If you were a home buyer in the 1970s and 1980s, you might remember how land contracts played a big role in helping buyers finance their new homes. Back then, interest rates were pretty high, and lending requirements were pretty stiff. Land contracts – also known as ‘contracts for deed’ or ‘installment sales contracts’ – offered more attractive financing terms for buyers.
As the interest rates on mortgages started to plummet and lending criteria started to soften, land contracts started to fizzle out. But they’re still around, and many buyers are still taking advantage of them, especially since financial institutions started making their loan qualifications more rigid following the economic crisis in 2008.
What Exactly is a Land Contract?
Land contracts are basically a security agreement between a seller and a buyer. In this case, the seller agrees to sell their property by financing the purchase on behalf of the buyer, while the seller still holds legal title of the property, and the buyer gets equitable title.
Both parties in the contract agree that the land contract will be held in escrow by a neutral third party before closing. The seller financing might include a mortgage balance that still exists, or the property may be free and clear of any outstanding mortgage.
An agreed-upon sales price is reached between the buyer and seller, and once this amount is fully paid off (or when the buyer is able able to get approved for a commercial mortgage), the deed is taken out of escrow and title is officially transferred to the buyer.
Let’s illustrate how a land contact would work in real life: A seller owns a property that he’s looking to sell for $300,000. There is no outstanding mortgage on the house, so the property is free and clear.
A buyer signs a contract, and gives a 10% deposit to the seller – or $30,000. The buyer then agrees to pay the difference to the seller on a monthly basis based on an interest rate that both parties have mutually agreed on.
So, if the agreed upon interest rate is 5%, the buyer will have to pay $1,440.97 per month. The buyer also agrees to pay the property taxes and the house insurance.
Of course, this is a simplified version – the numbers change when there is an underlying existing mortgage on the property, which we’ll get into below.
Why Would Buyers Choose a Land Contract Versus a Traditional Sale and Mortgage?
There are a number of reasons why a buyer might want to go the land contract route when buying a property. The biggest advantage is perhaps the fact that there’s no need to qualify for a conventional mortgage. This is especially advantageous for buyers who otherwise would be turned down for a traditional mortgage at the bank. These transactions also tend to close rather quickly, many times within a week.
The down payment amount is totally negotiable between the seller and buyer, so there’s more flexibility when it comes to how much money a buyer can put down. Other negotiable items in this type of agreement include the length of the land contract term, the interest rates, and the payment amounts. And since there are no lender fees to be responsible for, the closing costs are quite low.
Why Would Sellers Choose a Land Contract?
While there are obvious benefits to buyers in land contracts, sellers also have their fair share of benefits. For starters, sellers can effectively get more money for their property without having to get the place appraised. And if the funds are taxable, sellers might be able to qualify for deferred gains.
The fast closing and being relieved of obligations to maintain the property is another big benefit for sellers, as is the decent rate of return that they’ll get on their money.
There’s also another big advantage for sellers in the case of a land contract with an existing mortgage on the property. If the existing mortgage has a lower interest rate than the interest rate stated on the contract, the seller can earn extra cash on the interest on money that doesn’t even belong to the seller.
Let’s use the same example above to illustrate. If there is an existing underlying mortgage is $100,000, payable at 4% interest, monthly payments will equate to $475.52 per month. The seller will earn 5% interest on $170,000 of equity ($270,000 minus $100,000), in addition to 1% interest on the existing mortgage of $100,000, and will pocket $965.45 a month.
The buyer can agree to pay the existing mortgage lender directly and make a separate payment to the seller, or the buyer might choose to send one lump payment to the seller who will then disburse the funds to the underlying lender.
If you’re a buyer, make sure you get an appraisal and title insurance, and use the services of a holding company or lawyer to keep possession of the contract. If you’re a seller, make sure you run the buyer’s credit report, and include both your name and the name of the buyers on the insurance policy. And regardless of what end of the playing field you’re on, be sure to speak with a real estate lawyer and agent to make sure the contact is carefully drafted.