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Owner Financing: What It Is And How It Works

Kevin Graham8-Minute Read
December 27, 2021

You want to buy a home, but you’re not quite ready to qualify for a mortgage from a credit standpoint. If this is you, owner financing might be an option. In this article, we’ll touch on what it is, how it works and how it differs from a traditional mortgage. Then we’ll discuss the process and the pros and cons before getting into how to make the necessary calculations and find a home.

What Is Owner Financing?

Owner financing – or seller financing – is a real estate agreement that occurs when homeowners sell their property and let buyers purchase their home without relying on traditional lenders for a loan. Instead, the seller finances the purchase with a higher interest rate and, often, a balloon payment due within a certain period of time.

Seller financing allows the home buyer to circumvent traditional mortgage lenders and instead pay the home seller, typically in installment plans over a shorter period of time. Also unlike with the traditional mortgage process, seller financing is not as highly regulated, which can come with numerous risks and benefits to both parties.

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How Does Owner Financing Work?

When you’re putting together an owner financing agreement, it's between you and the current homeowner with no third-party lender involved. Many of the terms of the agreement may be similar to working with a lender, though. As an example, you’ll have a minimum down payment and a certain term.

It’s important to note that seller financing is usually pursued as an option only after traditional lending options have become inaccessible. You’ll usually secure better terms through a mortgage lender.

Like everything in real estate, the appeal of seller financing fluctuates with the current state of the market. Since mortgage lenders adapt their risk assessments for lending over time, whether you’re able to secure a loan may vary depending on when you’re looking to purchase a home.

Seller financing typically increases during periods of economic downturn, when financial institutions may be more reluctant to lend money, and it decreases when lenders are less strict or have more attractive rates.

How Does Seller Financing Differ from A Mortgage?

When you purchase a home with seller financing, there's no third party involved giving you a mortgage. Typically, buyers and sellers will opt for this arrangement if the buyer is having a hard time qualifying for traditional lending options because of credit issues. Examples might be a past bankruptcy or foreclosure.

Instead of the deed being transferred to you with a mortgage lien on it, an owner-financed transaction typically involves the seller transferring the legal title to you only after you’ve made all payments under the negotiated contract.

However, the new homeowner does gain equitable title, meaning they gain equity in the home as they make their payments. This is important if the new homeowner plans to refinance through a traditional lender down the line.

On the seller’s end, they may not get a lump sum payment from the sale, but they do get a continual income stream from your monthly payments. Additionally, because home buyers opting for seller financing typically don’t qualify for a standard mortgage, the seller can charge a higher interest rate.

Finally – and this is an important point for buyers to understand – because the seller can negotiate the contract, they can put in more onerous penalty terms than you might see in a traditional mortgage contract. For example, they might be able to evict you for as little as one missed payment.

However, seller financing is an arrangement that only works when the home seller owns the property free and clear. If the seller themselves has an existing mortgage lien on the property, since there is an existing lien owner, you won’t be able to do a seller finance purchase as the existing loan would have to be paid off.

The Owner Financing Process

Now that you know the basics, let's go a little bit deeper on the process of negotiating owner financing.

Enlist The Help Of A Real Estate Agent

The seller financing process usually requires the aid of real estate experts – both parties should enlist the help of an experienced real estate agent or a real estate attorney to draw up a sales contract and a promissory note.

A promissory note is a document that keeps track of all the terms and conditions the home seller and buyer have agreed upon. Similar to a Closing Disclosure, a promissory note will include information regarding established interest rates and a payment schedule with respective consequences or fees for any late or missing payments.

Beyond contract concerns, it’s never a bad idea to have an experienced real estate agent to advocate on your behalf. If you’re looking for one, we would love to have you work with one of our Verified Partner Agents who can align on your goals as well as your budget to negotiate the best deal for you.

Discuss Terms With The Seller

A seller financing agreement is usually fairly short-term and typically lasts no longer than 5 years with a balloon payment at the end. And just like in a conventional real estate transaction, a seller financing arrangement begins with a down payment.

