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When we think about buying a house, one of the things brought to mind is lining up mortgage financing. If we have enough cash on hand, maybe we consider buying the house outright and avoiding a mortgage altogether, even though mortgage interest makes for a nice tax deduction.
Regardless of how you come to own your home, you might think the only path is to sign the closing documents and get the title in your name. But there is one type of contract where you don’t get the title right away: a land contract. While Rocket Mortgage® does not offer land contract financing, it’s important that you understand what they are and how they work in case this is an option you are considering.
Land Contracts: The Basics
A land contract is a type of real estate financing in which the buyer makes payments directly to the seller instead of a lender. Once the contract is fully paid off, the title to the property passes to the buyer. This is in contrast to a traditional mortgage where the buyer would receive the title at closing.
Buyers and sellers negotiate a contract that includes things like the down payment, the term of the loan, the interest and how that interest will be paid off. A land contract is also known as a contract for deed, an installment land contract, a memorandum of contract, a bond for title, or a real estate contract.
How Does A Land Contract Work?
A land contract is established when a buyer and seller enter into a formal, legal agreement regarding the purchase of the seller’s property. The buyer will make the agreed upon payments until they’ve satisfied the contract requirements or until they’re able to refinance to pay off the contract.
Negotiations Between Buyer And Seller
The buyer and seller determine and agree upon the terms of the land contract. The contract should include the following basic elements:
- Property sales price
- Down payment required (could be a percentage of the sale price or a fixed dollar amount)
- Interest rate (including how and when it could change over the life of the contract)
- Monthly installment payment amount
- Required balloon payment at the end of the contract (if applicable)
- Prepayment penalties (if applicable)
- Clauses concerning default (what happens if the buyer doesn’t make their payments)
It’s essential that the contract is clear so that each party is aware of their rights and responsibilities. To ensure that the contract is air tight, it’s a good idea to have it reviewed by a real estate attorney.
Legal Title Vs. Equitable Title
With a land contract, the seller typically retains the legal title until the buyer has paid the full balance due on the property. Once the final payment has been made, the seller will transfer the title. In the interim, the buyer does receive an equitable title which allows them to build equity in the property over time.
Straight Vs. Wrap-Around Land Contract
When people think of a land contract, they probably think of a straight land contract. That’s what we’ve discussed above. However, there’s another option - the wrap-around land contract.
With a wrap-around land contract, the seller keeps paying their mortgage as agreed. The buyer’s monthly payment reimburses them, and any amount leftover goes into their pocket. The biggest distinction between a straight land contract and a wrap-around land contract? The buyer gets the property’s legal title and assumes full ownership from day one.
For the wrap-around land contract to happen, the seller’s mortgage company has to be onboard. That’s because they won’t receive the full amount owed on the home. To protect their interests, they’ll put a junior lien on the property so that they can reclaim it in the event the seller stops making their mortgage payments.
Land Contracts Vs. Land Loans
A land contract is made with a seller who agrees to finance your purchase of their home. A land loan, by contrast, is financing for land itself. You may choose to put a house, a store, an art gallery or any number of other things on the land. Loans for this type of transaction are typically acquired through financial lenders.
Rocket Mortgage® doesn’t finance land by itself. There must be a home being purchased.
Why Use A Land Contract?
Depending on your situation, a land contract can be an appropriate solution. There are a few main benefits to going this route, including:
- Does not require mortgage approval
- Offers greater flexibility (contract terms are customized for mutual benefit)
- Potentially helps the seller sell their home faster (with an avenue to take back the property if the buyer defaults per the contract terms)
A land contract is helpful if you can’t get or don’t want traditional mortgage financing. This might happen for a couple of reasons.
If you’re buying a distressed property in order to fix it up, the property might not meet basic conditions to pass an appraisal, usually because of safety restrictions. The mortgage company needs to know the property you’re buying is livable because the loan is secured by the property; if something happens to the home, the mortgage company’s investment is also impacted.
The seller may not want to make the repairs because they may not realize their full investment when the appraisal comes back from the appraiser.
There are mortgages you can get to rehab a property. These allow you to finance both the cost of the purchase and the cost of the renovation necessary to make the house move-in ready. However, many lenders, including Rocket Mortgage®, don’t offer these loan options. And if the seller only accepts cash buyers, the market of potential buyers is limited.
If the buyer is unable to get a mortgage, seller financing through a land contract is an option. The buyer pays off the cost of the property over time at agreed-upon terms.
Mortgages sold on the secondary market are backed through outside sources like Fannie Mae, Freddie Mac, or the FHA. These agencies standardize underwriting guidelines so investors can be confident in the bonds they buy based on the loans.
