What Is A Land Contract And How Does It Work?
A land contract is another way to buy a home and can be an excellent alternative for a potential buyer who doesn’t qualify for a mortgage loan. Rather than not purchasing a home, buyers can work out an arrangement with sellers to buy it from them.
Land contracts work differently from traditional mortgages and have many pros and cons. It’s essential to understand how they work and what the consequences will be not only today but long term before choosing this option to purchase a home.
How Does A Land Contract Work?
A land contract, as the name suggests, is a contract to transfer land. In the contract, buyers and sellers must agree on a variety of terms, not just the sale price and closing date. Buyers and sellers must also agree on many other details.
The land contract is a legal agreement, just like a buyer would enter with their bank if they took out a mortgage. But there are major differences between the land contract and conventional loan.
For starters, buyers don’t have to qualify like they would with a mortgage lender. Sellers still may have specific qualifying requirements, but they are often much more lenient than a bank might be.
Another major difference is the balloon payment sellers may require. Sellers often provide financing for a short period, time enough for buyers to get standard financing and pay off the seller. The balloon payment is one that covers the remaining balance of the loan after any previous payments are deducted.
Sellers and buyers set the term together, but buyers should understand that most sellers only offer to finance temporarily. They don’t intend to be in the contract long-term.
It’s important to understand two main differences between buying a property outright (with bank financing) and using an installment contract or land contract to buy the land.
How You Hold Title
Buyers on a land contract hold the equitable title but not the legal title. This means the buyer has the right to earn equity in the property but can’t transfer ownership because they aren’t the legal owner. Buyers obtain legal title once they pay the seller off in full, usually through financing.
With the seller owning legal title, they still call the shots. There is still a possibility of the seller getting liens attached to the property, too, so buyers should make sure they’re working with a reputable seller.
Land Contract vs Land Loan
Many people confuse a land contract and a land loan, but they are two different things. As we’ve discussed, a land contract is an arrangement with the seller to make installment payments to take ownership of the land eventually.
A land loan is financing buyers secure from a bank to buy a piece of land, much like they’d take out a mortgage to buy a home. Buyers can use a land loan for many purposes, including buying a property or even a commercial piece of property.
Negotiations Between Buyer And Seller
Similar to when buyers purchase a home and use mortgage financing, they must negotiate the land contract terms. Both the purchaser and seller have a say in the terms, and both must reach an agreement before executing the contract.
- Purchase price: Negotiating the purchase price is normal for any transaction. The buyer and seller must agree on a price before signing the contract. This is the ultimate amount the buyer must pay off to own the land.
- Down payment: The buyer and seller must also agree on a down payment or money the buyer will put down on the property and not finance it. This is just like when you take out a mortgage, and the lender requires 3% – 5% down. The money you put down is your investment and makes you less likely to default. It can be a percentage of the sales price or a flat dollar amount. It depends on what the buyer and seller agree on.
- Interest rate: The seller can set a fixed rate or adjustable rate, depending on how they want to handle the transaction. Some are fine with a fixed rate because the contract has a short-term and balloon payment. Others set longer terms but make up for the risk by charging an interest rate that increases over time.
- Monthly payment amount: The buyer and seller must agree on a monthly payment amount, but you may even set other terms, unlike traditional financing. The seller may be willing to accept bimonthly payments or any other arrangement you need.
- Balloon payment: Most land contracts have a balloon payment or payment of the amount left after a couple of years. It’s typically a short-term arrangement to help buyers get on their feet while taking ownership of the land they want.
- Prepayment penalties: The seller has the right to set a prepayment penalty. This is a penalty buyers pay if they pay the installment contract off early. Sellers (and lenders) set this up to ensure they make a set amount. When the buyer pays the loan off early, the seller loses out on interest. If they were using this as an investment, they might want to ensure their returns. Buyers should be wary of this situation. If they can’t prepay the contract but can finance at a great rate, or they come into money and can pay it off, they’d be stuck with a loan and paying interest they don’t need to pay.
- Default clauses: The seller usually sets the default clauses to determine what happens if a buyer defaults on the loan. It’s essential to read this section carefully to know what would happen if a buyer can’t afford the loan.
- Title: Buyers don’t receive legal title until they pay the balance in full. This means they can’t transfer ownership until they pay the seller off in full.
It’s advisable to seek counsel from a real estate attorney before entering a land contract. Both the buyer and seller have a lot at stake and should clearly understand who is responsible for what and why it should be recorded in the land contract.
Straight Vs. Wrap-Around Land Contracts
Sellers can offer two types of land contracts: straight and wrap-around. Straight land contracts are what we’ve covered up until this point. The seller owns the land free and clear (no mortgage) and has the legal right to sell the property.
A wrap-around contract is different. Sellers don’t own the property free and clear, they still have a mortgage on it. But rather than paying off the mortgage with the proceeds from the sale, they enter a wrap-around land contract and use the monthly payments from the buyer to make the payments.
If there is a difference between the agreed-upon monthly payment in the land contract and the mortgage payment (there should be), the seller profits.
Before a seller can enter a wrap-around contract, they must get prior approval from their lender. The seller’s lender has a lot at stake and will usually enter a junior lien on the property if the seller stops making payments.
Buyers should be wary of this because if the seller stops making the mortgage payments, the lender can have a stake in the property. In a wrap-around contract, buyers get a full legal title (unlike a straight land contract), so the lien would be the buyer’s responsibility even if the buyer made his payments, but the seller didn’t pay the lender.
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Why Use A Land Contract?
Buyers and sellers should think carefully before entering a land contract. While they have many advantages, there are downfalls too. Understanding both sides can help buyers and sellers decide if it’s right for them.
Advantages Of Land Contract Homes
Land contracts have many advantages for buyers, including:
- Relaxed underwriting requirements
- Faster closing process
- No lender fees to pay
- Buyers and sellers can negotiate the terms
- No appraisal or inspection to worry about passing
Disadvantages of Installment Land Contracts
Land contracts have disadvantages both buyers and sellers should think about too, including:
- The potential to have a balloon payment
- Larger down payment requirements
- Higher interest rates with the potential to increase/change
- Ambiguous property ownership
- The buyer has the potential to have a junior lien on the title with a wrap-around land contract
How To Refinance Your Land Contract Into A Mortgage
The goal for most buyers is to refinance the land contract into a conventional loan eventually. The land contract should set the stage, allowing buyers to purchase a property with more relaxed guidelines, providing more time to improve credit or save more money to get traditional financing.
To refinance the property, property owners must ensure the following.
Credit Is Improved
Most buyers enter a land contract because they have less than optimal credit and can’t get a mortgage. Checking credit before applying for the loan and ensuring the score is as high as possible is important.
Have Proof Of Being Able To Afford The Loan
Buyers must be able to prove beyond a reasonable doubt that they can afford the new loan. This includes providing adequate income and low enough debts to keep the debt-to-income ratio in line with what’s necessary.
The title must not have any liens, which fall on the seller. Buyers must ensure the seller kept the title clean by paying all liabilities on time, including any outstanding mortgages the seller had.
Qualify For A Loan Amount High Enough To Cover The Balloon Payment
Since land contracts usually have a balloon payment, buyers must be able to afford a loan amount that’s at least as high as the amount owed. Some buyers wrap the closing costs into the loan too, which means an even higher loan amount.
The Bottom Line
A land contract offers buyers a way to own land faster than if they applied for standard financing. Buyers with low credit scores or other qualifying issues often benefit from this method of financing.
Before you enter a land contract, research the advantages and disadvantages and consult with a real estate attorney and home loan expert to ensure you understand your refinancing options when it’s time.