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How a Contract for Deed Works
A contract for deed, also known as a land contract, is a way to buy a home without getting a mortgage from a traditional lender such as a bank. With a contract for deed the property seller provides a loan for the buyer to purchase the property according to terms outlined in a contract. This is why a contract for deed is also referred to as seller financing. The buyer is usually not required to make a down payment. The buyer takes possession and responsibility for the property when the purchase transaction closes but does not legally own the property until the terms of the contract are fulfilled which usually happens when the seller loan is repaid in full. It is similar to purchasing a home using a rent-to-buy or installment plan.
Terms of the contract typically require the buyer to make the monthly loan payment for a certain period of time as well as pay for property taxes, homeowners insurance and all property repairs and renovations. With dilapidated properties, the contract may require that buyers bring the properties up to code and make them habitable within a certain period of time.
Even though the buyer lives in the property, makes a monthly loan payment to the seller and is responsible for taxes, insurance and property renovations, the buyer does NOT legally own the property with a contract for deed
The buyer only takes legal ownership of the property when the terms of the contract are fulfilled. For example, the terms of the contract may require the borrower to pay off the loan provided by the seller over twenty years (along with property taxes, insurance and any repairs). If the buyer adheres to the terms of the contract, he or she receives legal ownership of the property after twenty years when the final loan payment is made (or earlier if the buyer can refinance and pay off the loan from the seller before twenty years). If the buyer does not follow the terms of the contract, such as missing a loan payment or not paying property taxes, the seller can assume possession of the property, evict the buyer and keep any money the buyer has paid the seller up to that point.
Home buyers who use contract for deeds tend to be lower-income individuals with poor credit profiles or individuals who cannot or do not want to get a mortgage from a traditional lender. They usually work best when a buyer uses it as an interim step to getting a regular mortgage and buying a home. For example a buyer with poor credit or a lack of employment history may use a one to buy a home. After the buyer’s credit profile improves he or she can qualify for a regular mortgage and use the proceeds to pay off the seller loan, fulfilling the terms of the contract. Unlike the contract, a regular mortgage typically has a lower interest rate and the borrower takes full legal ownership of the property.
Contract for deeds are offered by different types of property sellers including private individuals, property investment firms and through non-profit housing agencies. There has been a higher degree of fraud associated with contract for deed transactions so we recommend working with a local housing agency to protect your interests.
- Find local housing agencies in your area STATE PROGRAMS
Buying a home with a contract for deed affords you less legal protection than buying a home with a mortgage. With a mortgage if you fall behind on your payments or go into default for any reason you typically have six months to a year to resolve the issue before losing the property. With a contract, you may only have sixty days to correct any issues before losing the property depending on the terms of the contract and state real estate laws.
The interest rate on a contract for deed loan is typically 3% - 6% higher than the rate on regular mortgage. A higher interest rate means a higher monthly mortgage payment plus you are also responsible for property taxes and insurance even though you do not own the property. Some contracts require the buyer to to make a large payment at the end of the loan, which is also known as a balloon payment. If the buyer cannot make the balloon payment, usually by obtaining a new mortgage on the property, the buyer defaults on the seller loan and buyer loses the property to the seller.
Additionally, loan payments made under the contract are typically not included on your credit report so the buyer may not get a credit score boost by making timely payments. You can work with the seller and credit bureaus to try to have these payments included in your credit score but it does not happen automatically, unlike with mortgage payments.
Purchasing a home using a contract for deed does not require a property appraisal, title report or home inspection. This exposes the buyer to significant risk because there may be outstanding liens (such as an unpaid property tax bill or second mortgage) on the property or significant property damage the buyer is unaware of. If you use one, hire an independent property inspector to document and estimate the cost of any property repairs because you may be required to pay for any renovations.
With a contract for deed the buyer does not take legal title of the property when the purchase transaction closes. This is super important for buyers to understand. Despite buying and living in the property you do not legally own it until you fulfill the contract which exposes you to significant risk
Additionally, check with your county recorder office and the seller’s mortgage company to make sure there are no outstanding liens or loans in default on the property. These issues could cause the seller to lose ownership of the property and you would lose possession of the property. Additionally, the property purchase transaction and contract are not automatically filed with your county recorder office. It is in the buyer’s best interest to personally file the contract for deed with your county recorder office. This affords you more protection in the event you have a dispute with the seller.
Use the FREEandCLEAR Lender Directory to find lenders that offer a wide range of no and low down payment programs. Buying a home with a low down payment program may be a better option than a contract for deed.
It is also more difficult for you to access the equity you build in the property because you do not actually own it. Even if you are paying down the loan the seller provides, you cannot access the equity in the property until you legally own it. Although the property may be worth significantly more than your loan balance, you cannot sell the property or take out a home equity loan until the terms of the contract are complete and you take legal ownership title of the property.
Plus, if you default on the contract before taking ownership of the property you may not be entitled to any equity in the property. For example, if you buy a home with a 20 year seller loan and you default on the loan in year 19, you may lose all of the equity you have gained the first 19 years of the loan. In other words, you lose all of the money you have paid to the seller or put into the property until that point and do not have the opportunity get some of your money back by selling the property like you would with a mortgage. Real estate laws vary by state so buyers may receive more protection in the event of loan default depending on where you live.
The seller is responsible for making the payments on any mortgages on the property. Because the seller maintains title to the property they can keep a mortgage on the property and potentially take out a second mortgage. If the seller defaults on a mortgage against the property the lender could take ownership of the property and the buyer could be forced to vacate the property without compensation.
The main benefit to a contract for deed is that it usually does not require the buyer to make a down payment which makes buying a home more affordable. It does not have the same credit score or borrower qualification requirements as a regular mortgage so it makes buying a home possible for people who may not qualify otherwise. The purchase transaction does not require a mortgage application, appraisal or title report. This results in lower closing costs and a much faster closing timeline but exposes the buyer to significant risk that the property has significant damages or outstanding liens against it.
Buyers need to understand the terms of the contract including the property purchase price, the interest rate on seller loan, the length of the loan and if the loan requires a balloon payment. Buyers should understand exactly what they are responsible for paying for under the contract for deed. In addition to making monthly loan payments to the seller, buyers are typically required to pay property tax, homeowners insurance and for any repairs to the property. Buyers may also be responsible for making significant renovations to bring the property up to code within a certain time frame after the transaction closes. Make sure you know what costs you are responsible for and that you can afford them. Hire an independent property inspector to identify any repairs the property requires because you will likely have to pay for them when you take possession of the home.
Make sure the seller actually owns the property and that there are no outstanding liens against the property. You can do this by contacting your county recorder office or a title company. You want to make sure that the person you are buying the property from actually owns it and is not trying to rip you off. You also want to make sure that there are no claims against the property that could prevent you from living in or taking legal ownership of the property in the future. Make sure the contract for deed is filed with your county recorder office. Depending on what state you live in this may or may not happen automatically.
Sources
Myslajek, Crystal. "Risks and realities of the contract for deed." Federal Reserve Bank Of Minneapolis, January 1 2009. Web.
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