What Is a Land Contract, and How Does Installment Buying Work?

FT Contributor  | 

One of the biggest financial decisions of your life is to stop renting and buy a home. A home is one of the biggest investments you’ll make and in most cases, you won’t be able to pay cash for it. If you don’t qualify for a home mortgage or you’re not receiving satisfactory offers from financial institutions, you may have other financing options.

You may be able to finance your real estate investment with a land contract. While this type of financing option is called a land contract, it may be used in a transaction involving a home, condominium, commercial building, or any other type of property. Also referred to as an installment loan, an “installment sale land contract” is a financing agreement made between you and the current homeowner.

Similar to a home loan, you agree to make installment payments on the home until the loan is satisfied. Since the agreement is between you and the seller, you have more leniency when deciding on the loan terms, which may provide an easier path to homeownership. Reviewing how a land contract works and your rights as a home buyer will help you decide if this financing option is right for you.

How Do Land Contracts Work?

A land contract is similar to a home mortgage you obtain through a bank but the agreement is made between you and the home seller. The terms and conditions of the contract may vary, depending on what you and the seller agree upon, including the purchase price, down payment, interest rate and loan term.

If you don’t qualify for a regular home loan, a land contract may allow you to purchase a home without having to pay cash. However, there may be strict terms and conditions associated with the contract, including a high interest rate or penalties if you miss a payment. Without a bank involved, the seller risks you defaulting on payments and having to pursue legal action directly.

When both you and the seller sign the land contract, you agree to make payments until you’ve satisfied the contract. When you’ve completed your payments successfully, the owner provides you with the deed and you officially own the home outright.

Straight vs. Wrap-Around Land Contracts

A homeowner may offer a straight or wrap-around land contract. In a wrap-around land contract, the current homeowner already has an existing mortgage on the home. The buyer provides their payments directly to the current homeowner and they provide this payment to the existing lender but keep the excess. If the land contract includes an interest rate that’s higher than the existing mortgage, the interest is overridden and the current homeowner pockets the extra.

For example, a buyer purchases a home and agrees to a land contract to finance $100,000 at 5% interest. There’s a current $20,000 loan on the home with an existing lender at only 4% interest. The buyer pays the homeowner one monthly payment. The homeowner pays the current lender, then keeps the rest. The buyer is also responsible for property taxes, fees, and insurance while making payments on the land contract.

With a straight land contract, the buyer makes separate payments to the existing lender and the homeowner. Since the lower interest rate isn’t overridden, the buyer pays exactly what’s owed to the existing lender. This saves the buyer money each month and keeps the contract payments lower.

Understanding Power of Sale

In most cases, a land contract is drafted through a title company. The current homeowner, referred to as the vendor, the home buyer, called the vendee, and a trustee are involved in the contract. The trustee is provided with interest in the home and the title.

If the vendee doesn’t fulfill the obligations laid out in the land contract, the trustee has the right to foreclose on the property under the power of sale. The trustee files a notice of default with the state. If this happens, the home’s title goes back to the original homeowner and they keep the payments the vendee made on the home, if any, including the down payment. The vendee is evicted from the home.

Acceleration and Alienation Clauses

An acceleration or alienation clause usually comes standard in most mortgages backed by financial institutions and the government. These clauses state that the lender may demand the entirety of the mortgage at once if a homeowner sells the property and transfers ownership or breaks the rules of the mortgage in some other way.

In some cases, lenders don’t exercise their right to claim the acceleration or alienation clause as long as mortgage payments continue to be made in full and on time. However, homeowners and buyers entering in a land contract are taking a risk. Government lenders, such as Freddie Mac and Fannie Mae, are more likely to utilize the alienation clause and demand satisfaction of the mortgage upon transfer of ownership.

The Pros and Cons of Land Contracts for Buyers

Depending on its terms, a land contract may include benefits and drawbacks for both the vendor and the vendee.

Pros

  • The seller is in control of the land contract terms. They can set the loan term and interest rate to benefit their own situation.
  • If the buyer defaults, the seller may keep the property and the money already paid. A default on a land contract allows the seller to evict the buyer from the home.
  • Sellers receive profit from the sale over a long period of time. This allows them to stretch out the capital gains taxes they owe on their profit.
  • Buyers who don’t qualify for traditional mortgages may work with sellers on a land contract. This gives them an opportunity to purchase a home without a good credit score or large down payment.
  • A buyer can purchase and live in a home while working on financial issues. They can build credit or lower a debt-to-income ratio to eventually qualify for a traditional mortgage.

Cons

  • The terms of a land contract aren’t always clear. Factors like who is responsible for home repairs or an inspection may not be clearly outlined in the contract.
  • The seller may not be able to locate the buyer when they default on payment. This is important because forfeiture of ownership papers must be physically delivered for validity.
  • Interest rates and loan terms may not always be satisfactory for the buyer. With no other lending options, a buyer may feel stuck and agree to unsatisfactory terms.
  • The buyer relies on the seller to make payments to the current lender. If the seller fails to make these payments, the original lender may foreclose on the property.
  • A buyer may invest in home improvements but then default on the loan. Once they default, the home, along with its expensive upgrades, belongs to the vendor once again.

What to Do Before Signing an Installment Land Sale Contract

A land contract is a legally binding contract between the homeowner and buyer. Before signing this document and agreeing to buy the home, you should:

  • Order an appraisal: Have a professional appraisal company provide you with insight on the market value of the home so you can compare it to the purchase price.
  • Get an inspection: A licensed inspector will provide you with information on repairs the home needs or may need in the near future so you can factor these into your budget.
  • Seek title insurance: Obtaining title insurance protects you from any defects on the title or ownership issues to ensure you obtain ownership when you satisfy the land contract.
  • Review your budget: Ensure you can afford the monthly payments and down payment you’re responsible for before agreeing to the land contract.
  • Hire legal assistance: If there’s an existing mortgage, land contract terms may be complex. Legal representation helps you better understand your responsibilities under the contract.

If you want to buy a home but don’t qualify for a traditional mortgage, a land contract may help you obtain homeownership. As a private contract between you and the current homeowner, the loan term, interest rate, down payment, and other factors may vary. It’s important to review this contract and ensure you can satisfy the conditions before agreeing to it.


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