Buying a home is a prescriptive process for most people. If you are buying a new home, you will likely find a real estate agent, talk to a lender to secure an interest rate on a mortgage, get your earnest money together, and write a purchase agreement. For most people, this is a great process (& even better in this low interest rate environment)!
However, sometimes buying a home requires additional creativity. What if you have trouble securing a mortgage or coming up with the entire down payment? What if you have the income and portfolio assets to afford a home, but lack the liquidity? What if the perfect house comes along and you need a more creative solution? You might want to dust of one of the oldest and rustiest tools in the shed: contract for deed.
What is a contract for deed?
Contract for deed has waxed and waned in popularity. In the high interest rate environment of the 1980s and during the Great Recession, contracts for deed were a popular option for those who could not secure a mortgage or could not afford the interest payments on a mortgage. You may have heard contract for deed referred to as a “bond for deed,” “land contract,” or “installment land contract.”1 In this scenario, the seller finances the purchase of their home rather than a bank, credit union, or other mortgage lender. The buyer contracts to pay the purchase price of the home (plus interest) in monthly installments to the seller. The buyer then occupies the home while the seller maintains the legal title to the property.
At the end of the contract, there is often a balloon payment in which the buyer is expected to pay the remaining balance on the home. This can be after one year, two years, five years, or any other time period agreed upon by both parties. When the balloon payment is due, the buyer usually secures a mortgage to cover the balance owed and legal ownership transfers to the buyer.
Sounds great, right? Well, only if you are in the right situation. Occasionally, contracts for deed have been used in a predatory manner in situations designed to fail2. We do not condone that behavior. Rather, we view contract for deed as a creative tool for both buyer and seller as long as the risks are understood.
The balloon payment
If payment is not made when the balloon payment is due, the buyer is in default and the seller can reclaim the house. After all, they still hold and control the deed. You must be certain you can either make the balloon payment in cash or secure a mortgage when the balloon payment is due.
Why would you risk a balloon payment if you are already having trouble getting a mortgage? Well, perhaps you are low on liquidity now but will be more liquid in the future. You might have stock options to exercise in the future but cannot do it now for one reason or another. It might be the case, too, that a lender would require a high down payment now to secure a mortgage. We have heard many lenders are requiring 30% down on high value homes! A contract for deed may present a better interest rate option.
Risk of default
If you miss a payment on a contract for deed, there are far fewer legal protections for you as a buyer. Only utilize contract for deed if you are certain you can make the monthly payments. This is how contracts for deed have been abused in the past: the seller knows the buyer will likely default but enters the agreement anyway. That way, they can try again on someone else and keep getting monthly income. It may help to have the counsel of a good real estate attorney if you are able.
Lack of legal ownership
Another risk is that you, as the buyer, do not own the home during the contract for deed. You pay your monthly installments, maintenance fees, homeowner’s insurance, and property taxes, but the home is still legally owned by the seller. This makes the arrangement high risk. Again, this calls for the use of a good real estate attorney.
Fast & easy!
For the buyer, the rewards for contract for deed are enticing: it’s fast & easy! A contract for deed addendum can be filled out by your real estate agent or attorney when you make an offer. This method cuts out the time required for mortgage approval. You might have to present a financial disclosure to the seller, but you will not have to wait for a lender to pull your credit score, look over your financials, and approve you.
Negotiable interest rate
When you sign a purchase agreement with a contract for deed addendum, you choose the interest rate. This will likely become a point of negotiation, but the opportunity to propose an interest rate provides you with tremendous flexibility. Instead of a lender offering an interest rate to you, you get to offer an interest rate to the seller.
We discussed how the balloon payment presents a risk to the buyer. Part of the risk of a balloon payment can be mitigated by using contract for deed on only part of the purchase price instead of the full value. Note that in this scenario you would also get a mortgage upfront and pay your mortgage and the contract for deed at the same time. You must account for the additional cashflow. That said, this is a great way to offer an acceptable down payment but finance its payment if you do not have enough liquidity now.
Additionally, since you get to negotiate the interest rate, it is often favorable for both the seller and the buyer to compromise on a higher purchase price and a lower interest rate. This creative construction will allow the seller to get what they think their home is actually worth, and the buyer will pay less in interest.
Income for the seller
Contract for deed is also enticing for the seller depending on their situation. Instead of receiving a lump amount from the sale of their home, they can look forward to monthly income from you for the duration of the contract! And if you fail to make a payment, the contract ends, and the seller can walk away with the income and put the house on the market a second time.
Contract for deed is not the right solution for everyone, but it might be the right solution in the right circumstances. At Story Capital, we value creativity in planning for our clients. We are committed to researching all the options – even the rusty options – in search of the best fit for our client. Give us a call if you have a problem that requires a creative solution!
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