Owner Financing Primer
1. The buyers may not pay. This is the only risk novice buyers and sellers really think about. Participants in a owner financed transaction need to realize they are going into the banking business in a small way. Everyone knows banks have large buildings and make a lot of money. They sort of forget banks also take some heavy losses. However, banks get to play the odds. They try to make more loans on which they profit than loans on which they take a loss. For the seller trying to unload his house the news on the day the monthly payment is due is either all good or all bad. Sellers frequently insist on terms that actually increase the chances the loan will get into trouble. I talk about t hem on the Loan Term and Payment pages.
2. The sellers may need their cash faster than the contract pays. This can be a subtle trap.The sale is done and some time later something happens in the sellers life which causes them to need a chunk of cash. The obvious source of funds would seem to be selling the contract for cash. After all, the buyer has been paying every month and the interest rate on the note is well over what banks are paying on CD's.
A few calls to the note brokers advertising in the paper will spoil that illusion. In the United States home ownership is reguarded as a sacred right and governmental systems are in place to make sure cheap money for home buyers is always available. The government backs the bonds that get issued to provide the money so loans can be made at the lowest possible rates. When you try to sell a privately held note the buyers of the note will expect much higher rates. The way they do this is to discount the value of the note.
Note discount calculations are complicated and depend on a lot of factors. However, even a short term note, with market interest rate, and a good payment history may be discounted by 25% or more. One of the difficult parts of being a note broker is educating consumers about the true value of their note on the open market. Successful note brokers typically do that by proposing terms which help the note seller feel like they are getting more for their note than they really are. This works because few people really understand the mathematics of notes.
3. There may be unintended tax consequences. As long as the seller continues to hold the note and reports the interest as income the tax situation remains simple. For the buyer the interest is deductible and the tax results are obvious. The tax situation is more complex if the note gets sold to a third party at a discount. It will also be more complicated if seller financing was used in the sale of an income property. In that case the sellers "basis" in the property comes into play and the allocation of the money from the payments is more complex.
4. There may be title/ownership issues. Title issues are rare in the residential home market. Subdivisions have to on the books for years so there are few boundary issues. Title insurance is a almost always used so potential problems are found and corrected early. With land and income property title related problems are more likely. Owners get sued, make bad business decisions, fail to pay their taxes, get divorced and do other things that result in clouds on the title. Even with residential property, sellers may "forget" to mention they deeded an interest in their home to their kids who then will have to sign the deed as part of the sale. Even though it is expensive, I would strongly suggest title insurance.
5. Poorly drawn paperwork puts sellers at risk of not being able to enforce the contract. Serious problems will require a trip to court to resolve. THis is expensive and takes a long time. In the meantime the buyer may live the the property for months without making payments. The seller is stuck making payments on the underlying loan(s) to protect his equity without any income. I have known sellers who would drive buy "their" property and watch it being destroyed without being able to do anything about it. In court the only thing which will really matter is the paperwork. Things that were said or promised are not considered. This is the time when the seller may realize the generic document they got at the stationary store really doesn't protect their interests well. In other words, the parties to a seller financed sale should do everything with the idea that they may eventually be in court and the documents they are signing will determine what happens.