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

The good news is that although this setup is a private mortgage loan between two individuals, it is a legally binding contract with specific terms, conditions, and requirements that both parties must follow, and it includes recourse if those terms are not met.

The bad news is that it’s a private loan between two individuals. If you’ve ever had issues lending money to family or friends, it’s understandable for a seller to feel uneasy about extending a larger sum to someone they don’t know.

“Seller financing can go really well if you’re dealing with financially solvent people who have good jobs and are honest,” says Edie Waters, a top-selling agent in Kansas City, Missouri, who’s sold over 74% more single-family homes than her peers.

“That’s the biggest risk the seller takes: ‘Is this person honest? Are they going to abide by the terms of the loan?’”

Is owner financing a common practice?

“Seller financing is very rare,” Waters says. It used to be more common, especially when interest rates were high, but today’s market has shifted quite a bit.

Back in the 1980s, when rates hit around 18%, seller financing became a popular workaround. Homeowners with lower-rate mortgages could offer buyers better terms than what banks were offering at the time.

Today, things look pretty different. With more lending options available and generally lower interest rates, seller financing is not as common as it once was. Waters suggests avoiding it if you still have an existing mortgage on the home you are selling. In that situation, you would be on the hook for managing and qualifying for two mortgages at once.

Unless you can comfortably handle that financial load and have a clear reason, like tax benefits, it may not be worth it. If the buyer defaults, you could end up responsible for both loans, which adds a lot of risk.

“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 come with some real benefits, but it is important to understand the risks as well. One of the biggest concerns is the chance that the buyer might default.

Waters notes that while seller financing can work well when it is set up carefully, sellers need to be ready for the possibility of taking the property back.

In many cases, buyers who go this route may not qualify for a traditional mortgage or do not have enough funds for the full purchase price, which can make them higher-risk borrowers. That higher risk naturally increases the chances of default.

On top of that, if a buyer stops paying and won’t leave the home, the seller may have to deal with the added stress and cost of foreclosure. In today’s market, seller financing is usually only recommended if you own the home outright.

If there is still a mortgage on the property, you would be juggling and qualifying for two loans at once, which can put serious pressure on your finances, especially if the buyer defaults. Foreclosure can also leave you with a property that may have been neglected or is in worse shape than when you sold it.

Beyond the risk of possibly ending up responsible for the property again, there are also limits on how you can set up the loan. After the 2008 financial crisis, the Dodd-Frank Financial Reform Act added rules around private lending. Balloon payments are not totally banned, but they have to follow certain rules to protect buyers from unfair terms.

Also, since you are the one acting as the lender, you get paid back in installments over time, similar to a bank. That means you will not have immediate access to all your equity, which can make it harder if you want to use that money to buy another property.

That said, it’s not all bad.

“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, like spreading out your capital gains tax liability over time instead of paying it all in one year.

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 are the common types of owner financing arrangements

Owner financing can take a few different forms depending on how the deal is structured and how much control or responsibility the seller wants to keep. Each option shifts things like ownership, payments, and risk in slightly different ways. Here are some of the most common types of owner financing arrangements.

• Purchase-money mortgage: In this setup, the seller acts as the lender and provides a mortgage directly to the buyer to help finance the purchase. The buyer owns the home, but makes payments to the seller instead of a traditional bank.
• Land contract: With a land contract, the seller keeps legal title to the property while the buyer makes installment payments over time. Once the buyer finishes paying off the agreed amount, the title is transferred to them.
• Wraparound mortgage: A wraparound mortgage is when the seller keeps their existing mortgage and creates a new loan for the buyer that “wraps” around it. The buyer pays the seller, and the seller continues paying their original lender while keeping the difference.
• Lease-purchase agreement: In a lease-purchase agreement, also known as rent-to-own, the buyer rents the home with the option to buy it later at a predetermined price. A portion of the rent may go toward the eventual purchase if the buyer decides to move forward.

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 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 the 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 help you avoid awkward conversations with friends or family, but it also means you may not really know their financial track record. To protect yourself, it is important to do a thorough financial background check on the buyer.

This gives you a clearer picture of their financial situation, similar to how traditional lenders vet borrowers. The key is making sure you really understand who you are dealing with before you move forward with the 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, [and] 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 homeowners association (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 ask for a substantial earnest money deposit upfront. “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.

Make sure the check fully clears the bank so there are no surprises later. This deposit is not just about showing serious intent. It also acts as a cushion if the buyer ends up defaulting.

If that happens and the buyer refuses to move out, you may need to involve an attorney and go through an eviction, which can take around 90 days and come with extra costs.

“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. Make sure to consult with the right professionals before moving forward so you fully understand the risks and structure of the deal.

A top real estate agent can also help you navigate the process and make sure your interests are protected from start to finish. Connect with a proven professional today through HomeLight’s Agent Match tool. 

Editor’s note: This article is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. HomeLight always encourages you to reach out to an advisor regarding your own situation.

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