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What is Contract for Deed?
While contracts for deed offer some advantages over a traditional mortgage, such as speed and simplicity, they can entail distinct risks for buyers and sellers. This article presents basic facts and features of the contract for deed and offers suggestions for minimizing those risks.
Because of recent credit tightening, some homebuyers may be less likely to qualify for mortgages than they were just a few years ago. Some financial counselors predict that borrowers with limited options may turn to alternative means of purchasing a home. One such alternative is the contract for deed.
In a contract for deed, the purchase of property is financed by the seller rather than a third-party lender such as a commercial bank or credit union. The arrangement can benefit buyers and sellers by extending credit to homebuyers who would not otherwise qualify for a loan. Indeed, public and nonprofit housing advocacy organizations have used the contract for deed as a tool to help low- and moderate-income households attain homeownership.
Nonetheless, this alternative financing mechanism lacks many of the protections afforded borrowers who have traditional mortgages. In addition, these contracts may contain provisions that leave room for abuse and can pose risks and uncertainties for both the buyer and seller. The following article presents basic facts and features of the contract for deed and offers suggestions for minimizing the risks associated with this mortgage substitute.
Facts and features
A contract for deed, also known as a "bond for deed," "land contract," or "installment land contract," is a transaction in which the seller finances the sale of his or her own property. In a contract for deed sale, the buyer agrees to pay the purchase price of the property in monthly installments. The buyer immediately takes possession of the property, often paying little or nothing down, while the seller retains the legal title to the property until the contract is fulfilled. The buyer has the right of occupancy and, in states like Minnesota, the right to claim a homestead property tax exemption. The buyer finances the purchase with assistance from the seller, who retains a security in the property.
The contract for deed is a much faster and less costly transaction to execute than a traditional, purchase-money mortgage. In a typical contract for deed, there are no origination fees, formal applications, or high closing and settlement costs. Another important feature of a contract for deed is that seizure of the property in the event of a default is generally faster and less expensive than seizure in the case of a traditional mortgage. If the buyer defaults on payments in a typical contract for deed, the seller may cancel the contract, resume possession of the property, and keep previous installments paid by the buyer as liquidated damages. Under these circumstances, the seller can reclaim the property without a foreclosure sale or judicial action. However, laws governing the contract-cancellation process differ from jurisdiction to jurisdiction and the outcome may vary within any one state, depending on the contract terms and the facts of the specific case.
Because the buyer in a contract for deed does not have the same safeguards as those afforded a mortgagor in a purchase-money mortgage, the contract for deed may appear to be essentially a rent-to-own arrangement. However, in a typical contract for deed, the buyer becomes responsible for the obligations of a mortgagor in possession, such as maintaining the property and paying property taxes and casualty insurance. In addition, unless prohibited by the contract, either party may sell his or her interest in the contract.
Speed, simplicity appeal to buyers
Homebuyers may be attracted to a contract for deed purchase for several reasons. This method may be especially appealing to homebuyers who do not qualify for a mortgage, such as people who work cash jobs and are therefore unable to prove their ability to make payments. Since the contract for deed process is significantly shorter than the mortgage-approval process, it may attract buyers who face time constraints or have limited options, such as people who are losing their homes to foreclosure. First-time homebuyers who lack experience in the market or individuals who are wary of traditional financial organizations may also choose a contract for deed because of the relative simplicity of the buying process.
The risks for buyers
Despite favorable changes in the legal enforcement of forfeitures, contracts for deed pose distinct risks for buyers. One major risk stems from the short time period required to cancel the contract in the event of default. For example, in Minnesota, when a buyer falls behind on payments, the seller can file a Notice of Cancellation of Contract for Deed with the county and serve the buyer with the notice. The buyer has only 60 days from the date of the filing to address the items of default and pay the allowable attorney fees to "reinstate" the contract. This is a short time span in comparison to the six months or more afforded mortgagors who face foreclosure. As a result, a defaulting contract for deed buyer has a much narrower window of time to find a new home and is likely to have limited housing options.
Another major risk for the buyer is the balloon payment. Unlike most traditional mortgages, the majority of contracts for deed are not fully amortized. Instead, the contract is most frequently structured to require monthly payments for a few years, followed by a "balloon payment" that completes payment on the house. To make this balloon payment, the buyer will almost inevitably need to obtain a traditional mortgage. If a buyer is unable to qualify for a mortgage at the time the balloon payment is due, he or she is likely to face cancellation of the contract.
Some buyers enter into contracts for deed with the hope of repairing their credit. They expect to improve their credit profile during the first part of the contract period and then qualify for a loan at the time the balloon payment is due. However, according to Dan Williams of Lutheran Social Services in Duluth, Minn., a contract for deed often does not improve the credit of the buyer because individual sellers typically do not report to credit agencies. The buyer may attempt to use a letter from the seller stating that he or she makes the contract payments on time, but unfortunately, most lenders do not honor such a letter.
Williams warns that unexpected home repair costs may also pose a risk to buyers in a contract for deed. While this risk also applies to buyers who purchase homes through conventional mortgages, it may be greater in the case of homes purchased through contracts for deed, because a seller can execute a contract for deed with limited disclosure about the condition of the property. Minneapolis-based attorney Larry Wertheim explains that in a third-party financed sale, the lender's stringent requirements for title examination, title insurance, and appraisal provide the collateral advantage of disclosure for the buyer. Unless the buyer in a contract for deed has legal assistance or is aware of the need for appraisal and title examination, the transaction may not include these safeguards. In addition, since many homebuyers choose a contract for deed because their weak credit precludes them from obtaining a conventional mortgage, they are unlikely to qualify for loans to finance repairs. Ultimately, defects in the property could increase the chances of the buyer defaulting on payments and losing the home.
Another risk for contract for deed buyers stems from the fact that the seller retains the title to the property during the life of the contract. Since the seller retains the title, he or she may continue to encumber the property with mortgages and liens. The seller is only obligated to convey good title when the purchase price is fully paid and it is time to deliver the title. He or she does not need to have good title at the time the contract is executed nor during the life of the contract. Depending on state law and whether the contract is recorded in a timely manner, the buyer's interest may be junior in priority to these pre- and post-contract encumbrances placed on the property by the seller.
In addition to the problems described above, no two contracts for deed are alike and, according to Cheryl Peterson of Twin Cities Habitat for Humanity, the terms of the agreement are often unclear. The contract for deed is typically a one- to five-page document that includes the amount of the purchase, the interest rate, the monthly payment, and some verbiage regarding cancellation. The documents often do not include a standard arrangement for beginning the cancellation process. This lack of clarity in contracts for deed creates difficulties for financial counselors who give advice to buyers facing forfeiture. According to Peterson, "You can't say, 'If you've seen ten contracts for deed, you've seen them all.' It doesn't make you an expert, because the next ten will all be different."
Ensuring a positive outcome
It is important to note that despite their risks and sometimes negative associations, contracts for deed are not intrinsically bad. When used wisely, they can be a good fit for some consumers. Contracts for deed offer a swift, streamlined option for people who do not qualify for traditional mortgages or would prefer not to deal with mortgage lenders. When administered by agencies contracts for deed can be a tool for building credit, promoting homeownership, and stabilizing neighborhoods.
To protect their interests in contracts for deed, sellers and buyers must do their homework, so to speak, by making sure they learn and understand what specific provisions and risks the contracts entail. Buyers in private contracts for deed should take additional steps. These include assessing the condition of the property, confirming that the seller has clear title, and recording the signed contract at the appropriate government office. By being informed and prepared, the buyer and seller in a contract for deed can help ensure a positive outcome for both parties.
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