Land Contracts: What They Are And How They Work
Kevin Graham8-minute read
March 03, 2023
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Land contracts are seller-financed alternatives to traditional mortgage financing. They’re typically used when buyers are unwilling to get a mortgage through a bank or other mortgage originator. They may also be unable to get a mortgage due to their credit situation or other qualification reasons.
It’s for this latter reason that land contracts have seen growth and been considered a viable option after the mortgage crisis of 2007 – 2010. Those who have experienced a foreclosure or short sale may be able to use a land contract to get into a home when they might not otherwise have been able.
Although they can be helpful, loan contracts certainly have their downsides, so it’s important to read your contract in full before signing on the dotted line. In this article, we’ll examine the pros and cons of loan contracts, go over what to watch out for, and learn when to use a refinance to convert your land contract into a traditional mortgage.
What Is A Land Contract?
A land contract is a written legal contract, or agreement, used to purchase real estate, such as vacant land, a house, an apartment building, a commercial building or other real property.
As a type of specialty home financing, a land contract is similar to a mortgage. However, rather than borrowing money from a lender or bank to buy real estate, the buyer makes payments to the real estate owner, or seller, until the purchase price is paid in full.
Depending on the legal or common real estate terminology in your area, you may see these types of deals referred to as either land contracts, installment land contracts, land sale contracts, contracts for deed, memorandums of contract, real estate contracts or bonds for title.
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How Is A Land Contract Different From A Mortgage?
Mortgages tend to be structured so that they can be sold to major investors in the mortgage market, such as Fannie Mae and Freddie Mac. Because of this, mortgages have a fairly standard set of formalized terms for what happens when you miss a payment or when any adjustments need to be made to modify the loan.
Unlike traditional financing, land contracts are completely between you and the owner of the house, so each one will likely look a bit different. As a buyer, you really have to be careful when negotiating to ensure that the terms don’t put you at too much of a disadvantage.
How Does A Land Contract Work?
A land contract is typically between two parties: the buyer – sometimes referred to as the vendee – and the seller, also known as the vendor. In a land contract, the seller agrees to finance the property for the buyer in exchange for the buyer meeting the terms agreed upon in the land contract.
Traditional Land Contract Vs. Wrap-Around Land Contract
Let’s compare two ways to structure a land contract:
- Traditional land contract: In this type of land contract, the seller keeps the legal title to the property until the land contract is fully paid off. Meanwhile, the buyer gets equitable title, which enables them to build up equity in the property and can allow them to pay off their land contract by converting it into a regular mortgage, which we’ll discuss later.
- Wrap-around land contract: In a wrap-around land contract, the buyer and seller essentially agree to a seller-financed land However, the seller keeps paying on their existing mortgage, pocketing the difference between their mortgage payment and what they are paid on a monthly basis by the buyer. Unlike a straight land contract, the buyer in a wrap-around land contract gets the warranty deed to the property immediately, meaning they own the home from the beginning of the contract.
One key difference between traditional and wrap-around land contracts is that the seller’s lender has to agree to a wrap-around land contract because they won’t be getting the full payoff amount. The lender also takes a junior lien position in these agreements so they can take the home back if the seller holding the underlying mortgage stops making the payments.
Otherwise, both land contracts typically have installment payments due at periodic intervals as agreed between the buyer and seller. At the end of the term, the buyer may or may not need to make a balloon payment, which is a lump sum that must be paid to satisfy the loan terms.
What Does A Land Contract Cover?
A properly executed land contract has several components. Let’s look at a few of the basic items.
This covers how much the property is being sold for. Once you pay off this amount of principal, your obligations under the land contract are over. If it’s a straight land contract, you’ll get the legal title and will take possession of the property at the time of payoff.
Down Payment Amount
Your down payment is due at your closing and may be expressed as a percentage or a flat amount in your land sale contract.
The interest rate is defined in the land contract, as are terms around whether the rate can ever change. If it can, the timing and conditions under which the interest rate could change should also be defined.
The amount of your payment should be spelled out along with how often the payment needs to be made, monthly or otherwise. The contract may include specific due dates and late fees, as well as whether a balloon payment is due at the end of the loan term. You should also be aware of whether the contract includes any penalty for paying off the loan early.
Responsibility Of The Parties
In addition to the basics, the contract should include clauses stating the responsibilities of the parties to each other – for example, whether the buyer will be agreeing to make the mortgage payment.
For the benefit of both parties, the contract should have clear language regarding what happens if the buyer defaults – or falls behind – on their payments. If any missed payments are allowed, the contract should explicitly state the timeline for paying them back, as well as under what conditions the buyer might become delinquent to the point that the seller takes the property back.
