How a Land Contract Works for Buying Homes
Why Home Buyers Like Land Contracts
Land contracts for buying homes were very popular in the late 1970s and early 1980s. Back then, installment sale contracts, sometimes called contracts for deed, offered more attractive financing terms over the higher rates and rigid qualification standards of institutional lenders.
Land contracts began to disappear when loan requirements softened and rates dropped below 8%. But they have not vanished altogether and, in fact, tiptoed back into the market during the mortgage crisis. Previous homeowners who lost their homes to foreclosure or sold through a short sale began to lean on land contracts as a financing alternative when the big banks turned them away.
What Is an Installment Sale Land Contract?
An installment sales contract is any type of contract that calls for periodic payments, but in real estate, it is generally referred to as a land contract, contract for deed, or contract for sale. The term "land" is misleading as a land contract can be used to purchase any type of real estate with or without improvements.
The installment sales contract spells out the sales price, the amount of down payment, interest rate, amount of monthly (or periodic) payments, and the duties of each of the parties. It covers such responsibilities as who will maintain the home, pay for insurance, and property taxes -- which is generally the buyer. The contract will include a recourse for the seller in the event the buyer stops making the installment payments.
- Land contracts or contracts for deed are a security agreement between a seller, called a Vendor, and a buyer, called a Vendee.
- The Vendor agrees to sell a property by financing the purchase for the Vendee.
- The Vendor retains legal title and the Vendee receives equitable title.
- The owner-carried financing can include an existing mortgage balance (see more below) or the property can be free and clear (best option).
- Upon payment in full, the Vendor hands the Vendee a deed to the property.
All-inclusive (Wrap-around) Land Contracts
- Wrap-around contracts contain an existing mortgage.
- The Vendee makes one payment to the Vendor.
- Upon receipt of the payment, the Vendor pays the underlying lender's payment and keeps the rest.
- If the existing mortgage has a lower interest rate than the interest rate on the contract, the Vendor earns extra interest on money that does not belong to the Vendor. This is known as an override.
Following is how it works.
- Say the sales price is $100,000.
- The Vendee puts down $10,000.
- The Vendee agrees to make payments on $90,000, bearing interest at 6.5%, payable $567.
- The existing underlying loan is $50,000, payable at 5% interest with a payment of $268.
- The Vendor earns 6.5% interest on $40,000 of equity, PLUS 1.5% interest on the existing mortgage of $50,000 and pockets $299 a month.
- The Vendee also pays taxes, insurance and all other costs of ownership.
There is no override of interest in a straight contract. The Vendee can agree to pay the existing lender directly and make another payment to the Vendor, or the Vendee can send one payment to the Vendor, and the Vendor will disburse payment to the underlying lender. Let's look at the previous example on a straight contract:
- Sales price of $100,000.
- Vendee puts down $10,000.
- Vendee makes one payment of $268 on the existing loan balance of $50,000, bearing interest at 5%.
- Vendee makes a second payment to Vendor on $40,000 owner-carried financing, bearing interest at 6.5% and payable at $253 per month.
- Total of both payments is $521, which saves the Vendee $46 per month over the wrap-around.
Power of Sale
- Some title companies draft and insure land contracts that contain a Vendor, a Vendee and a Trustee. You will need to call around to find such a title company.
- Like a trustor in a trust deed, the Vendor and Vendee assign right, title and interest to the trustee for the purpose of securing the Vendor's and Vendee's obligations.
- In the event the Vendee stops making payments, the Trustee has the power to foreclose under the power of sale.
- The process of filing a notice of default varies from state to state.
Acceleration Clauses in Underlying Loans
All loans today contain acceleration and alienation clauses. Lenders have had a long history of calling loans immediately due and payable if buyers took title "subject to" to the existing loans. That's because lenders wanted the buyers to qualify, pay loan points and higher interest rates.
Sue Heimbichner, an escrow officer at Chicago Title in Sacramento, has been in the business since 1976 and has watched the popularity of land contracts come and go. One of the biggest lawsuits from that period evolved from buyers taking title subject to existing mortgages held by federal savings and loan associations. Congress passed the Depository Institutions Act of 1982, effectively wiping out the ability to take over existing loans.
Heimbichner says lenders today tend to look the other way. "Some lenders are glad to have their payments made," she said. But don't try to take over government-backed loans. "You don't want to mess with the government," Heimbichner warns, "because you're going to get slapped." If your land contract contains an existing mortgage, you should seek the advice of a real estate lawyer.
Samples of government-backed loans are Fannie Mae or Freddie Mac, and government loans are FHA or VA.
Vendee's Bundle of Rights
For all practical purposes, the Vendee owns the property and has the right of:
- Quiet enjoyment and use of the property.
- Exclusion, forcing others to leave the premises.
Benefits to the Vendee
- No qualifying, although the Vendor could ask for a copy of the buyer's credit report.
- Down payment flexibility. The amount is negotiable.
- The length of the land contract term, interest rate, and payments are negotiable.
- Low closing costs. There are no lender fees to pay.
- Fast closing. Transactions can close in 7 days or less.
Benefits to the Vendor
- Typically higher sales price and no appraisal. Although buyers are advised to obtain an appraisal.
- If taxable, possibly can qualify for deferred gain.
- Monthly income.
- Often a better rate of return than money market accounts.
- If the property is non-conforming, it's an easy way to sell.
- Fast closing.
- Pull the buyer's credit report.
- Include both Vendor and Vendee names on the existing insurance policy.
- Hire a disbursement company to handle contract collection.
- Talk to a real estate lawyer.
This article is not to be misconstrued as giving legal advice. Only lawyers can offer legal advice.
At the time of writing, Elizabeth Weintraub, Cal BRE #00697006, is a broker-associate at Lyon Real Estate in Sacramento, California.