How Do Land Contracts Work?
July 22, 2022
We have talked a lot about getting a mortgage when buying a home and the general requirements that come with that decision. Mortgages usually need a down payment, solid credit history, income verification, and more in order to be approved. In some cases, even all of this is insufficient. Not everyone can easily get approved for a mortgage, and that’s where alternatives to getting a mortgage come into play – like a land contract. In this blog post, we go through what a land contract is and how land contracts work.
What is a Land Contract?
A land contract is a form of special home financing in which a written contract is formed between a buyer and seller to purchase a property like a house, vacant land, or condo. In a land contract, rather than borrowing money for a property via a mortgage from a bank or lender, the seller acts as the lender and the buyer makes payments directly to them until the property is paid off fully. One of the main differences between a land contract and a traditional mortgage is that the seller doesn’t get paid in full after closing. The buyer stays in the purchased house and pays the seller in installments until the balance of the agreed-upon purchase price is paid off.
How Do Land Contracts Work?
A land contract is strictly between the buyer and seller, which means that any terms can be included as long as both parties agree to them and comply with local laws. That being said, there are terms to expect in a typical land contract agreement.
For one, since the seller isn’t getting the funds for the property in full, they retain the legal title to the house. The buyer can live in the house but only receives the legal title to the property after they have paid off the house in full. In the meantime, the buyer gets an equitable title to the house, which allows them to build equity in the property. The equitable title also prevents the seller from taking out new loans on the property and allows the buyer to move in and make renovations. Land contracts are similar to mortgages except instead of going through a lender, the buyer makes payments with interest to the seller based on the terms of their contract.
Sellers using land contracts aren’t interested in very long-term payment periods, so the terms are often shorter than a typical mortgage. A common land contract runs for three to five years, but some can be as long as 10 years. There is usually a balloon payment required after a certain amount of time when the buyer pays the remaining balance of what they owe in one lump sum. If the buyer can’t make this final payment with their own funds, they can take out a loan to pay the balance.
Read More: Can You Buy a Home With a Bad Credit Score?
When Are Land Contracts Useful?
Land contracts have fewer restrictions than mortgages, which means buyers with low credit or poor financial history can still buy a home. Buyers that have trouble getting approved for a mortgage may turn to a land contract to buy their dream home. Since the approval process is less stringent, land contracts create a lot of risks for sellers when it comes to finding a buyer who will make payments reliably. However, there are benefits to sellers using land contracts.
Sellers can often use land contracts to sell their property quickly without waiting for a buyer to get approved for a mortgage. Also, the seller can potentially receive more money for their home as the interest rates for land contracts are often higher than traditional mortgages. Lastly, the seller may be able to negotiate a higher, all-cash down payment on the house.
If The Buyer Defaults…
If the buyer of a land contract property defaults on their payments, there are steps a seller can take to protect themselves. A land contract forfeiture is a legal process in which the seller can retake ownership of the property and keep all of the money paid to them by the buyer. This process is often used as a last resort by sellers who have unsuccessfully tried to work with the buyer to make payments.
The other option for sellers when buyers default is to go through the foreclosure process. A foreclosure is a legal process that allows the seller to reclaim ownership of the property while also allowing them to receive the entire unpaid balance on the property from the buyer. The foreclosure process usually takes longer than a forfeiture and requires going to court. It is also typically more expensive than a forfeiture.
The Typical Land Contract Terms
You should always create a land contract with the help of an attorney to make sure the terms and conditions meet your state requirements and protect your interests as the seller or buyer. That being said, typical terms are often included in land contracts.
The total amount the buyer will pay for the property.
The initial payment is made by the buyer to the seller when the contract is signed. This is typically a percentage of the total purchase price.
Defines the rate of interest the buyer will pay on the remaining balance of the purchase price as well as if the rate can be changed.
How often payments need to be made along with the amount of each payment. Also defines the terms of late fees, prepayment penalties, and specific due dates.
Many land contracts have a required balloon payment, which is a lump sum the buyer needs to pay at a specified time. This final payment is typically for the remaining balance of the purchase price.
It’s important to have it in writing that the seller will provide an equitable title to the buyer at the time of closing and the legal title once the property is paid in full.
An escrow account can be used as a neutral third party that holds onto the property deed while the buyer is paying off the house. An escrow service protects both the buyer and seller by having the seller show an act of good faith but keeping the deed in suspension.
There’s a reason mortgage lenders require an appraisal before approving a loan – the bank wants to make sure they’re not lending more money than the property is worth. An appraisal will help make sure that the purchase price is fair.
A home inspection is important for a buyer to understand the condition of the property they’re buying as well as any potential repairs that need to be made.
The seller should record the land contract with the city and county in what’s called a memorandum of a land contract. This legal record makes the land contract public record which protects the buyer’s interest in the property.
These terms should define what happens if the buyer misses a payment or otherwise defaults on the contract. These clauses also often define the terms of any legal action that may be taken by the seller.
Land Contracts Can Be Harmful
Land contracts are often looked for by people who are desperate to buy a house but have low income or bad credit. This is why many sellers who use land contracts can have malicious intentions. You can find many land contract horror stories online where the buyer loses their house after missing one payment. Not getting the legal title to the house until after paying it off gives the seller a lot of power in a land contract. You have to do your due diligence when signing a land contract to make sure you’re not being taken advantage and you should always work with a real estate attorney.