How to Become the Bank: All About Owner Finance
As an experienced investor, I’ve learned that many people want to buy houses instead of renting, but simply can’t get the bank to give them a loan or mortgage. But what if you could solve this problem by becoming the bank yourself while also getting massive profits, all the while helping them to buy their home? This is where owner finance comes in…
What is owner finance and how do you get started?
Owner financing is when you own the house that you are selling. The big difference is that you are the lender!
Here’s an example: I have a house. You need a house. I will sell you my house on a 20 year note for 8%. Instead of giving the bank a down payment, you give me the down payment. Then you would pay me all of the regular mortgage payments. I own the house until you pay if off or sell it.
Essentially, owner financing is when you become a bank.
Why Owner Finance is Awesome
When you think about it, banks are in business for a reason. They loan out money at a higher rate than what they pay for. With owner financing, you become the bank.
A lot of the time, people who need owner financing usually can’t get a conventional mortgage. Sometimes they are illegal immigrants and they have bad credit or not enough cash to meet the down payment requirements. There are a number of reasons but regardless, they are unable to secure a mortgage. Their options become very limited. Either they rent an apartment or they look for someone to give them an owner financed note.
As an owner financier, you can charge a higher interest rate than a normal mortgage since these people can’t get a normal mortgage. Typical owner financed mortgages can be anywhere between 7%-13% percent. The deals that I have done were usually in the nine percent range and they worked out pretty well.
That’s why I think owner finance is awesome.
Difference Between Owner Finance and Rent-To-Own
Owner finance and rent-to-own are very similar. I would even say that they are almost identical except in rent-to-own, you have a renter. I can kick out a renter and all the same renter rules apply.
Usually in rent-to-own, you have clauses such as, “You rent this and after 15 years we’ll turn around and sell it.” You are still the landlord and you still collect a monthly check. They will call you for repairs and you have to approve them. With an owner finance, they own the house. You’re completely separated from the house at that point. You are just the bank collected the check and they can do whatever they want with the house.
Usually they will improve the house on their own. I would say that is the main difference between the two. In rent-to-own, you are still treated as a renter and have a landlord versus owning the house and being your own homeowner.
I 100% prefer owner financing over rent-to-own because you have essentially washed your hands of the property and you’re just collecting the check at this point. As long as you have sold the house to someone who is reasonably and fiscally responsible, it’s going to turn out to be a very good investment and a good cash flow for you.
When you have a rental, you’re going to get a cash flow with that as long as you own that rental. With rent-to-own, you get the cash flow for the time that they’re paying off that mortgage. That could be 20 years! If you sell on a fixed note of 20, then after 20 years you’re no longer going to get income on that note. That’s the big difference between a rental and a owner financed home. One is a fixed contract and the other is indefinite as long as you want to keep the house.
How it Works
There are a couple ways to go about this. You can own the house outright, but you have to make sure that it is completely paid off. You put up the “For Sale by Owner” sign in the yard. When someone eventually buys it, you say, “Hey, we’re looking to owner finance this property. I’ll sell you the house and you give me 10%-15% down,” or whatever percent you guys agrees on. Then, offer a 20 year note for 9%, and if they agree, sign all the mortgage documents.
It’s exactly like a mortgage, except that this mortgage is with you personally. The buyer then owns the house.
Since you are the first lienholder, the house goes back to you if they default.
A Note About Wrap Loans
Now in some instances, you will own the house and have an existing mortgage with the bank. If you resell the house while having an existing mortgage, it’s called “wrapping”. A new loan around an existing loan is called a wrap loan.
Technically, the bank can call the note due, because almost every mortgage written today has a “Due on Sale” clause. I’ve done this three times, and we’ve never had a bank call and say, “Note due.” Generally speaking, banks want the mortgage—hey want the monthly payment. So as long as that’s coming in they’re usually not going to ask any questions.
I know all this is confusing, so let me help clarify the loan situation further.
Say for example I have a loan on a house. I have a 30 year note from the bank on this house. On top of that, I was able to get a conventional mortgage and I’m paying 3.5% interest. And let’s say my monthly payment is $500 per month.
