The real estate investing business offers many ways to finance buying an investment property, one of which is owner financing. Could this investment property financing method be the best for real estate investors, or is it just too complicated? Let’s break down everything property investors need to know about owner financing.
What is Owner Financing?
In real estate investing, the most common way among property investors for financing the purchase of an income property is through a traditional mortgage loan. In this case, a real estate investor borrows money from a bank. He/she then makes payments to the bank in order to pay off the loan.
Another known investment property financing method is owner financing (also called seller financing). Here, the seller of the income property agrees to take installment payments from the buyer until he/she has paid off the purchase price instead of paying fully in cash or taking a mortgage loan.
How Does Owner Financing Work?
From the definition of owner financing, one might think it’s a simple way to buy investment properties. However, this financing method involves a certain amount of legal paperwork. Here are the typical owner financing terms that real estate investors should know beforehand.
Although owner financing is labeled as an investment property financing method which does not require a down payment, it is common for the seller to ask for a down payment. To sellers of investment properties, a down payment is what the buyers stand to lose if they default. As a seller, you can ask for 5% – 25% for down payment. If you’re a buyer, don’t worry about hefty down payments as (unlike working with a bank) there’s often room for negotiations with owner financing.
When going with a traditional mortgage loan, real estate investors typically have a 15 – 30-year amortization to pay off the investment properties. With owner financing, on the other hand, you won’t have this long amortization period as sellers don’t want payments dribbling in over 3 decades. Property investors should expect a shorter amortization period, normally 5 years.
With a balloon payment, the entire remaining balance is due in full at a certain time period before the end of the amortization period. Thus, the seller of investment properties might accept a 5-year payment schedule but wants a balloon payment at the end of 5 years. Meaning, he/she doesn’t want to drag out monthly payments past the 5-year mark. As a real estate investor buying an income property with owner financing, you must pay off any remaining balance – whether with cash or by getting a new loan.
A promissory note is simply a document which specifies the loan terms and expectation for repayment. A promissory note will typically include the amount of debt, interest rate, the repayment schedule, payment amount, how payments are made (monthly, quarterly, etc.), and balloon payment.
Moreover, the promissory note will also provide penalties if the real estate investor is late in paying. So basically, for the real estate investor, this is your promise to repay the debt when financing an income property with owner financing.
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Mortgages and Deeds of Trust
These two documents basically serve the same function – to provide security for the loan. They place a lien on investment properties and provide security for the seller in case the real estate investor defaulted on payments.
Pros and Cons of Owner Financing
Based on the terms of owner financing, you can see that they offer benefits to both the seller and buyer of the investment property. However, just like everything in real estate investing, there are some downsides of this investment property financing method.
Advantages for Buyers
- Besides being able to start real estate investing when you’ve been denied a traditional mortgage loan, owner financing has easier qualifications
- Down payment, interest rate, and terms are all negotiable
- A lot of what property investors pay for closing costs is simply services that banks provide for traditional mortgages. So, when you go for owner financing instead, you end up with lower closing costs
- Closing on the investment property is quicker, meaning you can start making money in real estate investing much faster
Disadvantages for Buyers
- Property investors may not find sellers willing to carry financing investment properties
- The flexibility of owner financing comes with higher interest rates and shorter repayment periods
- Difficulty if there are underlying mortgages
Advantages for Sellers
- Make money through passive income
- Can sell the property much faster “as is” which also means avoiding costly repairs and save some money
- Can ask for a higher price for the income property, thus a higher return on investment
- Can get the property back if it forecloses
- Higher interests rate – which can also result in a better return on investment
Disadvantages for Sellers
- Don’t get all cash up front
- Might face some problems collecting payments
- The investment property can end up in foreclosure
- Sellers have to administer the loan
- The Dodd-Frank Act of 2010 placed limits on owner carried mortgages
The Bottom Line
One of the many benefits of the real estate investing business is that there is more than one way to buy an investment property. Just because you were denied a traditional mortgage loan doesn’t mean you can’t buy an income property and make money from real estate. Owner financing might be just the solution you’ve been looking for!
Owner financing is an arrangement in which a real estate investor makes payments directly to the seller rather than acquire a traditional mortgage loan to finance buying an investment property. This might seem like a laidback financing method. However, it comes with advantages and disadvantages to both parties.
So, is owner financing the best way for real estate investors to finance investment properties or is it just too complicated and risky? Let us know what you think in the comments!