Land contracts and their risks

In short

A friend of mine once bought a small house on a handshake and a typed agreement, and he slept better the night he finally held the deed in his hand. If you are looking at a land contract, you are probably short on a bank loan, and that is no shame. In a land contract, the seller keeps the legal title while the buyer makes payments and lives in the home. The buyer does not get the deed until the last payment is made, so everything rests on the paperwork and on the seller staying in good financial shape. Rules for these deals differ from state to state, so the buyer should read the contract with a real estate attorney licensed in that state. The buyer should also check the county records for liens, back taxes, and any loan the seller still owes. Paying on time, keeping receipts, and recording the contract at the county office protect a buyer most.

The whole of it

What it is

I once watched an old farmer sell a back lot to his neighbor's son with nothing but a pen and a kitchen table. That is the heart of a land contract, though today it usually comes with more paper. It goes by other names too, such as contract for deed, installment sale contract, or bond for title. The names change from place to place. The idea stays the same.

If you are holding one of these papers, here is what it says. The seller agrees to sell the property. The buyer agrees to pay over time, often with interest. Legal title stays with the seller until the buyer pays the full price or refinances. Equitable title, which means the buyer's right to own the property once the contract is done, belongs to the buyer in the meantime.

Why do people turn to this? A buyer may have a thin credit file, or a new job, or too little saved for a down payment. A seller may want steady income, or may have a house that is hard to sell the usual way. Both sides can have good reasons. That is fair enough.

How it works

A neighbor of mine tried to explain his land contract to me once, and it took us most of an afternoon and a pot of coffee. So let me go slowly.

The buyer signs a contract that sets a price, a down payment, a payment schedule, and an interest rate. The buyer then moves in. The buyer often pays the property taxes, the insurance, and the repairs, just like an owner. The seller holds the title as a kind of security, much like a bank holds a lien under a mortgage.

Many contracts end with a balloon payment. That means a large lump sum due on a set date, often after five or ten years. The buyer has to find a lender by then and pay off the seller. If the buyer cannot, trouble follows.

Now the hard part. If the buyer misses payments, the contract may let the seller cancel it. In some states that can happen faster than a regular foreclosure. It is called forfeiture. The buyer can lose the home and every dollar paid so far, and may have little time to fix it. Some states give buyers more protection than others, and a few require a court process. A real estate attorney in the buyer's state can say which rules apply.

The numbers, and where to find yours

I like numbers that a person can check at his own table. A land contract has several that matter.

The first is the purchase price and the interest rate. A buyer can compare them with what nearby homes have sold for, and with current mortgage rates. The Consumer Financial Protection Bureau publishes plain guides on mortgage costs at consumerfinance.gov. Its pages can help a buyer see whether a land contract rate is out of line.

The second is the seller's own loan. Many sellers still owe money on the property. If the seller stops paying that loan, the lender can foreclose, and the buyer may lose the home even with a perfect payment record. The county recorder's office, sometimes called the register of deeds, keeps the records of liens and mortgages against the property. A buyer can look them up there.

The third is the property tax bill. The county assessor or treasurer can say whether taxes are paid up. Unpaid taxes can lead to a tax sale, and that can wipe out a buyer's claim.

The fourth is the federal rule on seller financing. The Dodd Frank Act and rules from the Consumer Financial Protection Bureau limit some seller financed deals, and the limits depend on how many properties a seller finances. The seller's own attorney should know where a deal falls. For the buyer, the point is simple. Ask whether the seller follows the rules that apply.

The fifth is the balloon date and the amount due. Write it on a calendar. Then check what the buyer's credit and income must look like to qualify for a loan by that date. How much a lender will allow depends on the buyer's income and debts, so a buyer should talk to a lender early, not at the last minute.

A worked example

Let me tell you about a woman I will call Maria Alvarez. She is a made up person, and the figures below are my own round numbers to show the arithmetic, not a real deal. Maria works as a school cook and earns $38,000 a year. She has not yet saved enough for a bank loan, and she wants a home of her own.

A homeowner named Frank Dillon offered her his small house for $120,000. Maria would pay $6,000 down, then $900 a month at 7 percent interest, with a balloon payment due in five years.

Here is how the first year looks for Maria. Twelve payments of $900 add up to $10,800. The down payment of $6,000 plus $10,800 is $16,800 paid out of pocket in year one. Taxes and insurance, which Maria pays herself, add about $2,400 a year in this example. That brings her first year cost to $19,200.

Now look at what happens to the loan. The amount borrowed is $120,000 minus the $6,000 down, which is $114,000. Interest in the first year at 7 percent is about $7,980, because $114,000 times 0.07 is $7,980 if she owed the full amount all year. Her payments of $10,800 cover that interest and about $2,820 toward the balance, since $10,800 minus $7,980 is $2,820. Notice how little of her money reduces the debt. That is how a loan looks in its early years.

After five years, Maria still owes most of the money. Say the balance is about $104,000. The balloon payment would be $104,000, due all at once. If Maria cannot get a bank loan by then, she may lose the house and all the payments. Those payments would be the $6,000 down plus 60 monthly payments of $900. Sixty payments of $900 is $54,000, and adding the $6,000 down makes $60,000. On top of that comes the taxes and repairs she paid along the way.

Maria did one smart thing. She had an attorney read the contract, and she recorded it at the county office. The attorney found that Frank still owed $70,000 on his own mortgage. Maria asked that her payments go through a third party who would also pay Frank's lender. That one step protected her. It cost her a small fee, and it kept her home safe.

Where it goes wrong

I would not be your friend if I only told you the good parts. These deals can go sour, and they go sour in a few familiar ways.

The seller may fail to pay his own mortgage. The buyer may then lose everything. The seller may die, go bankrupt, or get divorced, and the title can get tangled in court. The seller may also have an unpaid tax bill or a lien from a contractor, which can cloud the title.

The contract may also be written with harsh terms. It might allow the seller to cancel after one late payment. It might make the buyer pay for major repairs on a house with a bad roof or old plumbing. It might hide fees. A buyer should read every line and never sign what is not understood.

Another trouble is the balloon payment. A buyer who counted on refinancing may find that rates rose, or that the home appraised for less than the price. Then no lender may give the full amount. That can end the deal.

Buyers sometimes skip an inspection and a title search to save money. That is a small saving against a very large risk. A title search shows who really owns the property and what claims sit against it. A title company or attorney can run one.

There is one more thing. Some states treat a buyer who has paid a large share of the price as an owner with real rights, and they may require a court process before the seller can cancel. Others let a seller cancel much faster. Each state sets its own rules in its own statutes, so the difference can be huge. That is why local advice matters so much.

Questions to answer before you leave this page

Have you read the whole contract, and has a real estate attorney in your state read it too? Do you know who holds the legal title today, and have you checked the county records for liens, mortgages, and unpaid taxes? Does the seller still owe a loan on the property, and what happens to you if the seller stops paying it? Will the contract be recorded at the county office so your claim is on the public record? What happens if you miss one payment, and how many days do you get to fix it? When is the balloon payment due, how much will it be, and could you qualify for a loan by then? Who pays for taxes, insurance, and repairs, and have you had the home inspected? Are there other ways to buy, such as a smaller bank loan, a credit union, or a program run by your state housing agency, and have you asked about them?