Owner Financing Definition Example How Does It Works

Owner Financing Definition

Explanation

It is merely a financing mechanism 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 at a particular interest rate instead of the bank. The buyer will be required to pay back the principal amount and the interest money to the supplier over a certain period.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Owner Financing (wallstreetmojo.com)

How does Owner Financing Work?

In an owner financing mechanism, the buyer of the property in question must make a down payment. Then the transaction is often executed and recorded utilizing a promissory notePromissory NoteA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date.read more. The down paymentDown PaymentDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. read more required to be paid by the buyer of the property is usually 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, including amortizations, interest rates, etc. The process is done under legal guidance.

Example

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.

Solution

Option 1

The monthly payment, balloon paymentBalloon PaymentThe balloon payment is a huge sum paid at the end of a loan tenure. Most balloon loans come with a short-term tenure; it could be a commercial loan, mortgage, or fully amortized loan. Also, the final installment is at least double the previous installments.read more due, and total payments due to the seller in the case of option one are calculated as follows:

Monthly Payment Calculation

Monthly rate of interest (r)= 8/12 = 0.67%

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

= 30 * 12Number 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) / 0.0067Cumulative discount factor = 136.28

Monthly payment = Amount financed / Cumulative discount factor

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

Balloon Payment Calculation

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 one are calculated as follows:

Monthly rate of interest (r)= 6.5/12 = 0.542%
= (1 – (1 + 0.00542) -360) / 0.00542Cumulative discount factor = 158.21
= $15,000 / 158.21Monthly payment = $94.81
Number of month = 15* 12 = 180
= $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 loan’s monthly payment if he chooses the second option. But as he is extending the repayment period for another five years in the second option, the interest rises, and he might end up spending higher than the first option. Therefore, Mike should go with the first option.

Risks

A buyer might default on the loan amount – One of the most significant risks is that the buyer might not repay the loan amount as they might have agreed while executing the transaction. There is certainly no way to fully confirm the buyer’s intentions and ability to pay back the loan and interest amount in the future.Record-keeping – Another substantial risk that a buyer might face is the seller’s process concerning record-keeping. The process of record-keeping is different for each seller. Some might record it themselves, and some get it done from a third party. The buyers must ensure that they are also maintaining the record of each payment 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 no difference between the two terms. Both the terms are interchangeably used.

Benefits

The first and foremost benefit of the 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.It allows the participants to create terms that they find mutually acceptable and advantageous.A seller can choose to collect monthly payments from the buyer and the balloon payment or 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 that it can be more expensive than other options available to the property buyers.Another disadvantage of owner financing is that if a seller of the property happens to take his property back from the owner, he might have to pay for repairs and maintenance costs, too, if the buyer did not take good care of the property in question.

Conclusion

Owner financing is also better known as seller financing, owner carryback, or seller carryback. It is a term used for a transaction between a buyer and a property seller. In this type of financing, the seller 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 principal amount along with interest within a certain period.