You’ll want to have a discussion with the home seller to determine the amount you’ll need to present upfront. While it’s possible that a seller may loan you the full amount and waive the down payment altogether, most sellers ask for 5% – 10% to show that you, the borrower, are financially committed. This down payment may be higher than you would have to pay as a first-time home buyer with a traditional mortgage, so be sure to plan for it.

You also need to negotiate an interest rate. At the time of this writing, a 5% interest rate is pretty good, but you should negotiate the interest based on your plans with the property. If you’re a flipper looking at the property as a short-term investment, you can afford a higher interest rate as you’ll most likely only have the property for a few months to a year. But if you’re planning on living in the home long-term, you’ll want to try and negotiate that rate down.

Another thing to consider when it comes to interest rates is the fact that the baseline for seller financing is going to be slightly above prevailing rates in the mortgage market. Because you can’t qualify for a traditional mortgage, you represent a bigger risk for sellers. The interest rate that they’ll get is higher to compensate for that.

Finally, you’ll need to negotiate how the loan ends. Is there a balloon payment? If there is, how much will you need to pay?

If you’re a buyer, it makes sense for this amount to be as low as possible, but a bunch of factors interplay here. In exchange for a lower balloon payment, the seller may require a higher down payment or interest rate. On the other hand, a higher balloon payment may be offset if you can get a low enough interest rate and/or down payment.

Negotiate The Maturity Date

Lastly, and very importantly, is defining the maturity date or due date for your loan – otherwise known as the term. Simply put, the term is how much time the home buyer gets to pay off their loan. A 5-year balloon is typical in seller financing, but if you expect to hold the property deed long-term, on one hand, you could try and negotiate the longest term possible.

The main benefit of a longer term is that it gives you more time to get your credit in shape if you plan to pay off the balloon payment at the end of the term by refinancing into a traditional mortgage.

Shorter terms have their benefit as well. At the same interest rate, you’ll pay less interest over a shorter term than you would over a longer one because the balance is being paid down faster.

The Pros And Cons Of Owner Financing For Home Buyers

If you're looking to get started with seller financing, this method of lending definitely has its advantages and disadvantages. Let's run through these.

Pros

  • The closing processwill be much quicker and cheaper than with a conventional mortgage lender.
  • You can expect fewer or even no closing costsdepending on your situation.
  • Seller financing may not require a home appraisal.
  • Home sellers are usually more flexible with their lending terms than a bank or a third-party mortgage lender.
  • There is no private mortgage insurance (PMI).
  • Seller financing can be extremely advantageous in a tight credit market.

Cons

  • You may need more capital for a down payment than you would with a typical mortgage.
  • In most cases, a seller financing deal will have higher interest rates than with a standard mortgage.
  • You have to do your research and ensure that the seller owns their property free and clear, and that they are able to finance the sale.
  • The risk for any unknown liens or encumbrances may subject the property to foreclosure. While you may be able to have a title search done in an attempt to mitigate these concerns when you buy the property, because you don’t get the legal title until you fully pay off the loan under the terms of the contract, the seller could do things that put your ownership in jeopardy in the meantime. Consult a real estate attorney on what can be put in your contract to gain assurances from the seller.
  • Balloon payments can be extremely daunting if you haven’t thought through your timeline or financing.
  • You must have a good working relationship and communication with the home seller.
  • You may have to sell yourself as a borrower to the home seller – this could include earning their trust or impressing them with your commitment to the home. There may also be a credit check.

With all of these pros and cons, when is it a good idea to pursue a seller financing purchase?

Seller financing is usually most attractive for those who may have trouble obtaining a traditional loan either due to poor credit or a particularly risk-averse market. However, many investors, flippers or home buyers looking to get into a home quickly can also benefit greatly from a seller-financed sale, as it’s a short-term agreement in itself.

