Owner Financing: Pros and Cons for Buyers

Owner financing can be an alternative source of funding when buying a house.  It may be a way for a homebuyer to purchase property for which he is not financially qualified (fully or in part) by traditional lending institutions.  But, if a buyer is not qualified for a loan, there has to be a reason a seller is motivated to take on the role of his mortgagee (lender).

Why isn’t the property attracting buyers?  —Well, it could be that tight funding has limited the number of buyers.  It could be that the property is overpriced or in poor condition.  (So, no interested, qualified buyers.)  Or, it could be that everything is fine and this owner wants a long-term income.  Regardless the owner’s reason, if you are considering this type of financing, you—the buyer—need to research the property for suitability and then decide if a private arrangement will work for you.

Here are some things to consider—both pros and cons.

I’ve already mentioned that the seller might be asking an exorbitant price for the property, perhaps relative to its location or condition.   (Note: It might not be you, but rather the property, that disqualifies traditional financing.)  Also, the owner may require a large down payment.  Or, the interest rate may be higher than that of a conventional mortgage.  (That may be the seller’s way of getting an equivalent to money that lending institutions charge as fees associated with mortgage loans.)  Monthly payments may be high. And often, owner financing is short-term (possibly, a few years) with a balloon payment due at the end of the contract.  Many buyers must be prepared to refinance.  (At that point their financial profile and the property must be conducive to qualifying for a traditional mortgage.)

With reference to the above:  In my last post I said that owner financing could be useful to a potential buyer with a less than desirable financial history—a history making him unlikely to qualify for conventional funding.  “History” is key here.  Entering into a sensitive financial contract, like a mortgage, while in the throes personal economic crisis (and given this type of financing, it is occasionally possible to do so) promotes disaster.  Homeowners always encounter unforeseen circumstances requiring the outlay of money—financial stability is imperative.

One risk deserves great consideration:  There are some forms of seller financing in which the seller remains financially responsible to a lending institution for the property. (Wrap, combo financing and, possibly, option financing are among these.) You—the buyer—make payments to the seller and he makes his mortgage payments.  But what happens if he doesn’t?  If he defaults, you could lose the property and everything you have invested in it.

A buyer does need to protect himself as much as possible.  As with other major financial commitments, it is wise to have a legal representative advising you as the terms of the contract are determined.  Most sellers do.

There are also a number of positives for the buyer to consider.  Right away you’ll notice that a few seem to be (almost) the flip-side to some of the issues requiring cautious regard.  —Many aspects of this financing have to do with the seller’s motivation.  Some sellers are actually predatory.  They find buyer after buyer who will not be able to sustain the contract and so, repossess and resell their property a number of times.  These people are unscrupulous, but as you are dealing in a private sector—owner financing— there are few regulations to enforce ethics.  Thankfully, most owners are interested in a successful sale.

If you are dealing with a well-motivated seller, you may be able to purchase a desired property for which a lending institution won’t qualify you.  (The issue of qualifying is complex.  Above, I said that sometimes the price, condition, or location of the property prohibits qualifying.  As another example:  Your finances may be quite sound.  Even so, because you recently married, divorced, changed jobs—and the list goes on—banks may refuse to qualify you for a mortgage loan; they don’t like change.)

Negotiations with the seller eliminate the need to shop around for the best deal.  This and other aspects can save some time:  Conventional lenders often take awhile to have the property researched for a clear title.  You can do this yourself and save time.  (Again, you would be wise to have knowledgeable legal counsel to guide you.)  Dealing directly with the seller may be speed up closing—and moving in before closing may not be an issue.

With owner financing you will avoid many of the fees associated with a mortgage from a conventional lender.   It’s also likely you will have considerably more input on the terms of the contract.  Down payment, interest rate, monthly payments, duration of the loan, even a resale clause are among the terms that can be negotiated.  Some of these can result in significant liberties and savings:  A private seller is not bound by “company policy” nor tied to a financial index.  You may even find a seller who is willing give you a discount should you do an early payoff.  (Banks frequently charge a fee for this.)

