Those who want to buy a home but can’t qualify for a mortgage — or perhaps don’t want one — sometimes find a path to homeownership via a land contract. Land contracts offer a streamlined and often less expensive way to buy or sell a home or land. However, there are enough risks involved that it’s a smart move to explore all of your mortgage options before committing to one.
What is a land contract?
A land contract is a legal agreement for a seller-financed purchase that doesn’t involve a bank or other mortgage lender. The buyer makes monthly or periodic payments to the property owner until the sale price is paid in full. Those whose credit has been damaged by a short sale or foreclosure may be able to use a land contract to buy another home. It might also be an option for buyers who don’t have enough saved for a down payment and closing costs, or for forward-thinking sellers seeking to spread the gains from the sale out for tax purposes.
A land contract goes by a variety of names. It may be called a:
- Contract for deed
- Bond for title
- Installment land contract
A land contract is not without risk, especially for the buyer, and laws governing land contracts vary by state. With this arrangement, it’s smart for the buyer and seller to each consult a real estate attorney to protect their interests.
Land contracts are more common in low-income neighborhoods with higher numbers of non-white residents, where public agencies and nonprofit housing groups use them to help families attain homeownership and to stabilize neighborhoods. If the seller is a nonprofit or public agency, there might be some protections for buyers who miss a payment, but that’s not always the case.
Land contracts are also used in the private sector. They surged after the housing crisis, but the exact numbers from that period are hard to pin down because property sales through land contracts often are not officially recorded.
Generally, the use of land contracts tends to increase when credit is tight.
“Credit is tighter than it was pre-pandemic, and is likely to remain that way until the pandemic is over and there is better visibility and comfort with the number of loan defaults,” says Greg McBride, CFA, Bankrate chief financial analyst. “Borrowers with weak credit histories or that lack a sufficient credit history are the most directly affected, though small business owners and borrowers lacking income documentation have been caught up as well.”
How does a land contract work?
Because there are no origination fees and high closing or settlement costs, a land contract is a faster, cheaper process than getting a traditional purchase mortgage.
Instead of the buyer borrowing money from a lender, the seller finances the purchase of the house. The buyer and seller negotiate a contract that includes details such as the sale price of the house, the interest rate, loan term, down payment and the amount of the monthly or periodic payments.
After a few years of installment payments, the buyer often has to make a balloon payment, or a large lump sum payment. In addition, the buyer usually has the responsibility to pay for maintenance, insurance and property taxes.
In contrast to a mortgage, the seller has legal title to the property until the final payment for the land contract is made and all conditions of the contract have been met. At that time, the buyer is usually responsible for filing the property deed with the new owner’s name with the appropriate government office.
Prior to the final payment and title transfer, however, buyers can protect themselves by filing a “lis pendens,” or notice, with their local office. This serves as evidence of the land contract in the event a seller attempts to enter into contracts with more than one buyer.
Land contract vs. mortgage: How are they different?
A land contract is a financing agreement with terms that have been negotiated between a buyer and seller. As such, the provisions of a land contract can vary widely based on situation, and aren’t subject to any conforming requirements or other criteria, like mortgages.
In contrast, mortgages are structured in standard ways (for example, a hybrid adjustable-rate mortgage or a 30-year term). They also come with a relatively predictable interest rate based on the market. With a land contract, the seller can set the rate at their discretion.
What does a land contract look like?
The laws governing land contracts vary from state to state, and since buyer and seller negotiate their own terms, each contract can be a little different.
Any land contract should lay out all the terms and responsibilities of both parties, however, including:
- Sale price of the property
- Interest rate the buyer will pay
- Down payment amount
- Monthly (or periodic) payment amount
- Amount of balloon payment at the end of the contract, if applicable, and due date
- Loan term, or how long the buyer has to pay off the purchase price
- “Equitable title” for the buyer, which prevents the seller from reselling to a third party or taking out liens on the property (the seller retains “legal title” until the buyer takes ownership)
- Who’s responsible for paying property taxes, insurance and upkeep (the buyer gets to live at the property and usually pays these costs)
- Assurance that there are no taxes owed or liens or other encumbrances on the property
- Default clause in case the buyer stops making the payments
- A requirement to record the land contract with the appropriate government entity
The National Consumer Law Center also recommends the contract contain requirements for an independent inspection of the property, including an estimated cost of repairs, and a third-party appraisal to verify the fair market value of the property. This is mostly for the buyer’s protection. As the buyer, you should also enlist a title company to perform a title search, and obtain title insurance.
