When you decide that you a ready to purchase a home, you may decide that financing this purchase is the appropriate move based on your own long-term goals and your current financial status. Generally speaking, financing can be divided into two categories, the primary difference between the two being the actual source of the funding. By far the most common form of mortgage involves financing from a bank or other large financial institution.
The bulk of homeowners will rely on bank financing when they decide to take the next step on the path to homeownership. That being said, financing provided by the owner of the property is also a possibility. Individuals who do seek out owner-financing contracts may discover that these loans include higher interest rates compared to traditional bank mortgages.
The specific interest rates attached to owner financing can vary considerably based on the relationship between the buyer and seller. On average, however, owner financing typically involves higher interest rates than those found in conventional bank mortgages.
The Basics of Owner-Financed Mortgages
Owner financing, also commonly referred to as seller financing, occurs when the owner of a property offers potential sellers the option to negotiate a borrowing arrangement that completely avoids the use of banks for funding. In essence, the original owner of the property is offering the buyer the opportunity to borrow from them directly.
The reasons a buyer may choose to pursue owner financing can vary tremendously. Generally, owner financing is considered a viable alternative for individuals who may have lower-than-average credit scores. Many banks require a solid, reputable credit history in order to secure financing through them. Although banks may continue to offer financing to individuals with below-average credit scores, interest rates will likely be exorbitant.
In a situation where an individual is ready to purchase a home but does not have the type of credit score they need to secure a competitive interest rate on the money they have borrowed, owner financing may become particularly appealing.
The Logistics of Owner Financing
When the owner of a property makes the decision to offer financing to sellers, they are simultaneously increasing the administrative burden on themselves and reducing logistical "red tape" for both parties.
Once the potential buyer has expressed interested in pursuing owner financing, the owner can then propose specific terms for the financing as they see fit. These terms can also be adjusted as needed to match the level of perceived risk posed by the buyer. For example, if the homeowner considers the buyer to be a relatively low default risk, they may choose to offer an interest rate that is competitive with current bank standards. However, if another applicant has very low credit scores, the owner can then tailor the financing package to ensure that the risk is worth the amount they are accruing in interest on a monthly basis.
Although there are certainly exceptions to the rule, owner financing commonly features higher interests rates than traditional bank mortgages. This is typically due to the fact that the owner of the property will be assuming a high degree of risk even in situations where the future buyer has excellent financial credentials. Unlike a bank, the homeowner likely does not have a large legal support base ready in the event that the buyer defaults on the loan. Any legal troubles stemming from non-payment could, in fact, become incredibly costly for the original homeowner.
Flexibility and Negotiation in Owner Financing
Even though interest rates may trend higher than those attached to traditional bank mortgages, one distinct advantage that owner-financed lending carries over banks is the fact that both the buyer and seller can reach repayment terms that may be incompatible with larger financial infrastructure. For example, the seller and the buyer may decide that a more extended repayment period is perfectly acceptable, helping to reduce the buyer's monthly payments while still ensuring a steady stream of income for the seller.
Unlike the paradigm commonly witnessed in bigger banks, where exceptions to the rule cannot typically be accommodated to their fullest extent, the buyer and seller in an owner-financed arrangement have total freedom to modify and tinker with these policies as often as they see fit.
That being said, it is not uncommon for the owner of a property to consult frequently with a lawyer during the selling process in order to ensure that they are adhering to current industry trends and are preparing legally enforceable documents as part of the contractual transaction. Essentially, the buyer and seller will need to complete a promissory note that carefully dictates all pertinent details related to the financing.
Ensuring Accuracy in Contracts
Here, the owner should ensure that the complete overview of repayment, including interest rates, repayment length, penalties, etc., is included. It is easy to overlook some of these small details in the agreement, particularly when the owner does not have legal references to fall back on. Regardless of what "technical support" may be available, however, these documents must match current industry standards in order to ensure that the buyer cannot dodge payment duties through a contractual loophole inadvertently created by the seller.
