All About Owner Financing a Home in Chicagoland
Suppose a buyer asked you if you offer owner financing a home in Chicagoland, what would you say? Would you extend your own money to a buyer so that they have the funds to buy your home? Ninety-nine percent of the time, it’s the buyer that brings the money to the seller, not the other way around. Why in the world would a seller front the costs for the buyer to purchase their own home?
It happens, and it’s called owner financing.
What is Owner Financing a Home in Chicagoland?
Other times this phrase goes by is “seller financing” or a “purchase-money mortgage.” In a nutshell, owner financing a home in Chicagoland is an arrangement in which the buyer interested in a home for sale borrows a portion - or all - of the amount from the home seller.
There are several scenarios that may play out preceding an owner financing a home in Chicagoland. First off, the home buyer may be taking out a traditional mortgage but are unable to borrow the full sale price. In these cases, the home seller might agree to lend the buyer a certain amount of money that would then make up the difference between the bank loan and the sale home’s price.
In another scenario, the buyer may not want to purchase the home, or perhaps does not qualify for the home from a traditional lender. In these cases, the seller would extend the loan to the buyer for the purchase price.
Let’s jog this idea with an example. Suppose that the sale price is $300,000 on a home. The buyer is interested in purchasing the home at this agreed sale price. The buyer has 20%, or $60,000, in the pocket as a down payment for the home. However, the bank only approves this buyer for a home with a $200,000 price tag or less. Therefore, with the downpayment and the qualified loan, the buyer comes up with $40,000 short.
With home seller financing, the seller can extend the additional $40,000 that the buyer needs to make up the difference.
Is this a Long Term Solution?
Short answer, no. Owner financing a home in Chicagoland is considered a stop-gap solution. It’s an arrangement that is short-term in nature, where the buyer can work on getting a traditional loan for the full mortgage amount within the next couple of years.
As you can imagine, the terms of the loans are designed to push the buyer to secure alternative financing. This motivation comes in the form of an annual interest rate increase or even an unusually large payment due to a couple of years into the life of the loan.
As you may already imagine, seller financing isn’t just a situation in which the seller hands over the cash that the buyer needs. There is an actual contract - a private mortgage loan - that is drafted between these two private citizens: the home buyer and the home seller. In this legally binding contract, specific terms, conditions, and requirements are defined so both parties have full knowledge of what is expected of them. If the contract terms are broken, there will be recourse terms as well.
Of course, there is a downside to this as well. As it is a private loan between two private citizens if the buyer within the next couple of years has trouble meeting the terms of the loan it can cause strife between the two parties. As well, when dealing with money between family or friends (as is often the case when owner financing a home in Chicagoland is used), there can be additional constraints and stress put on the relationship. Ever tried lending money to your friends or family? It can be rife with landmines.
Seller financing is often frequently an arrangement between two strangers. However, because the seller is putting their neck out, they need to be sure that the buyer is honest and financially solvent. If the buyer doesn’t abide by the terms of the loan, the seller can be in for a world of hurt.
How Often Do Sellers Use Owner Financing?
These days, owner financing is relatively rare. However, in the past when the interest rate for a mortgage loan resembled high-interest credit cards, hovering at 18%, seller financing was more common. In the 1980s, owner financing a home in Chicagoland became popular because interest rates were so high, many buyers couldn’t afford a loan.
The contract for deed became popular. In this scenario, the buyer doesn’t pay the bank loan at 18% (which may have been the only loan they qualify for), instead, they pay the seller’s mortgage interest percentage, which was likely much better than 18%. For example, if the buyer can only afford an 18% loan and the seller has an 8% loan, they could then charge the buyer 12%-15% in the new, seller-financed mortgage.
If seller financing is used today, it’s best for the seller to finance on a home that they own outright, not one in which they hold a mortgage. The reason being, if the seller is still paying a mortgage on the home they want to sell, and then get another mortgage for the home they want to move into, then they would be responsible (and have to qualify) for two mortgages. And if the buyer defaults on the previous loan, watch out. You’re on the hook!
Okay, So Tell Me the Cons
Seller financing is a great solution, as long as the buyer is financially solvent and does not default on the loan. This can be tricky, as the fact that the buyer seeks owner financing, to begin with, is because they don’t qualify for a traditional mortgage. This can be trouble because they are high-risk borrowers.
As high-risk, they may be more likely to default on the loan. That’s bad, but they may also decide to simply stop paying you AND continue living in the home. And if the house goes into foreclosure, it’s on the seller to pay for it. And as occupants of a home that is being foreclosed on often take the situation out on the home itself, the property may incur damage and be returned to the bank in a worse condition than what the buyer started with.
With seller financing, the seller lends the money (via their mortgage) and get paid in small installments over a period of time. So in effect, the seller becomes a lender of sorts - however, they cannot access the full equity in the home to help purchase another one.
Are you selling a home in Chicago, IL?
Now the Pros?
Seller financing offers many tax benefits, but these really should be discussed over with a tax professional. As the buyer pays you in small increments over several years, the government classifies this as an “installment sale” - it comes juicy tax breaks.
As well, since you are the lender you need not worry that the buyer’s mortgage company will demand expensive repairs or upgrades before approving the loan. So in these scenarios, the seller can sell their home “as-is.”
And finally, the seller keeps the title to the property until the home is paid for in full. If the buyer does end up going into default, you still own the house. Even if they’ve paid a lot of money towards the mortgage.
What are the Steps?
This is a complex process that needs the expertise of your tax professional, real estate agent, real estate attorney, and others involved. But let’s do a very top-level overview of the steps so you have a better idea of whether this is an option you want to pursue.
Step 1: Financial and legal requirements.
Assess whether you are financially secure to handle the risks that go hand-in-hand with the owner financing a home in Chicagoland. As mentioned, it’s best that you own the house outright as well as have money saved for repairs, taxes, insurance, and other unforeseen expenses.
It’s imperative that your real estate attorney briefs you on the legal requirements at both the state and federal levels. If you don’t do this the right way, you could end up losing your home.
Step 2: Examine the buyer.
If you’re using seller financing with a family or friend, you likely have a good idea of their financial solvency. However, with a stranger, things are less certain. In all scenarios, get their tax information, their job history, and what kind of savings they have, if any. Credit reports and references are also necessary.
Step 3: Draft the loan terms.
Draw up the loan terms, interest rate, etc. These must be very detailed. Down to the stove and dishwasher. If the buyer defaults, then they may strip the house and sell these items. You need a detailed contract so it’s clear what’s in the house (and the condition) when the buyer moves in.
Step 4: Earnest money.
With the contract signed, it’s time to collect the earnest money deposit.
This money should be squirreled away, in case the buyer does default down the road and you have to cover foreclosure, attorney, other fees.
Owner financing a home in Chicagoland is extremely complex. However, if you’re sure it’s for you it could be a good solution. Please be sure you loop in all of the professional minds necessary to keep your investment safe in case the buyer defaults and things go south.