When real estate markets become temperamental, would-be homebuyers seek new and better ways to finance a property purchase. This situation leaves these potential buyers wondering how does a land contract work — and could it work for them. A land contract can be a viable mortgage alternative; however, it comes with risks. Here are common questions about land contracts and how they work for buying and selling property.
What are Land Contracts?
A land contract is a property purchase agreement that allows a buyer to make direct payments to the seller. It’s another arrangement for buyers who can’t secure a conventional mortgage mainly due to:
- Low credit score
- History of seasonal employment or self-employment
- Recent bankruptcy filing
- Other financially limiting circumstances
Land contracts are common where the seller and buyer already know each other or have been in business for a while. These relationships often involve trust and familiarity, which is good because land contracts are less secure for both parties. A typical land contract example is renters buying their rental home from their landlord.
How Does a Land Contract Work?
A land contract works similarly to a mortgage in some ways. The buyer makes a down payment and agrees to make monthly payments. These payments include insurance, taxes, and interest. Sometimes, they may pay an outstanding mortgage, but land contracts are uncommon among sellers who don’t own the property free and clear.
Like a rental agreement, a land contract indicates who is responsible for repairs. That is usually the buyer since the land contract confers all the responsibilities of home ownership. It may also contain provisions limiting the use of the property while the buyer is still making payments, e.g., no major remodeling, no livestock, etc.
Having an attorney look over the land contract before you sign it is a good idea, as some provisions may be overly limiting. For example, any prohibitions against remodeling could stop you from making vital upgrades that improve sanitation and livability, e.g., replacing bathroom fixtures and plumbing, so you quit having clogged drains.
Isn’t a Land Contract Just a Mortgage?
No. A mortgage transfers property ownership to you, and the bank maintains a security interest, so they can foreclose if you stop making payments. In land contracts, the seller retains ownership until you make the final payment.
Also, land contracts rarely last more than a few years, while mortgages give you decades to pay off the loan. Land contracts involve a down payment, monthly payments for three to five years, and a balloon payment at the end. You can either pay this final payment in cash or apply for refinancing so you resume property ownership under a conventional mortgage.
Who Pays Property Taxes on a Land Contract?
The seller pays property taxes on a land contract until the buyer makes the final payment.
How Does a Land Contract Work to Your Advantage?
Land contracts are accessible options for those who can’t qualify for a Fair Housing Administration (FHA) program or conventional mortgage. Even FHA programs, which provide low-barrier home loans, have credit score and down payment requirements. They are also challenging to get if you’re self-employed or work seasonally. But a seller may have different financing standards that work better with your situation and allow you to pursue homeownership.
Also, land contracts usually involve parties who know each other. Few sellers are willing to contract with strangers. These arrangements are often made between relatives, landlords, long-term tenants, and business partners. For example, even if you’re a seasonal or self-employed worker (a big minus among mortgage lenders), a landlord may work with you on a land contract because you have a good record of paying rent on time. Mortgage lenders do not consider this history when approving loans, but someone who already trusts your payment history may offer more options.
What are the Disadvantages of a Land Contract?
While there are many benefits to using a land contract, there are also some disadvantages. Here’s a run down of some important downsides that sellers and buyers might face:
Higher Interest Rates
Since land contracts carry more risk, many sellers set higher interest rates. If the real estate market is temperamental, you may want to try financing first to see if you receive a lower interest rate offer.
Seller Remains on The Hook
During the contract term, the seller must still pay insurance premiums and property taxes while gaining no benefits from property ownership. Also, if the property value drops before the contract concludes, the seller incurs devaluation costs.
No Legal Title to the Buyer
The buyer faces risks too. Buyers cannot write the interest off their tax returns or enjoy tax deductions available to homeowners. They have no ownership benefits until the contract ends when they make that last payment. Meanwhile, they remain responsible for repairs and maintenance like an owner.
Little Payment Flexibility
A mortgage offers more flexibility if you face financial hardship and need time or assistance with payments. There are also state programs that help unemployed or disabled homeowners. Land contracts only work well if nothing changes for the worse. Unemployment, disability, or other contingencies can forfeit the agreement and any rights you have to the property. You cannot recoup previous payments, and any money you put into the property will benefit the seller – not build wealth for you.
Sometimes, a seller seeks a land contract to escape title issues, including liens, public record errors, boundary disputes, and forgeries. There are also missing heirs, e.g., a deceased property owner named an heir to the property who never took possession. So, the seller may not be authorized to transfer the title or wishes to hide the issues and stick them on you. Fortunately, there are resources to help you perform a title search and see if any of these issues would encumber your property.
Should I Buy Property through a Land Contract?
A land contract could be a good idea if you:
- Complete a title search and find no issues
- Know the seller or have a good relationship with them, e.g., the seller is your landlord, business partner, or relative
- Just need time to fix your credit to refinance later and buy out the land contract.
- Already put money into the home as a renter or caretaker and wish to preserve your investment.
- Have a stable income, and even if it’s irregular, you’ve kept up with rent and other expenses in the past.
However, if your finances are unstable, and you have no guarantee that you can receive financing or cash for the balloon payment, then your land contract could be doomed to fail. Also, land contracts make good mortgage alternatives, but they are by no means “easy” or a quick fix. You still have the same responsibilities as you do with a mortgage, only there are more ways to lose the property you wish to own.
How Does a Land Contract Work? Sometimes, With the Help of an Attorney
Now that you have answers to “how does a land contract work,” you may find this is a viable option. But there still might be legal issues you’re not aware of. Consider getting a free initial legal review before you sign any land contract agreements.