Here’s How Owner Financing (aka Seller Financing) Works for Real Estate Deals

Is owner financing a common practice?

“Seller financing is very rare,” Waters says. While it was more common in the past, especially during high-interest periods, the current market dynamics have shifted. For instance, in the 1980s, with interest rates soaring to 18%, seller financing became a popular alternative. Homeowners who had mortgages at lower rates could offer financing at more favorable terms compared to the steep rates available through traditional lenders.

Today, the landscape has changed significantly. Given lower interest rates and other financing options, seller financing is less prevalent. Waters advises against offering seller financing if you still have an outstanding mortgage on the home you’re selling. In such cases, you would be responsible for managing and qualifying for both mortgages.

Unless you can comfortably handle this financial burden and have specific reasons, like leveraging tax deductions, offering seller financing might not be advisable. If a buyer defaults, you could face the challenge of covering both mortgages.

“Today, I would not recommend that a seller offer owner financing if they still had a loan on their home,” Waters advises. “Not unless they could just absolutely afford it, and wanted to use it for a tax deduction.”

What are the pros and cons of owner financing?

Owner financing can offer significant advantages, but it’s essential to weigh the risks involved. One major concern is the potential for buyer default.

Waters advises that while seller financing can be effective if managed carefully, sellers should be prepared for the possibility of reclaiming the property.

Typically, buyers who request seller financing struggle to qualify for traditional mortgages or secure enough funds to cover the full home price, making them higher-risk borrowers. This increased risk means a greater chance of default. Additionally, if the buyer stops making payments and refuses to vacate, the seller could face additional challenges and costs related to foreclosure.

In today’s market, offering seller financing generally is advised only if you own the home outright. If you still have a mortgage on the property, you would need to manage and qualify for both mortgages, which can create financial strain, especially if the buyer defaults. Foreclosure can also mean dealing with a property that may not be in the best condition. “There’s a lot of risk on both sides, but there’s a lot more risk in it for the seller,” Waters says.

If it goes bad, the buyer will get a bad credit report, down to 500 or less if they default on a loan. But the seller is stuck with the house and the condition it’s in. They’re stuck with all the needed repairs, the cost of fixing it up, all the added wear and tear on things like the roof, the appliances and the HVAC. And they’re stuck with the time and expense of selling it again. So you have to be okay with the risk involved.

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Aside from the fact that there’s a high probability that you’ll become financially responsible for the seller-financed property again, you may face limitations in structuring the loan terms. Following the 2008 financial crisis, the Dodd-Frank Financial Regulatory Reform Act was implemented, which affects private loans. While balloon payments aren’t completely banned, they must follow rules that protect borrowers from unfair practices.

Finally, since you’re the one lending the money, you’ll only be getting paid in small installments over a period of time, just like a traditional lender. In other words, you won’t be able to access your full equity in the home immediately, which could affect your ability to use those funds to buy another property.

The news isn’t all bad, though.

“The tax benefits are potentially huge for sellers financing their buyers,” Waters says. “However, it’s crucial to consult with a financial advisor to fully understand the tax implications and benefits.”

Since the buyer is paying you in small increments over several years, the sale is treated as an installment sale, which can provide notable tax advantages.

Plus, as you are the lender, you don’t have to worry that the buyer’s mortgage company will demand expensive repairs or upgrades before approving the loan — you can simply sell your home as-is.

The biggest pro is that as the lender, you retain the title to the property until you’re paid in full, so if your buyer does default, the house is still yours — no matter how much money they’ve already paid toward their mortgage.

What steps do I need to take to offer seller financing?

If it sounds like seller financing is the right option for you, then you’ll need to follow these four steps:

Step 1: Check on the financial feasibility and legal requirements

First things first: Make sure you’re financially ready for the risks that come with seller financing. It’s not just about owning the house outright; you’ll need enough cash saved up for repairs, taxes, insurance, and any other costs that pop up before you can resell the property.

Plus, double-check with a real estate attorney to understand the legal requirements for seller financing at both state and federal levels. You definitely don’t want to risk losing your house over a contract that doesn’t meet the legal standards..

“If you’re going to offer seller financing, you need to understand your state laws,” Waters says.

“For example, let’s say your buyer loses their job, stops making mortgage payments and defaults on the loan. You need to understand the eviction process and how long it might take, because you need to have that money set aside to cover expenses on that house for the duration.”

Step 2: Vet your buyer

“Neither a borrower nor a lender be,” Lord Polonius famously says in Shakespeare’s Hamlet. That’s because lending to family and friends has been known to ruin relationships.

