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.
What Is an Installment Sale Land Contract?
Land contracts began to disappear when loan requirements softened and mortgage rates dropped below 8%. But they have not vanished altogether and began to tiptoe back into the market during the mortgage crisis of 2007 to 2010. 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.
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 includes a recourse for the seller in the event the buyer stops making the installment payments.
How Land Contracts Work
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 or the property can be free and clear (best option).
- Upon payment in full, the Vendor hands the Vendee a deed to the property.
Explaining 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.
This example shows how they are put together:
- Let's 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 as $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.
What Are Straight Contracts?
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:
- Assume a 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 may exercise a "due-on-sale" clause preventing anyone to take over an existing mortgage. Lenders prefer the buyers to qualify, pay loan points, and higher interest rates. If your land contract contains an existing mortgage, seek the advice of a real estate lawyer to prevent any unwanted surprises.
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
The biggest benefit is to avoid going through the standard qualification process. In addition:
- Down payment amount is negotiable
- Length of the contract term, interest rate, and payments are negotiable
- No lender closing fees to pay
- Transactions can close in less than a week
Benefits to the Vendor
Typically, the sales price can be higher, although buyers are advised to get an appraisal. In addition:
- Possibility for a deferred gain on taxes
- Monthly income
- Often a better rate of return than money market accounts
- Easy way to sell a non-conforming property
- Fast closing
What Should Buyers Do?
- Get an appraisal
- Obtain title insurance
- Engage the services of a holding company to retain possession of an executed deed and the original documents
- Talk to a real estate lawyer
What Should Sellers Do?
- 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 the initial writing of this story, Elizabeth Weintraub, Cal BRE #00697006, was a broker-associate at Lyon Real Estate in Sacramento, California.