What problems arise for the seller and the buyer in owner financed homes?

An alternative form of financing much hyped during a languish seller’s real estate market is owner or seller financing or owner carryback. This means the owner participates in financing the buyer’s purchase price of the property, either in whole or in part. However, if the deal is not properly structured, owner financing can cause significant problems for both the buyer and the seller under various circumstances. (Owner or seller financing typically becomes more prevalent when home sales slow down in a given geographical area and sellers of real property who are highly motivated to sell their property are more willing to take risks in its sale than they normally would if the real estate market was not slow.) Example: A seller owns his or her home free and clear with no mortgage. The home is worth $200,000. A buyer agrees to the purchase price of the home for $180,000 with $15,000 down and the seller agrees to carry the balance of the purchase price ($165,000) by way of a promissory note in his or her name secured by a first mortgage on the property being sold at a stated rate of interest payable in monthly payments for so many years.

Example: A seller owns his or her home free and clear with no mortgage. The home is worth $200,000. A buyer agrees to purchase the home for $180,000 with $15,000 down and the seller agrees to carry the balance of the purchase price ($165,000) by way of a promissory note in his or her name secured by a first mortgage on the property being sold at a stated rate of interest payable in so many years.

Unless the seller and buyer have an experienced real estate attorney assisting him or her in an owner (seller) finance, the chances for serious problems arising from the transaction can be significant to both the seller and the buyer.

What kinds of problems do buyers face?

A typical problem for the buyer is if the seller does not own the property being sold free and clear of any traditional mortgage or trust deed and the buyer cannot get a loan to pay off the existing loan, the buyer runs the risk of obtaining a loan from the seller and taking title subject to the existing loan in place. Should that happen, the buyer will have to pay monthly payments on this loan just like the seller was doing. The problem that could arise for the buyer is that the loan in place may not be assumable. If the loan is not assumable, the transfer of title to a new owner of the property may very well trigger a due on sales clause in the existing mortgage where the lender refuses to accept payments from the new owner. This will force the new buyer to scramble to get a new loan, assuming one is available. If not, the new buyer could lose the home in a foreclosure.

If a foreclosure proceeding happens in such a scenario, the seller will be forced to service the loan that was in place or risk losing the equity in his or her seller’s finance. As you can imagine, the above situation invariably leads to litigation by the seller against the buyer.

When there is an owner financing situation and an existing first mortgage, it is imperative that the seller disclose this fact to the buyer advising him or her to ascertain whether or not the loan secured by the mortgage is assumable or not.

What types of problems do sellers have?

A typical problem in an owner financing situation is when the buyer can only qualify for a loan from a traditional lender for up to a certain dollar amount and the loan needs to be in a first secured position to be sold. In such a situation, the seller may agree to “loan” the buyer the balance of the home’s sales price evidenced by a promissory note secured by a second mortgage on the home.

The problem with the seller being in a second secured position for his or her “loan” to the buyer is that if the buyer defaults on the first secured loan, the seller in order to protect his or her loan must keep current the first loan that has a mortgage on the property. If not, the seller faces the possibility that the first loan will foreclose upon the property, wiping out his loan on the home.

The most common problem arising out of an owner’s finance of a sale to the buyer is when the seller’s loan comes due for payment. Many times the buyer makes a claim that there are problems with the home that were not disclosed by the seller before the closing of escrow in an attempt to reduce the balance owed on the loan.

Most promissory notes have attorneys fee provisions within them. When a dispute arises concerning a promissory note containing an attorney’s fee clause, the result is usually very long and expensive litigation because the attorney’s fee clause seems to be the force that drives the lawsuit between the attorneys representing the buyer and seller.

Sale by Owner Can Be Scary

But it doesn’t have to be. On its face, an owner financing situation seems like a good idea. However, if the transaction is not properly supervised by an experienced real estate attorney for both the seller and the buyer, many hidden traps may emerge.

Case Studies: Navigating Challenges in Owner Financed Homes

Case Study 1: Buyer’s Problem – Existing Mortgage

John is interested in purchasing a home through owner financing. However, he discovers that the seller still has an existing mortgage on the property. Without proper due diligence or guidance, John proceeds with the purchase, assuming the existing loan is assumable. Unfortunately, he later realizes that the loan is not assumable, and the lender demands full payment upon transfer of ownership.

John is now at risk of losing the home to foreclosure if he is unable to secure a new loan. This situation highlights the importance of buyers conducting thorough investigations and seeking legal advice to ensure the property’s title and any existing loans are properly addressed before entering into an owner financing agreement.

Case Study 2: Buyer’s Problem – Undisclosed Home Issues

Amy enters into an owner financing arrangement to purchase a home. After the transaction, she discovers significant problems with the property that were not disclosed by the seller during the closing process. Amy believes these undisclosed issues should reduce the balance owed on the loan.

A dispute arises between Amy and the seller, leading to prolonged and costly litigation. This case emphasizes the need for clear and comprehensive disclosure of any known issues or defects in the property to avoid disputes and potential legal battles.

Case Study 3: Seller’s Problem – Second Mortgage Position

Sarah decides to offer owner financing to sell her property. To accommodate the buyer’s financing limitations, Sarah agrees to carry a second mortgage. However, by being in the second mortgage position, Sarah faces the risk that if the buyer defaults on the first mortgage, she must continue making payments on the first loan to protect her second mortgage.

Failure to do so could result in foreclosure by the first mortgage holder, potentially wiping out Sarah’s loan on the property. This situation underscores the importance for sellers to carefully evaluate the buyer’s financial capabilities and consider the potential risks associated with being in a subordinate mortgage position.