Then I’m at the point where I want to sell the house by using owner finance to someone else at 9%. Now, obviously I am not going to pay off the loan. I will still have my loan, but I am going to wrap this other person’s loan around my loan. I am going to charge them more interest so that their payments will be higher than 9%. Their monthly payments might just end up being $1,000 a month. I’ll take $500 from that to pay off my mortgage and then I net the other $500.
That is a wrap loan. It’s basically a spread. You have a loan and you’re leveraging the bank’s money to make more money on your loan because you are reselling the house and the note for a higher percentage rate.
Outcomes of Owner Finance
So there are two ways to do owner finance. You either have the house outright, or you have a house that has an existing mortgage and you want to resell it at a higher mortgage and collect the interest spread on that.
So there are a few outcomes that can happen with an owner financed house:
The buyer can buy the house from you and then turn around to sell it. In this situation, the note would be paid off in full just like you would pay off the bank. This will usually increase your ROI. Let’s say you have a 20 year note and they sell it after year seven, you collect 9% interest for those first seven years and then they pay you off. When you do the math, it turns out to be higher than a 9% interest rate. It ends up being 15% or a regular return on that. This is the best case scenario.
The second scenario is the buyer defaults. They just stop paying the mortgage payment for whatever reason. Just like what would happen with a bank, you have to foreclose on them. Ideal situation here is you give them the option to do a Deed in Lieu of Foreclosure.
When you foreclose on somebody you draw a black eye on their credit, not a lot of people like to do that. The Deed in Lieu of Foreclosure is basically saying, “Hey, I’m going to give this house back to the people who have the loan so that they won’t foreclose on me.” There will be no ding on their credit. They just sign the house back over to you. This is a really good option. You may have to do some repairs, but you get a 10-15% down payment on the house and then the mortgage payments on top of that.
The last thing that can happen is the buyer defaults and you have to foreclose on the house because they will not sign the house back over to you. You will have to get a lawyer to do the foreclosure. If can get messy but it is best to have a lawyer take care of all the paperwork. Usually people like this just tear the house up because they are angry at you. On the bright side, you did get a down payment so you can use that down payment to cover any repairs. You also have all the interest they’ve paid up to that point. Then you can turn the house around and sell it again. You get to collect another down payment and more interest for however long they pay for it.
Even though this outcome is not ideal since you have to pay for a lawyer and fix the house even more, it’s still not too much of a downer since you get to turn it around and sell the house again.
The properties I have owned thus far have all had different outcomes.
I sold one house to a guy who bought it for his primary residence. He lived there almost seven years and paid us regularly. Sometimes he would miss a payment, but it was rare. The note was 8.5% interest for 20 years and he gave us 15% down. This worked out great! At the end of those seven years, he contacted us to tell us that he got another job out of state and that he needed to move. He did not want to deal with having to sell the house since he had to move ASAP. We gave him the option to do a Deed in Lieu of Foreclosure. He did.
The house got signed back over to us. We took the house, turned it around and sold it. We made a massive profit on it since there wasn’t too much to fix. The only bad thing about this situation was that one of the rooms was in the middle of a rehab and it was stripped down to the studs, so we had to fix that up.
Now this was an awesome situation. We were pumped over how well this turned out.
For the next two properties, since we did so well on that first one, we were thinking, “Hey, this is working out great, let’s do some more.” We sold two houses to an investor who was going to turn them around and rent it out. The problem wasn’t that he was an investor. The problem was that he was a new investor. He bought the houses, paid us the down payment for both of them, and then paid the mortgage for about three months. Then he just stopped paying. We offered to do a Deed in Lieu of Foreclosure, but he just gave us the finger and said, “Screw you guys.” We ended up hiring a lawyer.
The foreclosure was completed in three months. Once we got the houses back, we found out that they were just absolutely trashed. Pipes were burst in one house, one of the houses flooded and was beyond saving. We almost had to gut it. The other one had been vandalized.
When you get into owner finance, you need to realize that as a financier, you’re going to encounter some mean people.
In this particular case, karma did it’s job on that investor. Turns out he was also a drug dealer and got arrested shortly afterwards.
What I Learned From the Good AND the Bad
Don’t Sell to an investor…
My take away from this experience was to not sell an owner finance property to an investor. Based on what I have seen and what my former partner has seen, when you sell to someone who is buying a house to use as their primary residence, they tend to take a lot better care of it. They treat it like their own property. The lesson here is when you do an owner finance, always sell it to somebody who is going to use it as their primary residence. Never sell to an investor.