Lending to a stranger might spare you from awkwardness with friends or family, but it comes with the risk of not knowing their financial history. To safeguard yourself, you should run thorough financial background checks on the borrower. This way, you’ll get a better understanding of their financial background, similar to how traditional mortgage lenders assess their clients. It’s crucial to understand who you’re dealing with before finalizing any deal.

“You definitely want to do your research up front on your buyer just as if you were a lender,” Waters says. “You’ll want to get their tax information, their job history, and what kind of bank reserves they have. Find out if they’re currently gainfully employed. Check court records for any pending litigation against your buyer. You should also pull their credit report, so you have a deep understanding as to why they aren’t qualifying for a conventional loan.”

And that’s just the start of doing your due diligence. You also need to find what kind of person they are, so you can gauge their level of responsibility, interest and willingness to pay their debts.

Waters says, “Request a set of references and call them — three deep. Ask each one to give you another reference, because by the time you go three deep on one reference, the third person you talk to will give you the true story on what your buyer is really like.”

Step 3: Draw up the loan terms

The third step is just as important as the second — and that is making sure that the mortgage loan contract you draw up is airtight.

“You do have to be careful to follow the guidelines of the loan contract. It needs to detail the exact condition of the house,” Waters says.

“And the buyer needs to understand that the seller is just loaning the money — the maintenance is entirely the buyer’s responsibility. So, if the dishwasher breaks, the buyer needs to replace it.”

The contract needs to mention more than just the house itself, but everything in it — in detail. We’re talking: everything. Of course you’ll want to include the big things like the refrigerator, stove, dishwasher, or hot tub. But you need to cover little things, too, like doors, sink and fixtures, even copper piping or wiring.

Why? Because if your buyer does default, there’s always a chance they’ll strip the house bare and sell everything — including the kitchen sink — just to have some pocket change to help them start over again.

If you haven’t detailed these items in the mortgage contract, you’ll have a hard time going after them to get the damage covered and the items replaced.

It also needs to detail that the buyer is responsible for all other financial obligations that come with buying your home, such as property taxes or HOA fees.

If your buyer doesn’t pay these fees, the government or HOA could put a lien on the property or even start foreclosure proceedings. And since the title is still in your name in a seller-financing situation — this puts you at risk.

Last but not least, the contract needs to spell out the financial details, like the purchase price and repayment schedule, along with all repercussions and recourse if the buyer fails to meet the terms of the loan.

This also must include the agreed-upon interest rate.

“Typically with seller financing, the buyer is charged a higher interest rate,” Waters says. In Missouri and Kansas, you can set higher interest rates for seller financing than you’d see with traditional mortgages because state laws are more flexible. While you could charge up to 15%, just make sure it’s within legal limits and isn’t considered unfair. It’s a good idea to check with a real estate attorney or financial advisor to keep everything above board.

Step 4: Collect the earnest money (and save it)

Before finalizing the contract, make sure to collect a substantial earnest money deposit. “With seller financing, always ask for a big upfront deposit that’s non-refundable. So, if you’re selling the home for $200,000, then the expectation would be $10,000 to $20,000 non-refundable down up front,” Waters says.

Then, verify that the buyer’s check clears the bank to avoid any issues. This deposit isn’t just a sign of serious interest; it’s a financial buffer in case the buyer defaults.

If the buyer does default and refuses to vacate, you’ll need to hire an attorney and pay the costs of eviction, a process that typically takes about 90 days. “During that time, you’re going to have to cover housing expenses, plus the attorney’s fees. And if the buyer didn’t take care of the home, you may need to spend more on things like paint or carpet to sell it again.”

In total, you might need to set aside $15,000 to $20,000 to cover these potential expenses. This reserve helps ensure you’re financially prepared for any emergencies that arise.

“So let’s say you need $6,000 to cover all housing costs, then an attorney’s going to charge anywhere from $2,000 to $4,000. Add on another $5,000 to $10,000 to cover the cost of getting it ready to list, and that’s a total of $15,000 to $20,000. You need to have all that money set aside for that emergency.”

Is owner financing right for me?

Seller financing is rare these days for good reason. It’s a tricky financial arrangement that comes with a lot of risk for the seller. That’s why many experts recommend sticking with a traditional mortgage.

“Doing a 5% conventional loan or 3.5% FHA loan is better for the buyer and safer for the seller,” Waters says.

However, if the pros outweigh the cons in your situation, seller financing can be done successfully. Just make sure you consult with the right professionals to help you through the complex process — including a top real estate agent.

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