When you first bought your home, you probably recall the ensuing nightmare in trying to secure a loan from your bank. Credit checks. The waiting process. The anxiety of wondering if you’d ever see approval. Yet you persisted and eventually became one of the over 700,000 Utah residents who are proud homeowners.
And it’s no different in today’s market. In fact, it’s much more difficult for potential buyers to finance a mortgage. So much so that the likelihood of being rejected for a mortgage is estimated to be one in three.
Owner financing (also known as “seller financing”) is becoming an increasingly popular alternative to listing your home with a realtor. And it can be as attractive for homeowners as it is for buyers. After all, neither particularly wants to wait the estimated 46 days to close on a home—and that’s just assuming pre-approval for a loan. And the added bonus of having a steady but certain source of monthly income as a result of owner financing can certainly be more tempting than paying both realtor and bank fees. But there are advantages and disadvantages of owner financing. And if you’re a homeowner in Utah considering seller financing, here’s some pros and cons that you should consider first.
What Is Owner Financing?
The most simple definition of owner financing is when a seller agrees to accept payments on installment directly from a buyer (secured via a promissory note) in lieu of a conventional mortgage from a lender. Most come with relatively short terms; owners dictate the terms of the loan, including interest rates, repayment schedules and liabilities. A typical seller financed loan might carry terms of up to a fifteen year amortization, with a clause indicating the option of regular monthly installments with one large balloon payment due after three to five years to cover the remaining balance.
It’s a judgement of good faith. Most Americans know that bad credit results from temporary financial setbacks; setbacks which occur as frequently to homeowners as they do to potential buyers. Banks, on the other hand, aren’t always so sympathetic. Their bottom line is the ability to repay. The average owner financed loan requires a certain level of trust in the buyer’s future financial situation. As a result, steady employment, yearly income and future projections of expenses are more important than bad credit.
Is Owner Financing a Good Idea?
There’s an obvious advantage to owner financing. Buyers with less than perfect credit don’t have to face rejection from traditional mortgage lenders. And sellers can dictate the terms of the loan. They can raise interest rates. They can choose to retain the title. They can command full list price, or even higher. And they can sell their home as is—quickly, without the need for costly renovations or waiting for approval from a mortgage loan originator.
Perhaps more importantly is the immediate access to home equity. Owner financing loans are common among both retirees and owners nearing retirement age. Homeowners with bad credit frequently have difficulty in both refinancing and accessing the necessary equity that would provide security in the event of emergencies. By providing a monthly stream of income owners are not only ensured of equity, but they can place that cash stream into a retirement account which could actually benefit from tax deferrals.
Even more advantageous is a form of financing known as a wraparound mortgage. A wraparound mortgage is essentially a junior mortgage that “wraps around” the primary one. With a wraparound mortgage, an owner is still responsible for paying monthly mortgage fees. But they can raise interest rates to a buyer to cover the risk and profit from the difference. Should the buyer default on his mortgage payments (which, like most lenders, typically occurs in seller financing after the third missed payment,) the owner has the legal right to foreclose on a home.
Disadvantages Of Owner Financing
One chief disadvantage of seller financing is that terms are subject to negotiation. If a buyer refuses to accept your initial terms, they’re open to bargain at a rate much lower than you expected. Unlike locked interest rates available from a bank, the four percent increase you initially hoped for can be negotiated down to two or less—which may be insufficient for any immediate needs. Both buyers and sellers are at the mercy of one another in owner financing.
We touched a point earlier which needs to be repeated: trust. You’re placing an incredible amount of faith in a buyer with bad credit. You’re making the assumption their rating is the result of a temporary hardship, and they’re slowly building their rating up. What if there’s a very good reason for that hardship? What if they face chronic unemployment? We all like to believe that all transactions are based on goodwill; but unfortunately, you can never be too careful. Particularly when it comes to real estate transactions. We’ve heard horror stories from Utah homeowners who have had to foreclose after an owner financed loan fell through only to find the cost of repairs and renovation wound up totaling almost a quarter of the value of the home!
Finally, there are certain restrictions regarding seller financing under the Dodd-Frank Act of 2010. If you’re using owner financing as an investment source (for example, selling 3 or more properties in the course of a 12 month period,) you may be prohibited from offering the option for a five year or less loan with a balloon payment due at the completion. There are certain exceptions to this rule, however. You may be able to sell multiple properties in a 12 month period if you qualify as a mortgage loan originator.
While owner financing is entirely legal, we recommend consulting with a qualified real estate attorney if there are any specific grey areas you might encounter.
AITD and Wraparound Mortgage
One common instrument of leveraging owner financing is known as an all-inclusive trust deed, or an AITD. An AITD occurs in conjunction with a wrap around mortgage when multiple loans are consolidated into a single loan vehicle. Typically under an AITD a buyer makes one lump sum payment which is split between the original mortgage lender and the seller as payment on a second mortgage. However, many lenders will flat out refuse AITDs knowing the potential risks of buyers defaulting.
Is Selling My Home By Owner Financing Right For Me?
That ultimately depends on your own particular needs. If you’re looking to access home equity immediately and potentially collect an additional cash flow, you might find owner financing to be an ideal solution. If you find the right buyer, that is. Many have legitimate concerns about terms in which loan modifications can be conducted for any reason—at any time—by a seller. In fact, many choose to continue to rent or seek alternative sources of loans, such as hard money loans, until their credit can be rebuilt.
But if you’re nearing retirement or need to pull equity out from under your home as quickly as possible, using a reputable house buying company can be very effective. Like any major transaction, there’s pros and cons to owner financing. You may ultimately decide it’s simply not an option for you. But if you do, here’s hoping your circumstances remain firmly in the pro camp!