Land contracts are a form of seller financing that occurs during a real estate transaction. It is a written legal agreement that can involve a house, a commercial building, or even vacant land. The only stipulation is that it must include real property.
It is a structure that is similar to the traditional mortgage. Rather than borrowing money from a bank, credit union, or another lender to purchase the real estate, the buyer will make their payments to the current owner (the seller) until the entire purchase price of the property is paid-in-full.
A land contract is not valid until both the seller and the buyer agree upon the terms and conditions of the legal contract and sign it. Once all of the terms are satisfied in the agreement, including payment of the purchase price of a specific time, the legal title of the property will transfer from the seller to the buyer. This process usually involves a warranty deed, but others used to convey title are possible as well.
If you are thinking about buying or selling real estate right now, then these are the land contract pros and cons that you will want to review.
List of the Pros of a Land Contract
1. It allows for more potential buyers to be available for a property.
Although the stipulations for mortgage financing have become a little more lenient in the past 10 years, they are nowhere near what they used to be during the subprime lending days. When a seller offers their property through this process, then they are creating more potential customers for the transaction. You can create a contract for the buyer that allows them to move onto the property and fulfill the obligations of the agreement until their credit issues resolve and they can purchase the real estate outright.
2. It gives sellers a win-win opportunity for their transaction.
When you create a land contract as a seller, then your buyer will typically pay rent on the property for an extended period before selling it at a fixed price. If your buyer doesn’t make the payments that you both agreed upon for the property, then they can be evicted just like any other tenant. The seller keeps the title to the real estate, can pursue the buyer for damages based on the terms of the agreement, and can even find a new buyer.
If the buyer is unable to make their balloon payment or changes their mind, then the seller still retains the property. That means they can do with it as they please.
3. It becomes a useful sales tool in a challenging market.
When interest rates are high, and credit is tight in a local market, then there are not going to be as many buyers available for the property in question. Sellers can use a land contract as an option to attract someone that might not have been able to purchase anything without this assistance. Although there are always risks to consider in any transaction, this option can help a seller secure a buyer and ongoing income for their property with some guarantees that can help them to meet their financial goals.
4. It offers flexible payment terms to the buyer.
Because there isn’t a third party involved in the real estate transaction with a land contract, sellers have considerable power to offer flexibility in the negotiation of the final terms of the agreement. There could be an option that doesn’t require a down payment to complete the initial transaction, rolling over the amount into the final balloon payment that is eventually necessary. A higher selling price could become possible through the generosity of other terms offered. Since any interest paid goes into the pocket of the seller, even the rate becomes negotiable.
5. It can expedite the transaction for sellers who are in a hurry.
If you are in a home as a seller and need to get out of it quickly, then a land contract allows you the exact opportunity you may need. When third-party lenders are involved in this transaction, then they typically require an extensive amount of documentation to release the funds that will complete the sale. If the buyer is not proactive about this process, then there can be significant delays in the purchasing process. Because the buyer and seller are in full control of this process, this agreement can be completed quickly to expedite the move for both parties.
6. It allows for possession to happen immediately for the buyer.
A land contract doesn’t require the same mandates at closing as the typical mortgage. You might even be able to take possession of the property as a buyer without a formal home inspection (although you wouldn’t want to do so if at all possible). You do not need to have the full purchase price available at the time of the transaction. The only requirement is to bring along whatever down payment was agreed upon in the terms of the contract itself. That makes the process about as fast as the typical rental arrangement when you are looking for a new home.
7. It lets the buyer avoid the immediate expense of closing costs.
When you apply for a traditional mortgage, then the lender will charge a variety of closing costs that are based on the product you choose to fund the real estate transaction. This cost can be several thousand dollars, reducing the overall impact of your down payment. When buyers can find a seller willing to work with a land contract, then they can avoid this cost until the time of the balloon payment. If they can gather up enough cash to avoid a mortgage in the first place during the payment period of the agreement, then they can avoid the extra lending costs entirely.
8. It allows a buyer to have more time to save their money.
Saving up for a down payment is a significant expense for many households. Even for a $100,000 property, putting together $20,000 for a 20% down payment on a mortgage to avoid PMI can be challenging. Without this money, you are forced to stay in the rental market. Land contracts offer buyers a secondary opportunity. It is possible to continue saving up for a full down payment while living in the home that you want while making payments in a manner that is similar to a lease. That means the future financing for the balloon payment can be a better rate because there is more money available to close.
9. It gives a buyer an option to walk away if necessary.
If you decide to purchase a home through the traditional mortgage process, then that property is yours until you either sell it again or stop making payments on it to start the foreclosure process. When you are in a land contract, the equitable title gives you the option to walk away from the balloon payment if necessary. Although that means the buyer will forfeit their down payment and monthly installments (plus other potential damages, depending on the agreement), it can get them free and clear of a property that develops unexpected problems over time.
List of the Cons of a Land Contract
1. It must usually be drawn up by a legal professional to cover all potential issues.
When buyers and sellers enter into a land contract without the help of legal professionals, then they can miss the myriad of potential changes that can occur over the lifetime of the agreement. You will need to ensure that the contract covers what will happen if the market appreciates or depreciates significantly before the balloon payment is due. You will need to address who will be responsible for the maintenance of the property. Who will carry insurance? What happens if the buyer opts out after some time, deciding not to offer the balloon payment?
