Property hunter: Is a contract for deed right for you?

For buying or selling real estate, you may want to consider using a contract for deed instead of financing the sale with a traditional mortgage. A contract for deed has some advantages over conventional financing—but also some risks.

Traditional financing options

Most real estate sales involve three parties: the seller, the buyer, and a financing company such as a bank or commercial mortgage company. At closing, the seller is paid in full, signs a warranty deed transferring ownership to the buyer, and is done with the transaction. After the buyer signs a promissory note and mortgage, they obtain full title, with the mortgage as a lien on the property.

Sometimes it's advantageous for the seller to finance the sale and eliminate the financing company. The seller can hold a mortgage, but a more common type of seller-financing is a contract for deed, sometimes called a land contract or agreement for deed.

How a contract for deed works

A contract for deed is a legal document containing the terms of the sale. Unlike with conventional financing, title is not immediately transferred to the buyer. The seller retains title until all amounts due under the agreement are paid, then signs a warranty deed transferring title to the buyer. If the buyer defaults, the seller keeps title to the property.

A contract for deed typically includes:

• The purchase price.
• Any down payment required.
• The interest rate.
• The amount of each payment, usually made monthly, which may consist only of interest or of a combination of interest and principal.
• The term of the contract, which can be whatever is agreed upon. Traditional mortgages are typically held for either 15 or 30 years, but a contract for deed is often from five to 40 years.
• Details of what happens in the event of default.

To protect the buyer, the contract for deed should be recorded with the appropriate government office.

If the full purchase price will not be paid by the end of the term, the balance—called a balloon payment—is due at that time. This balloon payment is made by the buyer either paying it directly to the seller, obtaining new financing, or negotiating a new contract for deed.

Advantages of a contract for deed

A contract for deed offers the following plusses for both parties:

• Avoiding or reducing closing costs of traditional mortgages, such as appraisals, surveys, title searches, attorneys, and inspections; as well as loan origination, document preparation, and numerous other fees typically charged to increase lender profits.
• Permitting a quicker sale, without waiting for mortgage approval. This can be attractive if the buyer needs to move quickly or the seller wants a quick sale.
• Allowing the sale of property that is difficult to finance through a commercial lender. This may occur if the property doesn't have a sufficient appraisal value, doesn't pass physical inspection, or has title problems.
• Allowing the sale if the buyer cannot qualify for a traditional mortgage, due to bad credit or not having sufficient down-payment funds, income, verifiable income, or income-to-debt ratio. For the seller, this can be important if the real estate market is down and traditional mortgage-qualified buyers are scarce.

A contract for deed can offer the buyer more flexible terms than those from a commercial lender. This can relate to the interest rate, term of the contract, and payment structure. From the seller's perspective, a contract for deed makes the property an investment. The interest rate under the contract may be greater than rates available elsewhere.

Disadvantages of a contract for deed

Buyers should be aware of the following risks associated with a contract for deed:

• You don't have legal title to the property, so you cannot sell it or use it as collateral for a mortgage or other loan.
• Depending upon state laws, if you default, it may be easier and quicker for the seller to recover possession than with a traditional mortgage foreclosure. For example, in some states, mortgage foreclosure may take six months or more, whereas cancellation of a land contract may take as little as 60 days.
• You can lose the property after years of making payments if you are unable to make the balloon payment. It is unwise to purchase on a contract for deed in the hope that you can repair your credit and obtain a conventional loan by the time the balloon payment is due.
• You have the responsibility to determine if the seller actually owns the property, whether there are outstanding mortgages, and if the property is in good condition and free of title problems.
• If the property is mortgaged, you need to make sure the seller makes the mortgage payments.
• If you have credit problems, you may have difficulty obtaining a loan for repairs if it becomes necessary.

Sellers need to be aware of the following potential disadvantages:

• The buyer may default, which is more likely if the buyer is unable to qualify for a traditional mortgage. You will then need to go through your state-specific legal procedure to repossess the property.
• Money tied up in the property might be used for better or safer investments elsewhere.
• You must be sure the property is insured and maintained and that property taxes are paid.
• You need to be sure the contract for deed does not trigger a “due on sale" clause in any existing mortgage.
• You may be subject to government regulation. Some states or localities require certain real estate sale-disclosure statements. Complaints about high-interest, long-term contracts for deed with low-income buyers have attracted the interest of various federal, state, and local regulatory agencies.

For many, buying or selling property with a contract for deed is a viable option. However, it is important to understand the benefits and risks compared to going the traditional financing route.