There’s a lot that goes into loan underwriting, but some of the big points that get considered are the buyer’s debt-to-income (DTI) ratio and credit score. While there are good reasons for lenders to rely on this data to help make sound investing decisions, this means some buyers won’t qualify for a mortgage.
Buyers may find it easier to obtain financing on a land contract. The seller may want to pull your credit in order to get a sense of your financial qualifications, but there are no defined credit guidelines to follow for a land contract.
Be Aware Of Land Contract Drawbacks
While a land contract has its perks, there are some big potential drawbacks to be aware of such as:
- Possible balloon payment at the end of the contract
- Requires a strong buyer-seller relationship -- especially with a wrap-around land contract
- Ambiguity over property ownership when it comes to legal or insurance concerns
- Interest rates may be higher
If you work out an agreement with the seller that states the payment on the land contract is at a fixed rate for the term of the loan, the agreement is fairly straightforward. However, many loans have fixed payments leading up to a large balloon payment at the end of the loan, where a significant portion of the balance is due all at once.
Land contracts also don’t feature some basic protections that mortgages do because the seller holds the title until the contract is paid off. Depending on the way your contract is worded, if you’re late with your payment just one time, the seller could choose to evict you. They do have to conduct a foreclosure process and you may have different rights from state to state, but it’s possible. (With a mortgage, this isn’t the case most of the time because your name is on the title.)
If the seller dies, doesn’t pay the property taxes, or make timely payments on any existing mortgages, there’s also the possibility that you lose the house because the house isn’t really yours until your name is on the title. This is the case with traditional, or straight, land contracts, but wraparound contracts work differently because you get the legal title right away. As a buyer in a wrap-around land contract, make sure that the contract gives you legal recourse if the seller stops making their mortgage payments.
During a land contract, property ownership is a bit of a gray area (particularly true in a straight land contract). That means when legal or insurance matters arise, it can be hard to determine who is responsible. It’s a good idea to have these matters addressed in advance within the contract.
Land contracts may have a higher interest rate than mortgages because the seller is taking on more risk, particularly if you can’t otherwise qualify for a mortgage. That high interest rate could cost you tens of thousands of dollars over the life of the contract.
How To Refinance Your Land Contract Into A Mortgage
As a buyer, if you become able to qualify for a traditional mortgage, you may want to consider refinancing into one. Doing so could help you get a lower interest rate or avoid making a large balloon payment at the end of the land contract.
If you decide it’s time to refinance your land contract into a mortgage, there are a few points to be aware of.
When you refinance a land contract, the initial contract you have with the seller gets paid off. Since you’re paying off the full balance of the contract, there are a couple things you need to consider:
- Ensure the title is clean and that the seller has the legal right to sell the property. Having multiple owners on the title could prevent you from being able to refinance. Using a title company to handle the initial recording of the contract can help make this process smoother.
- Look out for any prepayment penalties you may have for closing the contract early. If you really want out, you may choose to pay these anyway, but it’s something to be aware of.
- Know your credit score. If you had a credit score on the low end and haven’t cleaned it up, it could prevent you from refinancing.
- Land contract payments aren’t reported on your credit, so your lender will require other payment verification through canceled checks or bank statements, etc. It depends on the type of loan you get and whether your land contract was with a bank or an individual, but a good guideline is 24 months of payment history.
If you bought a fixer-upper and have made repairs and improvements, you’ll want to make sure that the home is fixed up enough to pass an inspection before attempting to refinance. This means there can’t be any hazards that would affect the livability of the property. When it comes to appraised value, it works a little differently.
- If you’ve been on your land contract for less than 12 months, the property value (for purposes of the mortgage) is based on the lesser of the purchase price or the appraised value. If the mortgage is an agency loan from Fannie Mae or Freddie Mac, you can add your remodeling costs to the purchase price and add those costs back into the loan if it totals to be less than the appraised value. If you’re considering a conventional loan, maintain a record for future selling or refinancing considerations.
- If you’ve had the land contract for more than 12 months, the home value is the value assigned at appraisal.
Should You Use A Land Contract?
So, is a land contract right for you? It depends. It can be a good option if you can’t get or don’t want a traditional mortgage. A land contract may also be a great deal for you if you want to unload a property that won’t qualify for bank financing.
However, entering into a land contract isn’t without risk. It doesn’t offer the same protections as a standard real estate transaction involving a commercial lender and a mortgage. That means you really need to do your homework and review all mortgage options before committing to a new contract or refinancing a current contract.