Owner Financing: Risks for the Seller

by Mary Gallagher ; Updated July 27, 2017
Seller financing should be handled the same way a bank loan is.

There are a number of benefits for the seller who issues a mortgage to his property's buyer. Profits are not immediately taxed. An income stream is created. Interest on the principal, which might be more than the seller could get through savings, is earned. But the benefits do not accrue without some level of risk. Sellers must write the mortgage in ways to protect themselves from the potential problems.

Borrower Fails to Pay Mortgage

The biggest concern a seller has when he writes a mortgage for the property he sells is that the buyer will default on the mortgage. There are no guarantees that can be produced to eliminate this risk. However, there are some steps a seller can take to minimize the risk. First, the seller can run income, credit and employment checks on the prospective buyer/borrower before he agrees to the loan. Second, the seller can require a hefty down payment, minimizing the likelihood that the buyer will walk away from his equity and ensuring a cushion of profit in case the buyer does default and the seller has to foreclose. Finally, the seller should treat the transaction professionally: If the borrower misses a payment, the seller must be quick to send a late notice and be prepared to begin a foreclosure process in a timely fashion.

Borrower Doesn't Maintain Insurance

If the borrower doesn't maintain insurance and the house burns down, the mortgage is never going to be paid. It is incumbent on the seller to require ample insurance coverage in the loan documents and require that she is named as co-insured on the policy. This will ensure that she is repaid the mortgage in the event of catastrophic damage to the property and that she will be notified if the policy is canceled.

Borrower Defaults on Another Mortgage

If the borrower gets another mortgage -- either a first mortgage to the seller's second or a second mortgage to the seller's first -- and doesn't pay the other loan, that lender will foreclose. If the seller has issued the second mortgage, he might end up with nothing after the foreclosure. If he issued the first, at best he may receive his funds at an inconvenient time or, at worst, won't get back all of the loan. Sellers should think twice about issuing a second mortgage and consider including a prohibition against second mortgages and equity lines in the loan documents if he issues the first mortgage.

Borrower Harms Property

Just as some property owners who have lost their homes to bank foreclosure have damaged their homes in anger before moving out, a buyer who is foreclosed upon by a seller/lender can take the same destructive actions. If you do end up having to foreclose, consider offering the buyers a move-out refund -- enough to prevent them from damaging the home before they leave. If you required a substantial down payment from the buyers at sale, you should have enough of a cushion for a small "cash for keys" payout to the buyers.

About the Author

Mary Gallagher runs Mary Gallagher Planning (mgaplanning.com), an urban planning and consulting business in San Francisco. She is the former assistant planning director for San Francisco and planning director for San Mateo. Gallagher has been writing about real estate, development and land use for numerous websites since 1995. She holds a master's degree in historic preservation planning from Cornell University.

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