Owner financing can be a powerful tool to get real estate transactions closed. For the owner, it potentially allows her to benefit from a long-term cash flow stream, while deferring capital gains tax. In turn, buyers receive alternative financing that may be more affordable or more flexible than bank financing. However, there are downsides to owner financing that affect both the buyer and seller.
Delaying the Inevitable
Many owner-financed property sales are structured with balloon payments and don't last long enough to be paid in full like traditional 30-year mortgages. The eventual balloon payment brings back some of the issues that drive people to seek owner financing in the first place. For the owner, it generates a large lump sum of cash, much of which will be subject to the same capital gains taxes that owner tried to avoid by financing a property sale. If the buyer used owner financing because he couldn't qualify for a bank loan, the balloon payment will require him to go back to a bank. If he can't get a mortgage to replace the owner financing, he could lose everything he spent on the property, and the owner could end up regaining ownership.
Methods and Costs
Banks frequently prevent potentially unwise transactions. For example, if a buyer isn't creditworthy, a bank won’t lend to him. With owner financing, the owner could end up lending to a buyer who won’t meet his obligations. Banks also protect property buyers from sellers by not making loans for properties that don't appraise at the price the seller wants. With owner financing, the appraisal process often gets sidestepped, potentially causing a buyer to overpay.
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In a traditionally financed transaction, the buyer and seller usually separate very quickly after the closing. With owner financing, both parties remain in contact for years. The owner knows that if the buyer fails to meet her obligations under the financing agreement, he must be willing to repossess the property. At the same time, because some owners remain attached to the property to protect their collateral, some buyers find that owner financing interferes with their "quiet enjoyment" of the property.
Owner financing structured as a contract for deed, also known as a land contract or an installment sale, has unique problems. In a contract for deed, the buyer makes payments to the owner so that when she fulfills the contract, she earns the title to the property. Until the buyer pays off the contract, the seller technically still is the owner of the property. This puts the buyer in a dangerous situation, because if the seller fails to fill any of his obligations as owner -- like making property tax payments or payments on existing mortgage -- the buyer could lose her interest. At the same time, since the seller remains on the title for the property until the contract is completed, he retains some liability for anything that happens at the property.
- The Federal Reserve Bank of Minneapolis: Risks and Realities of the Contract for Deed
- REI Maverick: Owner Financing Pros & Cons
- The Weekend Real Estate Investor; James O. Parker