Most sellers doing private financing are not credit bureau subscribers.  (Subscription fees are quite high.)  This means they cannot make as comprehensive a check into your finances and personal history as a bank; you will be able to maintain a greater level of privacy.  They may, however, ask you for references and to provide a copy of your financial report.  Another aspect of this is that your payments will not be reported:  Owner financing will do little to help you build a positive financial profile.  On the other hand, should you encounter financial hardship during the course of your contract, a motivated seller might be more responsive than a bank to concessions and renegotiation.  And again, it would be a private matter and at least mitigate the effect on your credit standing.

It is important to be financially prepared to buy a house.  It is also important to realize that finances are not the only factor involved when qualifying for a mortgage.  —And, to realize that not qualifying does not mean financing is not available.  Owner financing is not common.  But with patience and persistence, it’s possible you will find a suitable property and a motivated seller.

Owner Financing

Owner financing can be an alternative to a bank loan when you are buying a house.  Even when mortgage money is tight—either because of a falling economy or because of a poor credit history—there are owners who are willing to “carry back” a part of the purchase price to facilitate the sale of their property.

The term “owner or seller carryback” refers to the seller of a property being willing to finance (in part or whole) the purchase price of the offered property.  Typically, this is not a monetary loan.  Also, in some of these arrangements, the seller does not receive full payment at once—but the property is his security.  Instead, the seller extends credit to the buyer and is paid back with interest.  Both parties sign a promissory note stating the sales agreement and payment terms; many terms of these can be negotiated, including down payment, interest rate, and length of contract.  Then, the agreement has to be filed with public records—usually as a trust deed, mortgage, or land contract.

A seller can be involved with financing either pre or post closing. There are 8 common forms of owner financing.  Four involve a financial accord after closing and four before closing.

Post-closing types include:

Free and Clear Financing:  If the seller owns the property free of any encumbrances (no mortgage or other liens), the buyer and seller negotiate all terms.

Equity Only Financing:  When there is a mortgage or other lien in place against the property, the seller may not be free to finance anything but his own equity.  In this case the buyer must pay off the seller’s outstanding balance(s) at closing—usually by obtaining new financing.

Wrap Financing:  Sometimes, when the seller is still involved with a lending institution, he is allowed to do what amounts to passing along funds from the buyer.  In this case the buyer makes payments to the seller.  The seller (who might not have much equity in the property) remains responsible to pay his financial obligation on the property—usually a lesser amount than that received from the buyer.  The seller seems to continue to build equity in the property, but just as he passes payment to his mortgagee, the equity (essentially) passes to the buyer.  This type of financing is also known as “blanket,”  “issue to,” or “subject to.”

Combo Seller Financing:  If the seller has some amount of equity, but is still encumbered, he may generate what amounts to two loans to the buyer.  One loan finances the equity purchase, the other is wrap financing.  The terms (interest rates, payment schedule, duration, etc.) of each loan would be independent of the other.  Literally, this is a combination of equity only financing and wrap financing

The following four types of owner financing are in effect prior to closing:

Purchase Option:  In this form of owner financing the buyer and seller have an agreement (usually accompanied by an “option fee,” paid by the buyer) that locks in the purchase price—sometimes discounted—for a designated period of time.  If within that time period the buyer does not go through with the purchase, he is released from any obligation to buy (but the option fee is not refunded).  In the interim the seller remains financially responsible in full for the property.  Buyers, who have not prearranged funding, often find the Purchase Option useful.  —The “Rent to Own” arrangement is a well-known form of the Purchase Option.

Extended Closing:  This is similar to a purchase option, but more terms of the sale may be defined—one of them being an extended deadline for closing.  (Frequently, this gives the buyer time to sell a piece of property or terminate a lease.)  The arrangement is formalized with a Real Estate Purchase Contract.  Often a fee (basically, “Earnest Money”) is required of the buyer.  If this is the case, under certain circumstances, detailed in the REPC, that fee can be refunded if the sale does not go through.

Open–ended Closing:  This type of owner financing also involves a Real Estate Purchase Contract.  One of the terms on which the closing depends is a future event—often, something for which the seller is responsible—like the completion of a remodeling project.

Seller Partnerships:  In this arrangement “sweat equity” on the part of the buyer is an essential component.  Depending on the terms of the contract the seller may or may not actually transfer ownership to the buyer.  Either way, he retains financial interest in the property.  As in any partnership both parties contribute:  The seller contributes the property and possibly funds to improve it.  The buyer might also contribute financially, but his major role is to do “clean up/fix up”—to enhance the value and salability.  The buyer then refinances or sells the property.  At the closing the original owner receives his equity payment and is reimbursed for any capital contributed.  Profit is split according to the terms of the partnership agreement.