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How To Calculate Owner Financing Payments

If you do opt for owner financing, it'll be helpful to understand how your payment is calculated. Here are the steps you can take to do the math yourself.

Step 1: Collect The Necessary Numbers

To properly calculate the payment for a seller-financed purchase, you’ll first need to gather the following information from the land contract or your promissory note, otherwise known as the mortgage note:

  • The interest rate: The agreed-upon interest rate is determined by the home seller and the home buyer. Interest rates are influenced by factors such as your credit history and the established down payment for the purchase.
  • The loan term: The loan term is simply however long the seller has agreed to finance your loan. Same as with traditional mortgages, the loan term for a seller-financed transaction can vary, though terms of 5, 10, 15 and 30 years and everything in between are possible.
  • The loan amount: If your seller is financing the full purchasing price of the home, the loan amount is the full price of the home minus whatever you put in the down payment. Otherwise, the loan amount is whatever the home seller and buyer have agreed upon.
  • The number of payments: This is the total number of mortgage payments you’ll make.
  • The balloon payment: If you have a balloon payment at the end of your loan, it may be for the full amount of your loan. If that’s the case, you’re only required to make interest payments during the term of your loan. If you have no balloon payment, you can use a mortgage payment calculation formula like PMT in Excel or an online calculator. If you have a balloon payment, but your payment is something less than the full loan amount at the end of your term, your loan partially amortizes. While the same payment formula can be used, you’ll have to input the value of the balloon payment at the end of the formula in order to calculate your monthly payment.

For the sake of simplicity, we’re going to assume that you have an interest-only payment with the full loan amount due at the end of your term.

Step 2: Multiply Loan Amount By The Interest Rate And Divide By 12

For example, if a seller-financed loan is for $100,000 at an interest rate of 8%, you would calculate that $100,000 x 0.08, which means $8,000 in interest for the year.

In this scenario, a $100,000 loan at 8% would look like $666.67 in a monthly interest-only payment. Keep in mind that you’ll want to try and pay more than just the monthly interest payment each month in order to make the loan amount, or the principal balance, go down over time.

How To Find Owner-Financed Homes For Sale

When it comes to establishing a seller-financed offer with a home seller, you first need to learn whether the seller owns the property free and clear. Once you have that information, you can make a cash offer, but explain that if the seller is willing to enter a seller-financed arrangement that you’d be willing to pay more for the home. This will usually open the door for further discussion on owner financing.

You could also present the seller with a budget and concept for any repairs or renovations you’d want to make on the home, which would in turn increase the equity or value of the property. Not only would this show that you’re financially committed to making a deal with the seller, but in some cases, it could even replace a down payment as proof that you’re invested in purchasing the home. At closing, you could even put the money for renovations in escrow to reassure the seller that that money will in fact be used toward the house.

The Bottom Line: Owner Financing Could Be The Right Option For You

Owner financing is an unconventional loan method, but one that bypasses the need for bank or third-party involvement. This short-term method of lending can benefit both the seller and the buyer if the terms are right and is a great way to save money for house flippers or property investors.

Owner financing is also a great option for those who have been turned away from lenders due to poor credit or a strict market. On the flip side, owner financing typically comes with higher down payments, higher interest rates and a balloon payment at the end of the term.

Remember to do your research, ensure that a home seller is free and clear, and enlist the help of real estate attorneys or professionals. You’ll also want to use the time leading up to your balloon payment to build up equity and boost your credit score to qualify to refinance it into a traditional mortgage.

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Kevin Graham

Kevin Graham is a Senior Blog Writer for Rocket Companies. He specializes in economics, mortgage qualification and personal finance topics. As someone with cerebral palsy spastic quadriplegia that requires the use of a wheelchair, he also takes on articles around modifying your home for physical challenges and smart home tech. Kevin has a BA in Journalism from Oakland University. Prior to joining Rocket Mortgage he freelanced for various newspapers in the Metro Detroit area.