We definitely learned a lot along the way.
Always use a lawyer…
Another tip we learned is to always use a lawyer or title company to draft up the loan documents. This is a mortgage document. It’s the same one that you would sign with a bank. Most people are not savvy enough to know the ins and outs of a good mortgage document. You will want a real estate lawyer or a title company to draft this document up for you. They do these all the time and can probably have a canned document ready to go. The only thing that we had to do was request our lawyer to make the basic contract favorable to us if they default.
You should have a clause in the contract that says if the tenant is 60 days late on a payment, they lose the house and it reverts back to you and they pay any court costs incurred. Have the contracts written in a way that if they default, they can’t take you to court and you get the house back, no questions asked. If they do sue you, then they cover all costs.
Title companies will actually do this for you. Our lawyer put this in for us. It’s also important to use a note servicing company. Servicing the note is pretty much collecting the monthly payments, keeping track of the principal paid, interest paid, and escrow paid. If they are late, the note servicing company will send reminders and assess penalties. At the end of the year, these servicing companies will send you a statement summarizing all the payments and interest. Make sure to do your research and figure out which note servicing company is right for you and your situation.
We also noticed another benefit that comes with using a title company: buyers see the notice as an official note to take seriously as opposed to if it were coming from me.
Other Details of Owner Finance
Typically I would collect the minimum of 15% down payment, but some people insist on collecting 20-25%. I have even seen some people take 10%! Based on my experience, when people leave, there will always be some repairs that you’re going to have to fix. You need to have enough from the down payment to cover those costs so that you can resell and not spending too much out of pocket.
This is why I always recommend trying to get at least a minimum of 15%. Of course in some instances you can negotiate the percentage if you have a tenant who has bad credit or they just don’t have enough for the full 15%. Generally though, you want to get at least 15% down.
There are two ways you can handle the insurance: as the owner financier, you can carry the insurance and just use the escrow money that you are receiving every month to pay for it or you can have the buyer carry the insurance and have them pay for it out of pocket. We personally prefer carrying the insurance because we wanted to have insurance that actually covers the property. I didn’t want to rely on the homeowner to get the cheapest insurance rate they can find. In that situation, if the house burned down, we’d be screwed. We carried the insurance, so he just paid us an escrow every month that covered the insurance and taxes which we use to pay insurance.
You also want to keep an eye on the house. Even though somebody did buy it and the house is their primary residence, you still want to make sure that the house is not going into disrepair. It’s not like a rental house where you drop by monthly, but try checking up on it maybe once or twice a year, do a drive by and just look at the outside and see what’s going on. If you end up having to take this house back, you want to to be in somewhat of a good shape. Even if it is going into disrepair, there isn’t a whole lot you can do because the buyer does technically own the house at this point. It’s just like with a bank. The bank can’t take your house away if the grass is too high or if your house is starting to go downhill.
The way the house looks can get you to start a conversation with the homeowner to see if they’re having some financial hardships. Maybe you can cut a deal with them or help them get the house back up.
Last but not least, always do a credit check on the buyers. They are going to have low credit scores and they can’t get a conventional mortgage for a reason. That’s okay, but you want to try and avoid people who are already heavily leveraged. We have seen a lot of people and we have even sold to people that had credit scores in the 500s, which is pretty horrible. They weren’t leveraged out of the wazoo though.
If you look at a credit report, you can see how many loans they have taken out and how much debt they have. You’re looking for someone who has not bought stuff like five new cars or a boat and then they’re trying to buy this house from you. That is usually a bad investment right there. You want to find somebody who seems to be reasonably fiscal with their money and does not have an insane amount of debt.
The bottom line?
Of course, owner finance has its risks and challenges. You may encounter difficult people who may hurt your investment or you may simply trust the wrong people.
However, using owner finance to sell houses has the potential to be incredibly profitable and powerful for you. Owner finance gives you the chance to take command of your investment and buyers and bypass the banks’ rigid requirements.
You set the requirements for buyers yourself and can immediately acquire a steady cash flow on your investment.
With these tips and information, you already have an upper hand and can avoid rookie mistakes that other investors will make. Take the leap and try owner finance on your next house!