If you’re the buyer, you’ll want language that says you get the legal title once all terms of the loan are satisfied. If it’s a wrap-around mortgage, it’s a good idea to have it written in that the seller will make payments on the underlying existing mortgage. That way, if the seller doesn’t make the payments and the buyer loses the house because of it, they have the option of legal action.
You may also want a clause that requires the seller to keep careful track of your history of payments. This will make paying off your land contract with a conversion to a traditional mortgage easier later on.
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Pros And Cons Of A Land Contract
Now that you know how land contracts work, you should also know that a land contract isn’t for all buyers and every situation. Ideally, you should consider all financing options and types of home loans available to you when buying property. At the least, you need to be fully aware of the benefits and risks of using a land contract to complete a real estate transaction.
Let’s review the pros and cons of land contracts to help you decide whether this financing option is right for you.
Pro: It’s Easier To Get Financing
Land contract home financing is an option for buyers who might not be able to get it through the traditional means of a mortgage. Before you decide to pursue a land contract, however, you should know that many different types of mortgages are available, and some are geared specifically toward borrowers with low credit scores.
Pro: It’s A Win-Win For Sellers
The seller accomplishes the goal of selling the property while still getting a periodic income stream throughout the term of the contract. If the buyer doesn’t make the payments, they can take the property back pursuant to the terms of the contract.
Pro: It Provides More Opportunities To Purchase
A buyer who needs a bigger space but can’t qualify for it under traditional home loan guidelines may be able to obtain the property through seller financing. They can then pay off the land contract down the line through a mortgage once the balance is smaller.
Con: The Buyer Depends On The Seller
As a buyer, you’re placing a ton of trust in the seller. For instance, if it’s a wrap-around land contract with an existing mortgage still being paid off by the seller, the buyer can lose the home through no fault of their own if the seller doesn’t make the payments.
Con: Contract Vagueness
You have to really go in and make sure that the contract is ironclad around the responsibilities of each party. You’ll want to know exactly what the payment terms are, as well as whether the terms can change and under what circumstances. Legal advice may be necessary, so you might even consider hiring a real estate attorney to help you negotiate clear terms.
You’ll also want to get in writing that you get legal title to the property no later than when the principal is paid off as defined by the sale price of the property. To ensure the seller has ownership rights and can legally transfer the property, you may also insist on a title search. A title search will also reveal any encumbrances on the property or whether any liens have been placed on it for unpaid property taxes or other outstanding debt.
Con: Higher Interest Rates
The seller knows that you’re interested in a land contract likely because you can’t be approved for a standard mortgage. Because the seller is taking on the higher risk, they’ll probably charge you a rate that’s higher than current market interest rates for traditional financing.
Con: Homeownership Gray Area
In a straight land contract, you receive equitable title so that you gain equity as you make payments on the loan from the seller. However, the seller still holds legal title until the property is paid off. This could cause issues around who owns the home if any legal disputes or insurance claims need to be filed.
Ownership is further complicated by the fact that many jurisdictions don’t require that the land contract be recorded with the county. For this reason, it’s not really even possible to get a sense of how many land contracts exist in the U.S. The ones in the census numbers are those that are voluntarily reported, which means that – unless the contract is shown in a legal proceeding – the only parties who might know about it would be the buyer and seller.
Converting A Land Contract Into A Traditional Mortgage
For buyers who are able to take the time to get their credit in shape and work to meet other qualifying standards, you can get better terms and/or pay off a balloon payment by converting your land contract to a traditional mortgage.
The lender may verify the value of the property with an appraisal, and you’ll need the following items in addition to standard income, asset and credit checks:
- A copy of the fully executed land contract: The lender will need to know the balance they’re paying off to determine the loan amount. They’ll also want to make sure any underlying mortgage in a wrap-around contract would be paid off so that the title is clear.
- Payment history: It’s important to provide the lender with as long a payment history on your land contract as you can get your hands on. They’ll use this to verify your qualifications.
The Bottom Line: Land Contracts Are Another Option For Home Buyers
A land contract is just one path to becoming a homeowner – especially if your credit is preventing you from seeking traditional financing.
However, it’s also helpful to apply with and get quotes from multiple lenders. While you may not meet one lender’s underwriting standards, you may just qualify with another lender.
If you have questions about which financing option best suits your needs – or you’re ready to refinance your land contract into a traditional mortgage – start a mortgage application today or speak with one of our Home Loan Experts at (833) 326-6018.
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