Interest Rate Risks of Owner Financing

Both buyer and seller involved in an owner financed transaction are exposed to risk and reward resulting from interest rate changes. Adjustable rate mortgages are common in conventional home financing, but rare in owner financed transactions. If nothing else, the legal documents required to define how the adjustments are made are so complex they could not be drafted by the usual general practice attorney. Most seller financing will have a fixed rate of interest.

What happens if the interest rates increase?

The buyer is happy because their rate stays the same and may even be below market. The higher rates go, the better their deal looks.

The seller may be unhappy. However, in most cases the note was written at 3-5% above the bank rate for savings, so the seller may still be making more money than they could on their savings.

Where the seller will really suffer is if they are forced to sell the contract into the seconday note market after there has been an interest rate increase. Depending on a lot of factors the cash value of the contract may be reduced by 1/3 or more. Not a happy situation.

What happens if interest rates go down?

The buyers gets more and more unhappy and feel like they are paying to much. It their credit has improved since they bought the house, they are making more money or some other facet of their financial condition has changed, they will probably start shopping for a conventional loan at market rates and pay off the seller.

If the seller needs the money, getting paid off early is a good thing. However, if the sellers were counting on the extra interest for income, they will be less pleased. If overall interest rates are going down they probably can’t find any place to invest the note payoff funds at the rate they were getting. If large amounts of money were involved, this can mean a large drop in income for the sellers.

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admin August 31, 2011 at 5:57 pm

If I could predict where interest rates are going I would be rich. I remember buying houses many years ago that had fixed rate FHA loans on them at 10% because I was certain rates would never be lower.

As far as structure, that is both the advantage and disadvantage of owner financing. The buyer needs to have the right to do what they plan with the property. You need some restrictions that prevent an auto junk yard or hog farm. It needs to be clear who pays taxes and that either party has the right to pay them (and get reimbursed) if the other doesn’t. Within some range the IRS deems “reasonable” you can choose an interest rate and purchase price that yields the best division of capital gain and interest income. Payment amounts, frequency, and interest don’t have to stay the same for the life of the note. Notes can sometimes be structured to avoid problems with heirs.

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