. Subject to investing is similar to a Land Contract in that you are buying or selling a house that already has financing in place that you will not be paying off. Buying a home subject to is taking title to the home subject to any liens or loans already in place. Have you heard the term, “I can take over your payments”? That is a subject to deal with.
Many people believe that buying a home subject to the existing financing is illegal because it does violate a clause in almost all loan documents. But violating a clause is not a crime, and investors take title subject to existing financing all the time. The buyer’s risk is that the lender decides to call the loan due, which is their right, and the recourse of violating the due on sale clause. If this occurs, you as the buyer would need to find a way to pay off that loan, or you could lose the house. The real downside, however, is on the side of the seller. The seller remains responsible for the loan, even though they no longer own the house. If the investor defaults, it impacts the seller’s credit, not the buyer. And without proper steps taken, the seller would have no recourse against the buyer.
I have purchased multiple homes subject to the existing financing with little or no down payments and no qualifying. Each time I have done this, I have made all the payments on the loan and then sold the house or refinanced to pay off the loan and get it out of the seller’s name. Each time this was a tremendous benefit to the sellers. Julie’s two houses I purchased were both purchased subject to the existing financing.
Rent To Own
I include this as an example of owner financing, but it is not financing at all. There are huge upsides to both buying and selling houses with rent to own. Another term for rent to own is a lease option. Lease options are just as they sound. It is a lease agreement with the option to purchase the home at some point in the future. Often, a premium is paid upfront to give or receive the right to buy the house, and the price is locked in. If you have an option on a house and the value increases, your option is valuable. If the value decreases, your option is worthless, but you are not forced to buy the house either. I have done hundreds of these both as the seller and as a buyer. By far, this is my favorite owner financing strategy and how I was able to buy a house or two every month while I was in college. Check out my book for details on exactly how I did that and how you can too. www.45DayInvestor.com
Is Owner Financing Safe For Buyers?
Yes! But it would be best if you were sure it is structured correctly. For the most part, the risks with owner financing fall on the seller.
Pros For Buyers
The most significant benefit of using one of the owner finance strategies as a buyer is buying a lot of houses without needing to get bank loans. There are no guidelines for owner financing, so you can buy as many houses as you want. Depending on the seller and how you negotiate it, you probably don’t need much or any down payments or credit qualifying. These loans also do not show up on your credit report, so they will not hurt your score. Finally, since you will be limiting or eliminating bank loans, you will also save thousands in loan fees.
Cons For Buyers
It is not much, but a few cons I have seen over the years can get you if you are not careful. For example, most owner financing terms are shorter than you would get with a traditional mortgage. For example, an owner might be willing to carry a loan for you but ask that you pay it off within a specific time. If you go past the agreed time, you would be in default and could risk recourse. Some other downsides could include paying above-market interest rates or dealing with the seller if something goes wrong, like an insurance claim. Even with all this being said, the pros far exceed the cons, and with owner financing, it is really about how well you sell your ideas and what you can get the seller to agree to. The sky’s the limit.
Is Owner Financing Safe For Sellers?
Yes, but again, you need to structure it correctly. Because owner financing is far riskier for a seller, you need to be very careful with how the deal is structured. Giving someone title subject to your current loan is a hazardous proposition, for example. Most risks can be mitigated as a seller with a large enough down payment and proper documents. Unless I was doing a rent to own, which can be very safe for a seller, I always require a minimum of 10% down. I then keep that money liquid in case I need it as reserves. The last thing I want is a foreclosure with not enough reserves. Everything I try to avoid as a buyer, I require as a seller. For example, I want to qualify the buyer to be sure they can afford it and check their credit to be sure they pay their bills.
Pros For Sellers
There are huge upsides to using owner financing as a seller. I sold the hotel in Branson, a challenging deal to sell because I offered the financing. When I sell a house to a homeowner with owner financing, I can get more for the house—offering a way for a buyer to buy increases the number of buyers available. More buyers mean more money for you. It is also a massive benefit if you don’t need the cash to turn that into a stream of income at above-market rates.
Cons For Sellers
As mentioned, there are a lot of downside risks when selling with owner financing. The biggest one, and most obvious, is if the buyer defaults. Outside of rent to own, the recourse on default is foreclosure, which is a much more challenging process than an eviction. A few other cons to consider is you will lose access to the cash you would have received if you sold the home a more traditional way, and you will need to be aware of rules to stay compliant.
A Good Choice For Both Parties
Owner financing is a fantastic way to transact real estate deals. When negotiated correctly, and assuming everyone performs, it is much easier to create win-win situations. Sellers can typically get more for their property, and buyers can buy when maybe they ordinarily would not be able to. This is definitely an area of real estate investing worth considering.