Land contract pros and cons
Land contracts have advantages and disadvantages for both the buyer and the seller. Don’t sign a land contract until you are fully aware of all the risks and have consulted a real estate attorney.
Pros for buyers
- Buyers with poor credit or no credit history have an opportunity to buy a home because the seller, not a bank or lender, decides who’s creditworthy.
- The down payment and closing costs, if there are any, are much lower compared to a mortgage.
- Like buyers with a mortgage, a buyer with a land contract gets to enjoy the use of the property while making payments to the seller.
Pros for sellers
- Because a seller is turning over a property before being paid in full, he or she can charge more than a bank or lender, thereby pulling in extra income.
- If the buyer defaults on payments, the seller can keep the property and all the payments made up to that point.
- It takes much less time to finalize a land contract than it does to close a mortgage.
- Sellers usually don’t need to pay off any underlying mortgage on the property. Instead, the seller can make mortgage payments with the buyer’s installments and pocket any profit.
Cons for buyers
- Buyers don’t build up equity with their payments, even though they are paying property tax and are liable for all repairs (like a new furnace or roof).
- A buyer who can’t make the balloon payment risks losing the property, and all the monthly installments paid to date.
- The land contract might not improve the buyer’s credit, because sellers typically don’t report the payments to credit agencies.
- Buyers who can’t qualify for a mortgage are unlikely to qualify for a loan to pay for property repairs. Defects could increase the chances of the buyer defaulting and losing the home.
- A buyer faces risk from a seller who defaults on their mortgage or encumbers the property with mortgages and liens.
- A buyer who defaults may have little time to remedy the default and reinstate the contract or be kicked out of the property, whereas a foreclosure process can take months.
Cons for sellers
- Sellers have the risk of the buyer defaulting or not paying property taxes. The seller, as legal titleholder, is ultimately responsible for the property taxes until full ownership is transferred to the buyer.
- If the seller has a mortgage on the property, their lender could “call in” the loan and demand full payment. (It’s written into so-called mortgage “acceleration clauses,” but in reality, it’s rare for a lender to call in a loan.)
- The seller doesn’t receive the full purchase price of the property upfront like they would with a buyer who takes out a mortgage.
- The seller could end up with a buyer who can’t or won’t make payments or who damages the property, and have a hard time evicting the buyer if it comes to it.
Land contract tips
- A real estate agent can help you find sellers who are willing to finance, or you can check for local for-sale-by-owner listings online.
- Land contracts are legitimate alternatives to mortgages, but fraudsters have been known to prey on buyers who aren’t financially savvy.
- Both sides must retain a real estate lawyer to oversee the details. You’ll need a purchase agreement and a contract containing the legal description of the property, the payment schedule and payment dates.
- If the contract calls for a balloon payment, a buyer typically will need to take out a mortgage to cover it. This is something a buyer should consider, because if the lump sum can’t be paid, the buyer can lose everything they’ve put into the home. (As the seller, this is also important to consider, because if the buyer’s credit isn’t in good enough shape to get a mortgage now, that might not change when it comes time to get a loan later.) Ideally, the contract should include a “right to cure” protection in the event of default.
- The deed should be signed by the seller at closing and held in escrow by a lawyer or title company until the last payment is made, at which point ownership is transferred to the buyer.
Alternatives to land contracts
A land contract isn’t the only way for homebuyers who can’t qualify for a mortgage to become homeowners. In fact, for these buyers, it might be better to avoid the risk of a land contract entirely.
If you’re a first-time buyer, you might be eligible for a low- or no-down payment loan or other first-time buyer program instead, or assistance and grants to help cover some of the upfront costs of homeownership.
You might also decide to hold off on buying a home in order to work on your credit and save for the right moment. Check out Bankrate’s guides to improving your credit score and saving for a down payment.