Owner-Financed Mortgages and Closing Costs
Although the owner of a property may choose to implement standard closing costs on a mortgage, the common expectation is that owner-financed transactions typically reduce these fees. The reduction is generally caused in large part by the elimination of loan origination fees. Origination fees can be defined as an upfront fee charged by the loan officer which effectively compensates them for assisting the buyer.
Because of the fact that so many of these expenses are waved, sellers may discover that advertising owner financing actually increases the desirability of their property. Many buyers will relish the opportunity to pay less money upfront for the home acquisition, which ultimately will allow them to allocate more of their cash to paying down the balance of their loan.
Exploring Typical Owner-Financing Terms
Although owner financing is comparatively more flexible than traditional bank mortgages, you shouldn't enter into the process of securing this type of loan thinking that it will always be more advantageous for you.
Many elements of owner financing closely mirror those found in traditional bank mortgages. For example, buyers who secure owner financing will most likely have to pay a down payment on the property in question as part of their arrangement with the seller. Depending upon the risk profile of the buyer and the risk appetite of the seller, the down payment could vary in size dramatically.
Ultimately, there is no "correct" downpayment size for a property, irrespective of its size or cost. In fact, some sellers may choose to completely waive the need for a down payment, although this is highly unlikely. Similarly, it is also possible for sellers to request an extremely high down payment to help mitigate some of their risk.
Moving Beyond the Payment Agreement
It is important for both buyer and seller to remember that foregoing the traditional bank closing procedures will mean that both parties are responsible for ensuring that the transaction is legally valid. This will mean taking the time to properly file the deed with the local county clerk's office and complete a legally valid contract for purchase.
Many sellers choose to enlist the help of an attorney during the contract-writing phase of the process in order to ensure that the sale of the property will be recognized by the legal system in the event of a contractual dispute. The costs for these attorneys can be assumed strictly by the seller, or divided among both parties as part of pre-arranged closing costs. Generally speaking, buyers should be prepared to subsidize some of these costs if they are trying to ensure the most transparent and legally sound sale.
The condition of the property itself could also influence the conditions under which financing is obtained. If, for example, the buyer determines that the property requires significant structural repairs or improvements, this could factor into a discussion of interest rates. This is particularly true if the property itself may be considered "unsellable" by traditional mortgage standards.
This type of discussion typically follows a professional home appraisal. Again, it is to the benefit of both parties in situations such as these due to the flexibility offered by owner financing.
Interest Rate Considerations
As mentioned earlier, interest rates on owner-financed properties follow no set pattern or industry benchmark. Although many sellers will choose to keep their interest rates relatively close to those currently used by traditional lenders, there is no rule dictating that this must be done. Some financial experts recommend that sellers set their interest rates a few points higher than traditional mortgage rates for similarly qualified buyers. For example, if a major lender such as Wells Fargo had established current mortgage lending rates of 3.11 percent, a seller may choose to place their owner financing interest rates for 2019 at 4.8 to 5 percent. This is a well-established practice that has become quite common in the owner-financed mortgage arena.
Moving Ahead With Owner Financing
Just because a property owner decides to sell their home without requiring traditional bank financing does not mean that these individuals cannot seek the assistance of financial experts to help facilitate the process. In fact, many homeowners may choose to consult with a variety of appraisers and advisers to help determine a competitive price point for their home based on current market conditions.
If you are preparing to sell your property and are considering offering owner-financing, you might consider seeking both financial and legal counsel before doing so. Although many individuals do choose to offer buyers financing without any problems, the opportunity for legal or financial hurdles to arise is significantly greater than with traditional lending. Knowing what options you may have to help enter this type of transaction with a solid foundation is absolutely invaluable.
Perhaps the most important idea to remember is that a seller is in no way obligated to offer owner financing at any point. If you decide to revoke your owner financing options prior to the initiation of a contract, you can do so without any legal ramifications. Your comfort and confidence should always be the first priority in a transaction such as this due to its size and scope.
Ryan Cockerham is a nationally recognized author specializing in all things innovation, business and creativity. His work has served the business, nonprofit and political community. Ryan's work has been featured at Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.