What Is Owner Finance and How Does It Create Passive Income? (Ep4)
Owner finance, to put it simply, is you as the owner of a property providing finance to the buyer of the property instead of a traditional lender such as a bank.
Owner finance is also commonly known as vendor finance or seller finance.
Here is a breakdown of how owner financing works:
- You own the property (owner) –>
- You sell the property to a buyer (buyer) –>
- The buyer does not pay you the full amount up front –>
- The owner effective provides the buyer with finance for the property and charges them interest –>
- The buyer pays the owner interest plus principal until the full amount for the property is paid off –>
- When last payment is made title of the property is transferred into buyer’s name
So the original owner of the property effectively becomes like a bank or lender to the person who is buying the property.
Here is a simple scenario where it could occur
Bob owns a house which he purchase 20 years ago and has paid off the mortgage. Bob decides it is time to retire and he wants to sell his house and live off the income it generates.
Bob sells his house to Susie for $500,000 on owner financing terms. Susie pays $50,000 up front and assumes a loan with Bob for the remaining $450,000 at 7% per annum.
Susie now pays Bob $3,488.85 per month and will pay off the loan in 20 years. When Susie makes the final payment the title of the property is transferred into her name and she stops paying Bob. Bob then goes on to live his life, but he had 20 years earning a good amount of passive income from his property.
Why Is Owner Finance Beneficial for the Seller?
Owner finance is a popular way of buying and selling homes in the United States, however it is done a lot less frequently in Australia. However, it is still legal and possible in most states.
Owner finance is beneficial to the seller for a number of reasons:
1. The seller can usually command a high sale price for their property
Because you are attracting buyers who can not obtain a traditional loan with the bank you can often charge them a higher purchase price because you are providing owner finance.
The buyer understands that they are paying above market rates, but as they are incapable of buying a house otherwise they invest for the long term. Hopefully for the buyer capital growth will mean that soon the property will be worth more than what they paid for it.
2. They can collect interest on the loan making them extra money
The owner charges the seller interest on the purchase. So even though they sell the property for a fixed price, the buyer pays them interest on top of that fixed price.
In the above example where Susie assumes a loan with Bob for $450,000 at a 7% interest rate Susie has to pay for that interest to Bob on top of the $500,000 agreed price.
In fact if Susie doesn’t pay out her loan early then she ends up paying Bob $387,321.55 in interest on top of the agreed upon $500,000 for the property.
So Bob makes a total of $887,321.55 instead of just $500,000 if he had sold the property for cash.
3. They can usually charge higher interest rates than the banks
Because owner financing appeals to buyers who cannot obtain traditional funding they usually charge a higher interest rate than the banks.
If the owner still has a mortgage on the property then they can generate passive income without having a great deal of money invested into the property.
This is call a Property Wrap.
Why Is Owner Finance Beneficial for the Buyer?
So owner finance is clearly beneficial for the owner who is selling their property, but why is it beneficial for the person buying the property?
1. The buyer can get into the market sooner
In The Risks of Buying Positive Cash Flow Property I discussed how difficult it can be to save your deposit and actually get into the market. In most cases you need to save tens of thousands of dollars in the form of a deposit before you can even buyer a property.
Owner finance lowers the barrier to entry for the buyer because they can often pay a smaller deposit to the owner that is selling the property.
2. Access to lending which is not available otherwise
Owner financing really only appeals to buyers who cannot secure traditional lending. Property prices and interest rates are usually higher with owner financing, but these buyers wouldn’t be able to get financing otherwise.
This means the buyer can secure financing they wouldn’t have had access to otherwise.
3. The buyer can prove to a bank or lender that they can pay for the loan
It is very common for a buyer to sign up with owner financing and then get a more traditional (and cheaper) loan from a bank or lender at a later date.
Even though usually they wouldn’t qualify for traditional lending if the buyer can show they have consistently paid their mortgage on time their chances of getting a mortgage with a traditional lender increases significantly.
4. The buyer has the opportunity to get capital growth on their property
By getting into the market earlier the buyer can now take advantage of capital growth they experience on their property.
This could either be achieved by making improvements to the property or by waiting for the market to go up.
They can then leverage this equity in the future to purchase more properties and expand their portfolio.
What Is A Property Wrap?
A property wrap is a term used to describe an owner financed deal where the owner still has a loan with another lender on the property.
Owner Financing Can Be A Great Solution To Traditional Lending
As you can see owner financing can be a great alternative to a tradition sale (for the original owner) and can be a great alternative to traditional lender (for the buyer).
It can help you generate a passive income and can help buyers get into the market sooner.
As with anything it is important to be aware of the risks of owner financing before going ahead with it.