Land contracts are useful instruments for sellers who are selling a home and contemplating carrying the financing for a buyer. It gives sellers a built-in income and generally a better interest rate than rates offered on money market accounts or certificates of deposit. However, a prudent seller should take steps to protect equity and ensure the buyer can fulfill the terms of the land contract.
- Land contracts are similar to mortgages, but a difference is that the buyer does not get the title to the property until after the debt has been repaid.
- To protect themselves, sellers using land contracts should check the buyer's credit, ask for a large down payment, and insist the buyer obtain a homeowner insurance policy.
- Land contracts are complex legal documents, so it's probably best to at least consult a lawyer before tackling this process on your own.
Difference Between a Land Contract and a Mortgage
Land contracts are security agreements between a seller, known as a Vendor, and a buyer, known as a Vendee. The Vendor carries the financing for the Vendee, which may or may not contain an underlying loan. A main difference between a land contract and a mortgage is the buyer does not receive a deed or clear title to the property until the land contract is paid off.
Some states have laws that treat a land contract similar to a trust deed, and those land contracts provide for a trustee, giving a trustee "power of sale" to initiate foreclosure proceedings in the event the Vendee defaults on the contract. Other states give buyers a longer period of redemption, similar to those under a mortgage. For these reasons, it is important to reduce the chances of default by pre-qualifying the Vendee.
Protecting the Seller
If you have an underlying loan, given a choice between a straight contract or a wrap-around contract, offer the wrap-around land contract. It will give you an override on the existing interest rate of the first mortgage. Ask for legal advice about an alienation clause. The lender could call your loan due and payable if the lender discovers you have sold the home through a land contract.
- Obtain a Credit Report on the Buyer. If the buyer has filed a bankruptcy, made late payments to other creditors or, worse, no credit, those derogatory records are a red flag.
- Demand a Title Insurance Policy. Title searches of the public records will also show liens or judgments filed against a buyer. The title company will likely ask for satisfaction of those encumbrances before it will insure the land contract on a title policy. Ask to see a copy of the preliminary title report (or commitment for title insurance) to determine if a search reveals anything about the buyer.
- Ask for a Hefty Down Payment. Buyers are less likely to walk away from a land contract or stop paying on the installment sale contract if the buyer has made a big down payment. The more money invested upfront; the less likely a buyer will risk losing it.
- Carry the Financing Short-Term. You might amortize the payments for 30 years but ask for a balloon payment after five or ten years. It will let the buyer refinance or sell the property to pay you early. Check to see if this type of financing complies with your state laws. Balloon payments could be prohibited.
- Verify the Buyer's Employment. Make sure the buyer is employed and has been employed for at least two years, preferably longer. Ask if the buyer is employed by the company or is contract labor and whether the employment term could be slated for termination any time soon.
- Ask for Personal References. Check out the buyer's references, including past landlords. Ask about payment history on previous rentals, not just the current rental because sometimes landlords will say anything to get the tenant out of the property. Go back to the landlord before the existing landlord and inquire.
- Insist the Buyer Obtain a Homeowner Insurance Policy. You don't want to be responsible for the home after the land contract has been signed and notarized. Make sure the buyer names you as an additional insured and get a copy of the homeowner's insurance policy.
- Set Up a Disbursement Account. Many banks and financial institutions offer a service that will collect the payments from the buyer and send them to you or deposit them into your bank account. It prevents the buyer from knowing your home address, and the arrangement frees you to travel.
- Collect the Taxes From the Vendee. Ask the Vendee to pay the taxes to your disbursement company. The company can then make the tax payments to your property assessor and you can be assured the taxes will be paid on time.
- Include a Late Payment Charge in the Land Contract. If you are paying an underlying loan payment, you will want to receive your payments in a timely manner to avoid your own late charges. Charge the buyer a reasonable fee for payments received late to entice the buyer to pay on time.
- Ensure Continued Maintenance and Care. Consider including an acceleration clause in the contract, which will allow you to make the Vendee refinance the property if the condition of the property becomes a risk to your financial investment.
- Prevent the Vendee From Assigning the Contract. After you've done your homework to approve this buyer, you don't want to give the buyer the right to assign the contract to an unknown entity.
- Talk to a Lawyer. It's worth it to spend a few hundred dollars to obtain legal advice before entering into a land contract. Besides, a lawyer is likely to think of something that was missed in this bullet-point list.
At the time of writing, Elizabeth Weintraub, Cal BRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.