What Are the Disadvantages of Owner Financing?
Offering to owner finance a property has some real advantages for both the seller and the buyer. But, before you agree to finance the sale, get the rest of the story by considering the disadvantages of owner financing.
To be successful, owner financing starts with a willing seller and a qualified buyer (borrower). Both the seller and buyer need to go into this "partnership" with their eyes wide open as to their respective responsibilities. As we explore the disadvantages of owner financing it will become clear that the brunt of the responsibility of this owner financing arrangement falls on the seller.
Even though an owner financed mortgage note can be viewed as a passive cash flow asset, the seller will still need to assume a somewhat active role in protecting their interest in the property. To see that all the "ducks" stay in a row through the entire term of the note.
Let's delve into the disadvantages of owner financing for the seller first and then for the buyer.
Disadvantages of Owner Financing For The Seller
1. Who will handle the record keeping? Some sellers decide to be their own record keeper. The duties range from keeping track of the note payments each month to the preparation of yearly interest statements to providing a borrower with note payoff balances, all of which can be a complicated time suck. An alternative to this disadvantage is to hire a professional service company to take over this responsibility.
2. Is the buyer living up to the terms of the note? As the note holder you have an interest in making sure the real estate taxes are paid, the property is insured and maintained. It would be nice to assume the buyer is on top of these responsibilities but they need to be verified for the security of the note and your peace of mind. Are you prepared to wear the hat of bill collector when payments don't arrive on time?
3. The buyer stops making payments or violates other terms of the note: When all else fails, the seller may need to initiate a foreclosure proceeding. The good news is the property was pledged as security for the mortgage note and the seller can take the property back. The bad news, a foreclosure might be worth less than the outstanding balance due. Plus, if the seller has to take back the property, the seller is responsible for the cost of repairs.
4. The seller stills owes money on the first mortgage: When a seller owner finances a property and the seller still owes money on the first (underlying) mortgage, there is the risk the lender of the first or underlying mortgage will call the underlying loan due.
To have the right to accelerate the payment by the first position lien holder is known as a due on sale clause. The possibility the first position lienholder can exercise the due on sale clause can be of concern to both seller and buyer.
5. The seller gets tired of the monthly payments and would prefer cash? This scenario is common with owner financed mortgage notes. After all, the seller traded a purchase price in cash in exchange for waiting to get paid. Now the seller has a need or desire for cash.
The upside is, the note can be sold to an note buyer for cash now. The downside is, the note is usually sold at a discount. How great of a discount depends on factors such as the interest rate, equity in the property, borrower's credit, type of property, number of payments remaining and other terms.
6. The Dodd Frank Act: Although many sellers are willing to owner finance the sale of their property, they want to shorten the repayment term with a balloon payment. A balloon payment is when the balance owed on the note is paid in a lump sum after a certain time period passes.
The Dodd Frank Act can affect the ability to have a balloon payment. The situation may require a loan originator whose role is to verify the buyer is qualified to purchase the property. Using a loan originator can add to the cost of owner financing.
Disadvantages of Owner Financing For The Buyer
1. The balloon payment: A balloon payment would require the buyer to get a new mortgage when the balloon payment becomes due. What if the buyer can't secure a new mortgage by the time the balloon becomes due?
A solution would be to have the seller extend the balloon payment date but is under no obligation. In theory if the buyer cannot get a new mortgage, the seller has the right to foreclose and take back the property.
2. Higher interest rate: As an incentive to offer owner financing, the seller may require a higher than market interest rate on the mortgage loan. This higher rate will likely create a bigger monthly payment and might even disqualify the buyer from the loan.
You may be discouraged to participate in owner financing if you only consider the disadvantages of owner financing. A prudent person always compares the pros and the cons of any decision. Get the other side of the story by reading the Advantages of Seller Financing.
Many sellers and buyers have created a winning solution using owner financing. Don't go it alone, working with qualified professionals can help you keep a profitable arrangement from turning ugly.
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