Owner Financing

Owner Financing Definition

Owner financing can be defined as a scenario where the owner funds the transaction under consideration, i.e. the buyer instead of applying and taking a loan from a banking institution, takes the loan from the owner and repays them the principal amount along with the interest amount over a pre-determined time period.

Explanation

It is merely a financing mechanism that takes place between a buyer and the seller of a property. It is a scenario where the seller of a particular property takes in-charge of financing the transaction on behalf of the buyer of the property in question. In other words, the buyer in an owner financing mechanism will take the loan from the seller of the property itself at a particular rate of interest instead of the bank. The buyer will be required to pay back the principal amount along with the interest money to the supplier over a certain period of time.

Owner Financing

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How does Owner Financing Work?

In an owner financing mechanism, the buyer of the property in question is required to make a down payment and then the transaction is often executed and recorded by means of a promissory notePromissory NoteA promissory note is a negotiable instrument that represents the debtor's or the writer's (the maker's) written consent to pay a promised sum to the creditor (the payee) on a specified date.read more. The down payment required to be paid by the buyer of the property is often calculated as a specific percentage of the selling price of that property. The promissory note used is often referred to as an owner financing contract that carries all the terms and conditions of the purchase transaction that includes amortizations, interest rates and so on. The process basically is done under legal guidance.

Example

You can download this Owner Financing Excel Template here – Owner Financing Excel Template

The following are the two options available with Mike for purchasing a particular property. Evaluate the two options and determine which one yields less of all totals and turns out to be a better profitable option for Mike.

Owner Financing Example 1

Solution

Option 1

The monthly payment, balloon paymentBalloon PaymentWhen part repayment of principal loan such as mortgage loan, commercial loan, etc. is agreed to be made at the end of the loan period or at the maturity where the total outflow is higher than the approx. amount payable on the monthly basis since it does not fully amortize over the term of the loan due to its large amount then it is known as balloon payment.read more due and total payments due to the seller in the case of option 1 are calculated as follows:

Monthly Payment Calculation

Owner Financing Example 1.1
  • Monthly rate of interest (r)= 8/12 = 0.67%

Number of monthly payments = Number of years * number of months in a year

  •  = 30 * 12
  • Number of monthly payments (t) = 360

Cumulative discount factorDiscount FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more = (1 – (1 + r)-t ) / r

  • = (1 – (1 + 0.0067) -360) / 0.0067
  • Cumulative discount factor = 136.28

Monthly payment = Amount financed / Cumulative discount factor

  • = $17,000 / 136.2834
  • Monthly payment = $124.74

Balloon Payment Calculation

Example 1.2
  • Number of month in 10 years = 10* 12 = 120

Balloon Balance of a Loan = PV (1+r)n – P [((1+r) n -1)/r]

  • = $17,000 (1+0.0067)120 – $124.74 [((1+0.0067) 120 -1)/ 0.0067]
  • Balloon Balance of a Loan = $14,913.196

Option #2

The monthly payment, balloon payment due and total payments due to the seller in the case of option 1 are calculated as follows:

Monthly Payment Calculation

Example 1.3
  • Monthly rate of interest (r)= 6.5/12 = 0.542%

Number of monthly payments = Number of years * number of months in a year

  • = 30 * 12
  • Number of monthly payments (t) = 360

Cumulative discount factorDiscount FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more = (1 – (1 + r)-t ) / r

  • = (1 – (1 + 0.00542) -360) / 0.00542
  • Cumulative discount factor = 158.21

Monthly payment = Amount financed / Cumulative discount factor

  • = $15,000 / 158.21
  • Monthly payment = $94.81

Balloon Payment Calculation

Owner Financing Example 1.4
  • Number of month = 15* 12 = 180

Balloon Balance of a Loan = PV (1+r)n – P [((1+r) n -1)/r]

  • = $15,000 (1+0.00542)180 – $94.81 [((1+0.00542) n -1)/0.00542]
  • Balloon Balance of a Loan = $10,883.87

From the above-determined values for both options, it can be seen that Mike might save more on the monthly payment of the loan if he chooses the second option. But as he is extending the repayment period for another 5 years in the second option, therefore, the interest rises up and he might end up spending higher than the first option. Mike should go with the first option.

Risks

  • A buyer might default the loan amount – One of the most significant risks is the fact that the buyer might not repay the loan amount as what he or she might have agreed while executing the transaction. There is certainly no way to be fully confirmed of the buyer’s intentions and ability to pay back the loan and interest amount in the future.
  • Record-keeping – Another substantial risk is the fact that a buyer might face is the seller’s process with respect to record-keeping. The process of record-keeping is different for each seller. Some might record it themselves and some might get it done from a third party. The buyers must ensure that they are also maintaining the record of each payment that is made to the seller so that the same can be verified in case of any discrepancy.

Owner vs Seller Financing

Owner financing and seller financingSeller FinancingSeller financing is an agreement between the buyer and seller of the real estate in which the seller manages the mortgage process and provides a loan; the buyer makes an initial down payment of the principal amount and pays the remaining amount through monthly payments with interest.read more are most likely the same things. Seller financing can be defined as an arrangement where the seller finances the real-estate mortgage instead of the banking or a financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more. It means the same thing and there is literally no difference between the two terms. Both the terms are interchangeably used.

Benefits

  • The first and foremost benefit of owner financing mechanism could be the elimination of third party interference which ultimately allows the participants to save a lot of time, money and harassment too.
  • It allows the participants to create their own terms that they find mutually acceptable and advantageous too.
  • A seller can choose to collect monthly payments from the buyer as well as the balloon payment or can even sell the owner financing contract to the investors and earn a lump-sum amount on the same.

Limitations

  • One of the most significant disadvantages can be the fact that it can turn out to be really more expensive in comparison to other options that are available with the buyers of the property.
  • Another disadvantage of owner financing is the fact that if a seller of the property happens to take his property back from the owner then he might have to pay for repairs and maintenance costs too in case the buyer did not take good care of the property in question.

Conclusion

Owner financing is also better known as seller financing or owner carryback or seller carry back. It is a term used for a transaction between a buyer and a seller of a property. In this type of financing, it is the seller who does the financing, i.e. the buyer borrows a loan from the seller of the property instead of going to the bank and pays the former the principal amount along with the interest within a certain period of time.

Recommended Articles

This has been a guide to Owner Financing and its definition. Here we discuss how does owner financing work along with an example, its risk, benefits, and limitations. You can learn more about from the following articles –

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