How Does Owner Financing Work?

Finding a cooperative seller is key to obtaining owner financing for a purchase. Also known as seller financing or a seller carry-back loan, this unconventional form of financing can benefit both buyer and seller. Speak to a real estate attorney to ensure all loan terms and conditions are spelled out in your contract. Also, be sure you can afford the owner financing payments. Defaulting can lead to foreclosure, as with an institutional lender.

You may need a seller's help to purchase a home when insufficient credit, income, funds or another aspect of your financial situation prevents you from getting a traditional mortgage or reasonable loan terms. A seller may agree to finance a buyer if a low appraised value or market conditions prevent the seller from obtaining a desired price. Sellers can finance a buyer who has obtained a traditional mortgage, supplementing it with a second loan for the down payment amount or more. Sellers can also finance the entire purchase price. They might choose to if they own the home free and clear of a mortgage and their financial circumstances permit.

An owner-financing contract typically stipulates that the loan must be repaid within a specified number of years. It may require a large payoff at the end of the repayment term, known as a balloon payment, plus monthly mortgage payments with interest. Like traditional mortgage lending, owner financing involves a promissory note, which is a legally binding IOU that spells out the repayment terms. The home acts as collateral, securing loan repayment. Depending on the state, the document, or security instrument, used is called a mortgage or a deed of trust.

When the home is subject to a first mortgage held by an institutional lender, the owner financed loan takes a subordinate position, meaning it has less priority for repayment than the traditional mortgage.

As the buyer, the repayment period gives you enough time to obtain a traditional loan to pay off the home. It may also provide sufficient time for market conditions to change and the home's value to increase. An owner-financed loan may have a higher interest rate than market rates, usually 8 percent to 15 percent. The repayment term is short, such as five years, but the loan payments may be amortized, or stretched out, over a longer period, such as 30 years, making them more affordable. Precise terms are optional and negotiable between a buyer and seller.

Most sellers are unwilling to provide owner financing due to potential legal, financial and logistical ramifications. To reduce the risks of owner financing, both parties should consult tax experts, real estate agents experienced in seller-financed deals and real estate attorneys. You should also ask your mortgage lender whether it can finance part of the purchase price, subject to owner financing. Some lenders do not allow it, and those that do may require a significant down payment. Also, the seller must obtain its lender's permission to provide seller financing.