There are special considerations and challenges that must go into the terms of a land contract that often go beyond what the average buyer and seller and create and review on their own.
2. It can cause the buyer to feel like the property owner immediately.
Because a land contract eventually allows a buyer to purchase the property they are using, it is not unusual for them to feel like they are the immediate owner of the real estate. The household might make substantial changes to the property under the assumption that they will be able to secure financing for the real estate one day. Should that not occur, the tenant would be responsible for reversing all of those changes. That is why the issue of alterations should also be covered in the agreement before both parties sign onto it.
3. It places the buyer at the mercy of the seller until the balloon payment.
Because a land contract does not officially transfer the title/deed of the property to the buyer until the terms of the agreement are met, it is the seller’s responsibility to maintain any mortgage payments or taxes that are needed for the real estate. If they fail to do so, then liens could be placed on the property that would require clearance before the transfer takes place, or the buyer would be forced to assume responsibility for them.
It is even possible for the real estate in question to go through foreclosure proceedings if the seller does not maintain their mortgage payments. That would leave the buyer without a home and a worthless contract – unless there were terms included that would offer protection in such a circumstance.
4. It requires sellers to take legal action in case of default.
If there is a default on the contract, then the outcome available to the seller depends on what their state laws are in the United States. In the state of Michigan, the seller must choose between foreclosure or forfeiture, then notify the buyer of their choice as they file a lawsuit in court.
Under the forfeiture proceeding, the seller keeps all payments made and retakes possession of the property. The buyer would then owe nothing, but they would also be evicted from the premises. In foreclosure, the buyer is treated as an equitable owner, which means their payments allow for the same rights as the legal owner. The court would order a public auction, of which any surplus would go to the buyer, but they would also be liable to the seller for any deficiency in the original contract.
5. It might require a seller to obtain a mortgage loan originator license.
In some states in the U.S., selling a property that is not your personal residence requires that you obtain a license for mortgage origination before a land contract is permitted under local statutes. Those who use this option to liquidate their investment properties often encounter this situation. That means you would be required (in the seller’s position) to take a 20-hour course, submit to a background check, pass an exam, and then be listed in a national database. It usually takes about 2-4 weeks to get the documentation together, and then another 8-12 weeks to finish the application process. That means it might be 4 months before you could complete the land contract.
6. It may allow the seller to inspect the property before the balloon payment.
Because the land contract typically grants an equitable title to the buyer until they make a balloon payment, sellers do not usually have the option to inspect the property to ensure it continues to remain in good condition. The agreement that both parties sign can allow for this circumstance to occur, which is why it is a good idea to review the terms of it completely before agreeing to the transaction. Some sellers believe that this option creates a landlord/tenant relationship instead of a buyer-seller one, so they might appear at the home to tour it without permission.
7. It can require the entire balance to be paid in full with only one late payment.
Some land contracts contain a clause which allows the seller to demand payment in full for the entire property if there is one late installment on the agreement. Buyers will need to look in the terms of the contract to ensure this type of clause is not present. You would be asked to get the balloon payment at that time to ensure you could remain, even if you simply forgot about the installment. Repossession procedures are strictly regulated from commercial lenders compared to vendors in a land contract, so your rights as a buyer might be more limited than you may expect.
8. It can cause a buyer to lose the right to own the property after the sale with judgments.
Many lending experts suggest that a land contract is a bad idea when purchasing a home because they sound like a good deal at the time, but things can change when you’re ready to complete the terms of the arrangement. If there are too many judgments for a seller to facilitate the transfer of the title, then you cannot as a buyer force them into that situation. Your only solution would be to sue for a breach of the contract, and even then, a judgment debt is not something that someone might willingly pay.
9. It could cause buyers to lose their down payment in many different ways.
It is not unusual for a seller to request a down payment of 5% to 10% for a land contract, although some might go down to 3.5% to be competitive with some of the mortgage lending products that are available today. Let’s say that there is a $200,000 property for sale, and the seller is asking for a 5% down payment as part of the agreement. Not only would the buyer have the monthly payments to make, but they would also need to present a $10,000 check at the time of closing. If the buyer were to default or the seller was unable to deliver the property, this money could be lost (even if a judgment might be able to recover it). Since most buyers who enter into this arrangement have poor credit in the first place, it could be a devastating blow to their finances.
10. It does not resolve any issues or defects that can affect the title to a property.
There might be previously undisclosed easements on a title that could impact its transfer from the seller to the buyer over time. Some deeds can have problems with their language that make it challenging to complete the agreement per its terms. There might be environmental issues, liens, clerical or filing errors, or the prior deed might also be illegal and impact the enforceability of the arrangement. There can even be forgeries in the public record that could obscure the rightful ownership of the real estate in question. That is why all parties should perform their due diligence on a title or deed before agreeing to a purchasing contract of any type to avoid these common problems to avoid clouds on the title that could make completion of this arrangement impossible.
The pros and cons of a land contract often depend on what the seller needs to get out of their real estate and what buyers hope to find in a challenging market. It can allow those with challenging credit issues to get into a property they love while having the option to repair their credit for an eventual balloon payment. It could also be an agreement that offers numerous risks to both parties that might not be worth the potential advantages. As with any real estate transaction, proceed with caution, create a budget, and consult with professional assistance when needed for the best possible experience.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.