Beware the Contract for Deed

By Chris Watkins

These days, as many sellers are in a desperate struggle to sell their homes, and many potential buyers are having trouble qualifying for conventional mortgages (because of tougher loan underwriting policies), the result is that seller financing is on the rise.  One form of “seller financing” is the contract for deed.

WHAT IS A CONTRACT FOR DEED?

A Contract for Deed, sometimes referred to as a “land contract” or an “installment sale agreement,” is a form of seller-financing for real estate.  In a typical real estate transaction, the seller transfers title to the buyer (by signing and delivering a warranty deed), and the buyer finances the purchase by borrowing funds from a lender in exchange for a promissory note secured by a deed of trust (or a mortgage).   In some cases, instead of a third party lender getting involved, the seller acts as the “lender” and takes the promissory note and deed of trust.   In either case, title to the property transfers to the buyer at the closing.  If the buyer defaults on the loan, then the lender can foreclose on the property.

With a Contract for Deed, the buyer agrees to make payments to the seller over time, but does not take title until the purchase price is fully paid – often many years in the future (if ever).  If the buyer ever defaults, the seller has the option to take back possession of the property (foreclosure is not necessary because title was never conveyed), and the buyer is out all of the money paid up to that point.

Contracts for Deed are commonly used in situations in which the seller needs to quickly sell the property, but can find no buyer who can qualify for a conventional loan.  In many cases, the seller still owes money on the property and can no longer afford the mortgage payments, so he is looking to the buyer to provide the funds with which to make the monthly payments.  This is very risky, as discussed below.

WHAT ARE THE RISKS?

Whether you are the buyer or the seller, there are numerous risks involved with a contract for deed.

Buyers’ Risks:

• Homes sold through contracts for deed are often sold on an “as is” basis with little disclosure from the seller of defects in the property.  It is highly advisable for buyers to get a thorough inspection.
• If the seller has an existing mortgage/deed of trust on the property, the mortgage document will almost certainly have a “due on sale” clause that will be triggered by a contract for deed.  This means that, unless the lender consents to the contract for deed, the lender can declare the entire loan to be due immediately.  If you are not in a position to pay off the balance of the loan, the property could be foreclosed right out from under you, and you’d have little or no recourse.
• Another risk is that you do everything you are supposed to, and upon making the final payment, you discover that the seller is unable to deliver clean title to you (or any title). For example, there may be liens on the property from the seller’s creditors.  Or perhaps the seller divorces or dies, and various other parties claim ownership.  These are all problems that could require expensive litigation to sort out.
• It is very unlikely that a buyer will be able to get title insurance on the property, at least not until title is conveyed.
• The buyer has no equity in the home until it is fully paid off.  This means that even if you make payments religiously and on time for several years, but if you fall on hard times and fail to make a couple of payments, you could lose the house and all of the money you paid to the buyer.

Sellers’ Risks:

• One obvious risk is that the buyer in a contract for sale transaction is typically someone who could not qualify for a conventional loan.  There are all kinds of reasons why a buyer would not qualify for a loan (poor credit scores, little or no income, high debt, etc.), but they all mean that there is a pretty good risk that the buyer will default at some point.
• If the seller has a mortgage on the property and the buyer fails to make payments or if a “due on sale” clause is triggered, the seller’s lender/mortgage holder may accelerate the loan, thus forcing the seller to come up with funds to pay off the loan or risk foreclosure.
• If there is a fire or other casualty on the property, there may be a dispute about who is entitled to the insurance proceeds.  The seller needs to make sure his interest is insured.  Furthermore, the seller, whose name is on the title, could be forced to defend himself in a lawsuit if someone is injured or killed on the premises.

CONCLUSION

The risks associated with a contract for deed are great and neither buyers nor sellers should enter into such a transaction without careful consideration, and it is advisable for all parties to seek legal counsel.  Even if conventional financing is not an option, there are other alternatives that may be better, such as a simple lease or a lease with an option to purchase, or even seller financing in which the seller conveys title and takes back a promissory note and deed of trust.