There are many different types of owner financing. Generally speaking there is nothing necessarily illegal with owner financing, but there are many issues that can put both the buyer and seller at risk of losing their investment in the property. When the seller owns the property free and clear the seller may deed the property to the buyer and, for the balance of the sales price not paid in cash, take a promissory note with the property used as security.

When there is underlying financing the issues with owner financing become much more complicated. Some of the different ways the transaction can be structured are a "wrap," an assumption, a contract for deed, and while not technically owner financing, a lease purchase. If the underlying financing is left in place after a sale, it is extremely important that the terms of that financing are understood by both the buyer and seller.

In Texas the terms of the mortgage are included in the note and the deed of trust. It is likely that the loan not being satisfied at closing includes a due-on-sale clause in the deed-of-trust. This provision of the loan gives the lender the right to call the loan due and payable if they find that a beneficial interest in the property has been transferred by the owner, i.e. that the owner has sold the property. If this occurs and the loan is not paid in full the lender can foreclose on the property and extinguish both the seller's interest and the buyer's interest in the property. One way buyers and sellers attempt to circumvent this clause is to not record the deed showing the transfer of the property or to disguise the sale as one that doesn't trigger this clause. Either of these options are risky to the principals.

Other strategies are a contract for deed or a lease purchase where the property is not deeded to the buyer until the seller has received all of the purchase price. In Texas these agreements are termed "executory contracts" and are governed by Chapter 5, Subchapter D of the Texas Property Code. The requirements to comply with all of the provisions of this code are quite complex. One of the provisions that may apply is that if there is underlying financing on the subject property the lienholder must be notified with a disclosure specified in the code and the lienholder must not object to the agreement. If this provision of the code is not complied with the seller may be subject to a deceptive trade practices suit and be liable for significant damages.

As you can see there are many legal issues to owner financing. Before entering into any agreement or contract to purchase property, particularly one as complex as owner financing, get competent legal and/or professional advice.

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It depends. Most mortgage loans (except for FHA and VA loans made before 1990) have what's called a due on sale clause. It may also be called an assumption clause, an alienation clause, an acceleration clause, or a call provision. That means if the owners sell the house they are supposed to notify their lender and most likely the lender will require that they pay off the mortgage. The  Garn-St. Germain Depository Institutions Act of 1982 says these clauses are enforceable and that in most cases concealing the transaction from the lender is illegal.

17. Transfer of the Property or a Beneficial Interest in Borrower. If all or any part of the Property or any interest in it is sold or transferred (or if a beneficial interest in Borrower is sold or transferred and Borrower is not a natural person) without Lender's prior written consent, Lender may, at its option, require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if exercise is prohibited by federal law as of the date of this Security Instrument.

If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is delivered or mailed within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower.

The current owner's bank could call the loan and take the house back. I would never recommend buying a house this way--it leaves you with no protection if the sellers default on their mortgage. And your involvement could be construed as criminal. The bottom line is that your sellers probably can't sell to you and keep their mortgage without concealing the transaction from their lender. And if you participate, for example by allowing them to keep the homeowner's insurance in their name, you could be prosecuted.

In general, you should never do anything that cannot stand the full disclosure test. That is, if the deal could not be done if everyone involved, including all lenders, knew everything that was going on, the deal is probably unethical and illegal. What your seller is proposing probably can't be done unless the existing lender is kept in the dark about the change in control and occupancy of the property.

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