I began this post saying owner financing could benefit a buyer having a difficult time securing a mortgage from a traditional lender.  This does not mean that most sellers are particularly amiable to these arrangements.  They need to benefit also.  In my next post I’ll address the pros and cons of this type of financing

Mortgages

In my last few posts I’ve presented information about the traditional mortgage and adjustable rate mortgage:  The traditional mortgage is the most popular way to finance buying a house in the United States. An adjustable rate mortgage has features beneficial to someone with a fluctuating income.  (Those same features can turn detrimental if the homebuyer is not prepared to make payments that grow larger over the life of the mortgage.)

Compared to the traditional mortgage, an adjustable rate mortgage is creative financing—but it is acquired through traditional lenders, like banks.  A tight economy (or a less than appealing financial history) makes obtaining a mortgage from those sources difficult.  But, it may not be impossible to find financing.

Earlier in this series I brought up owner financing as an alternative to obtaining a mortgage from a traditional lender.  My next post will address ways motivated sellers provide funding in lieu of or in addition to a mortgage.

Owner Finance

Adjustable Rate Mortgage

The adjustable rate mortgage (ARM) is worth more than one post.  I last wrote that its great draw—a low initial interest rate—can be worked to a homebuyer’s advantage,  But, I spent more time explaining how the interest rate, being variable, can also be a pitfall.

There are some other features about this type of loan that have a double-edge.

You often hear an ARM called an option mortgage.  The option refers to the type of monthly payment you choose.  Lenders will offer several choices:

1)      Interest only

2)      Minimum payment

3)      Fully amortized

Only the fully amortized option (usually set up for 30 or 15 years) is designed for you to actually pay off the principal of the loan.  (Amortization is the gradual paying off a loan over a scheduled period of time.)  This involves paying back a designated portion of your principal along with all interest accrued each month.  (Paying against the loan principle gives you value—equity—in your property.)  Payment amounts will vary according to your current interest rate.  Also, if you opt (often or even occasionally) to use either of the other payment methods, the amount you pay against the principal will have to be refigured to keep your payoff on schedule.

—Yes, with this type of mortgage you can change your payment type from month to month.  But, the consequence of regularly using the interest only and the minimum payment options of an adjustable rate mortgage is that little or no equity is accrued and negative amortization is possible.  (Negative amortization is an increase in the unpaid balance of loan principal.  This contrasts with equity, which is an increase in the value you actually hold in your property as you pay off the principal. )

Consider:

1)   If interest only payments are made, nothing happens to diminish the principal.    

If this is your practice for the life of the loan, the whole of the principal will be due at the end.

2)   A minimum monthly payment is set in the mortgage contract.  Given that the  

      interest rate will vary, it’s quite likely that making minimum payments will

      not cover the interest owed at any current time, much less reduce the

      principal.  When this happens the monthly excess is added to the principal.  At

      the conclusion of the contract you could owe more money than you originally

      borrowed.

Lenders see a risk of not recouping principal in both these scenarios.  Limits may be set as to how long into the life of the loan these options are available.  However, if you—the borrower—choose to use these payment options, you need to be financially prepared at some point in time to assume fully amortized payments or to make what could be an extremely large payment at the end your contract (a balloon payment).

Paying off a mortgage is a long-term endeavor.  During that time, the status of both your personal finances and the general economy can fluctuate.  Most people, being familiar with charges that are fairly uniform, adjust their whole lifestyle to accommodate financial cycles and continue making payments.  An ARM may allow a homebuyer the luxury downsizing what is likely to be his largest payment—the house payment.  Frequent use of the interest only or minimum payment options can mask serious, deteriorating financial issues that will have to be addressed before the end of the mortgage contract.

The variable (and likely, rising) interest rate of an ARM along with the payment options feature can add to the challenge of successfully buying a house.  However, if you buy property with the intent of a quick resale (and therefore, are unlikely to be long in the mortgage contract) or are familiar and comfortable with large fluctuations in your income that will allow you to make an occasional large payment against the principal, an adjustable rate mortgage (an option mortgage) might be viable.