What is owner financing?

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• Owner financing refers to an agreement where a home seller provides the financing for a home purchase.
• This type of loan can be a useful option for buyers who don't qualify for a traditional mortgage.
• Owner financing can be more expensive than traditional mortgages, with higher rates and balloon payments.

Owner financing — sometimes referred to as seller financing — is one alternative that can help homebuyers get into a home of their own if they don't qualify for financing with a traditional mortgage lender.

But owner financing can be risky for both the buyer and the seller. Here's what you should know about these types of mortgages, regardless of which side of the transaction you're on.

How owner financing works

Owner financing is a home financing deal in which the seller of the property acts as the mortgage lender.

The buyer and seller must come to an agreement on the terms of the loan, including the interest rate and length of repayment. Then, the buyer will make a down payment toward the home purchase and pay off the rest through monthly installments according to the owner financing agreement.

In general, sellers can only offer financing if they own their home outright, with no existing mortgages or loans on the property. Otherwise, they'd need approval from their lender first. 

Owner financing typical loan terms

"Typically, the seller and buyer will agree to terms such as the interest rate, how many payments per year, and how many years the loan is amortized over," says Pratik Pathapati, owner of real estate investment company Rework Cash Offers in Sacramento, California.

Owner financing deals often have higher interest rates than what you'll find in the traditional mortgage market. They also typically have shorter terms and end with balloon payments that are owed after a certain number of years.

"Many times the seller will want what's known as a balloon payment within 10 years, which is when the buyer will need to pay off the entire loan, usually through refinancing the loan with a bank," Pathapati says.

Once the seller and the buyer agree on the terms of the financing agreement, they'll make the deal official using a legal instrument such as a promissory note, which makes the agreement and all of its terms legally binding.

Owner financing example

Let's say a homebuyer is using owner financing to purchase a home for $200,000. They make a 20% down payment and finance the remaining $160,000 at a rate of 8%. 

The buyer and seller agree to a mortgage that follows a 30-year amortization schedule — meaning the payments are set up to fully pay off the loan, including principal and interest, over the course of 30 years — that ends in a balloon payment after 10 years of payments.

This means that the buyer will pay $1,064 each month to the seller. If this were a traditional mortgage following the 30-year amortization schedule, this monthly payment amount would allow the loan to be fully paid off after 30 years. 

But under the terms of this mortgage, the buyer only makes payments for 10 years before the remainder of the loan is due. So after 10 years of making monthly payments, the buyer must pay the seller the remaining principal balance, which would be around $137,000.

At this point, the buyer may have enough equity in the home to qualify for traditional mortgage financing to pay off the loan provided by the seller.

Owner financing pros and cons

Pros

For both buyers and sellers, owner financing can be an advantageous option because it:

• Has less stringent requirements to qualify for a loan
• Comes with fewer closing costs and fees
• Allows for flexible loan terms
• Enables a speedier closing process
• Provides the seller with regular income through the buyer's monthly payments

"Owner financing is uncommon in today's real estate market but can be beneficial in a number of ways," Pathapati says. "The terms of the loan are not bound to specific standards so both seller and buyer can get creative in how the loan gets paid back."

Because an owner-financed loan agreement isn't held to the same rules and regulations of a traditional mortgage transaction, the sale can be completed faster and with fewer costs. For example, the buyer will only need to pay for an appraisal if they want to get one.

Cons

Though owner financing provides some important benefits to both parties involved, it also has some significant downsides, including:

• Terms are often less attractive than those that come with traditional financing (higher rates, balloon payments)
• Generally only available if the seller doesn't already have a mortgage of their own
• Sellers will have to initiate the foreclosure process if a buyer stops making payments
• Buyers will be subject to the seller's credit requirements
• Potential legal and financial risks for both parties

"The main risk with owner financing is that the buyer needs to fully understand the structure and terms of the loan," Pathapati says. "Any misunderstanding can later cause problems for the buyer and seller."

Sellers need to do their due diligence to ensure that their buyer is creditworthy, or they risk losing money. Likewise, buyers need to make sure that the seller they're working with is reputable.

The risks that come with these transactions are why they tend to be more common between people who already know each other, such as family or friends, rather than two strangers.