Looking for an Owner-Financed Home? 5 Things to Avoid

Home buyers can prevent headaches by anticipating potential problems in advance.

There are at least two good reasons a potential home buyer may turn to owner financing. Perhaps their credit score is not high enough to qualify for a traditional mortgage, or they're hoping to buy time to save for a larger down payment but want to purchase a house now. As attractive as owner financing may be, it's not without its problems. Here, we explain how owner financing works, what to look for, and what to avoid.

What is owner financing?

Owner financing allows you to pay for a new home by making payments directly to the former homeowner. There's no traditional mortgage in place and no mortgage fees to pay -- not at first, at least. Typically, a seller self-finances the transaction for five years, often at a higher interest rate than a mortgage lender would charge.

At the end of the five-year period, a balloon payment for the outstanding balance is due. That means that the new homeowner must either secure a traditional mortgage or come up with the funds in another way to pay off the loan carried by the seller.

How it works (in a nutshell)

• The buyer makes a down payment, although the amount is negotiable.
• Monthly payments are made directly to the seller for five years.
• During those five years, the buyer has time to put money into savings for a larger down payment (if they so desire) and closing costs.
• Shortly before the five year period expires, the buyer must decide how they're going to pay the balloon payment.
• If the buyer takes out a mortgage, the bank will require a home appraisal to ensure they're not lending more than the property is worth.

What to avoid

As well as owner-financing can work out, there are also ways it can go very wrong. Protecting your interests means avoiding the following pitfalls.

1. Failing to focus on the details

The single most important time in the owner-financing process is before a contract is signed. It's during this time that you must be laser focused on details. For example, you need to know:

• If the seller owns the house outright (ask for evidence). If they don't, their lender must approve the deal and few banks are willing to do that.
• If there are any liens on the property.
• If the property has any structural issues. Even though it's not required, it is in your best interest to spring for a home inspection before signing a purchase contract.
• What happens if you miss a payment? Let's say you get sick or lose your job and miss a mortgage payment. What does the contract say will happen? How soon can the seller repossess the property?
• How you are expected to pay property taxes. Will you pay them directly to the county or are you expected to pay through the seller?
• If the seller requires proof that you carry homeowners insurance.

2. Being overly optimistic

When you apply for a traditional mortgage, a lender will clearly let you know if it does not believe you can afford the property. Remember, you're not just making a house payment. You're also responsible for paying insurance premiums, tax bills, maintenance, and upkeep. If buying the house means stretching your budget to the limit, you're more likely to find yourself in financial distress.

3. Missing payments

Like a traditional mortgage, the lender has a right to repossess the home if you miss payments. It's up to you to know how many missed payments will trigger repossession. If your home is repossessed, you'll likely lose any money you've put into the home.

4. Failing to use those five years wisely

One of the benefits of an owner-financed home is that it gives you five years to save money and prepare to pay the balloon payment off in full. That means that you'll need a savings plan in place from day one.

5. Procrastinating

It's easy to forget how quickly 60 months can pass. Waiting until the last minute to find a lender puts you at a disadvantage. It may not give you enough time to rate shop and will certainly add an extra layer of stress to your life until the balloon payment is paid off.

An owner-financed home is a convenient way to get into a house if you need to work on your finances. The most important thing you can do is ensure that you understand what you're getting into before the papers are signed.