What Are the Disadvantages of Contract for Deed

Jan 6, 2023 | Mortgage Guides

DISCLAIMER: Wesley Mortgage does not facilitate contracts for deed transactions. This information is provided for your information.

The services of contract for deed buying and selling may appeal to individuals who want to purchase or sell a property without using existing mortgage options. However, there are noticeable disadvantages to using a contract for a deed to buy or sell a property. One of these things that a prospective buyer or seller must consider is the complicated process of ownership transfer that comes in addition to the financial commitments involved. Find out more below.

What Is a Contract for Deed in Real Estate?

One alternative way to buy a home if one can’t secure a mortgage is to buy a house through a contract for deed, or land contract. A contract for deed, or land contract, is a pathway to buy a home from a seller without utilizing banks, lenders, or third parties for financing.

In a contract for deed, a buyer purchases a home at closing directly from the seller but doesn’t own the legal title to the property. Instead, the seller owns the legal title until the buyer pays for the entire cost of the home. Often, along with the purchase price, the buyer will make monthly payments towards the principal cost via terms agreed upon in their land contract.

‍A land contract is appealing because it requires little money down. For example, in a typical home purchase situation, many lenders require a down payment before one can secure a mortgage loan. In addition to other benefits, contracts for deeds allow a buyer to move into a home and work towards owning it, often requiring little or no down payment.

How Does a Contract for Deed Work?

A contract for a deed is different from a mortgage loan, but it also has similar characteristics. For instance, contracts for deeds are usually paid down in monthly installments. They often have an interest rate, a purchase price, closing costs, and a down payment. The main difference between these and a mortgage loan is that a lender is not involved in financing the property. This ownership and financing arrangement is in sharp contrast to traditional mortgage services.

‍The lack of a mortgage lender in these transactions is appealing to some. Getting a mortgage can sometimes become difficult if someone has a low credit score. Since the seller exercises the land contract, they can create the purchasing terms they deem applicable.

‍For example, a seller may offer the property to someone with no credit history or a low credit score. Both are acceptable since the seller decides who they’ll accept for their contract. Furthermore, the seller is protected from buyer default risk because the buyer doesn’t yet own the home. This is another unique aspect of this form of property ownership.

Is Contract for Deed the Same as Seller Financing?

The main difference between seller financing and land contracts is that land contracts involve a third party protecting the contract in escrow. The buyer still makes payments directly to the seller, but a third party holds the contract if the buyer defaults. Such services are in place to protect both parties involved.

‍If a buyer defaults, the seller can file legal proceedings against the buyer to get their property back. Likewise, the buyer can countersue for reimbursements on any improvements or restorations they’ve made. The seller retains legal title to the property until the contract is fulfilled. So they can reclaim their property if the buyer stops making payments legally‍. This reality reinforces the importance of understanding things related to property ownership in the context of a contract for deed.

Why Do People Use Land Contracts?

The primary reason buyers use land contacts is that they don’t qualify for a mortgage. Furthermore, a contract for deed often offers a buyer more minor down payment requirements than a mortgage. If the purchase price of a home is high, a smaller down payment can help many buyers make the purchase, which, in addition to the flexible terms, can make this an attractive option.

‍From a seller’s perspective, a contract for a deed can increase the number of potential buyers on their home or property. To some, this increase in available applicants may make it worth pursuing this financing option despite the unique aspects of the deed contract and ownership transfer processes.

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How to Structure Your Contract for Deed

If you’re considering using a contract for a deed to sell your property, you should be thorough in your planning. This includes understanding all things related to this form of property ownership and any services or assistance you may need to navigate the process successfully. The agreement you draft must contain specific details to safeguard your investment and finances. A thoroughly signed document with up-to-date and comprehensive details offers not just legal security but can also provide a bevy of financial benefits.

You should include the following:

Price

The price, which is the total amount the buyer must pay, less interest, in order to take possession of the home, must be explicit in the agreement.

Term

This is the contract’s duration, commonly known as the loan amortization period. Keep the agreed-upon date in mind while understanding that a longer term signifies a more extended repayment period. Be prepared that it may take many years before you recoup your property costs due to the liens that may exist on the property.

Interest Rate

You are not required to offer an interest rate comparable to current mortgage lenders. If you intend to secure benefits from your contract for deed, consider employing an interest rate of 7 to 9 percent for later use. Also, abide by the usury laws in the state where the property is located. A bit of online search can provide you with this information.

Payment Structure

Under the agreement, you can split the total balance into equal monthly payments over the loan’s duration or provide the buyer with the option of smaller initial payments with a larger balloon sum towards the end. However, if you choose a balloon-style payment structure, remember that a note buyer might not purchase your contract unless the factors are attractive enough.

Property Use

Though most deed contracts permit the buyer to inhabit the property as if they were the owner, some sellers might want to retain some measure of access. Other sellers, like landlords, might undertake maintenance and repairs. These specifics should be detailed in the agreement.

Insurance and Taxes

The contract should also define who, between the buyer and seller, will bear responsibility for insurance (homeowner’s, flood, etc.), taxes, HOA fees, and other annual assessments during the agreement term.

General Details of the Property and Parties

Include the property’s legal description (found on the deed or at the local property tax office), as well as the buyer’s and seller’s full legal names and contact information.

If you’re considering going down the contract for deed path, consult with an experienced real estate attorney. These transactions are unique and can be customized to suit the specific parties and properties involved. An attorney can provide assistance in ensuring you are protected. This legal help is worth every dollar spent!

What Are the Advantages of a Contract for Deed?

The contract for deed arrangement boasts numerous advantages. From the buying perspective, contract for deed arrangements provides a path to homeownership for potential owners with credit and employment verification issues.

The absence of traditional mortgage lenders also speeds up transactions, cutting out their often lengthy underwriting processes. This can benefit both the buyer and seller, as the transaction process is shortened by several weeks.

The adaptability of contracts for deed agreements is another benefit. Both parties can tailor the contract to suit their specific situations, culminating in an agreement mutually beneficial to both.

Lastly, contracts for deeds allow sellers to refrain from the whims of market conditions. They can attract buyers by offering houses in a supply surplus or when mortgage rates are high and potential buyers are put off. This strategy also ensures a steady monthly income.

The Biggest Disadvantages of a Contract for Deed

However, remember to weigh in some core disadvantages if you opt for a contract for a deed to buy or sell a home. These disadvantages when dealing with real estate will change based on whether you’re buying or selling a property, just as the potential drawbacks of dealing with a bank for a home loan would.

Disadvantages for the Buyer

Buyers experience several disadvantages when using a contract for a deed, similar to the struggles some may face when seeking to purchase homes in a saturated market area. If the buyer defaults on their payments, the seller has the right to terminate the contract. In these situations, the buyer then has to forfeit their rights to the property. Furthermore, the buyer loses any equity they’ve built throughout their payments.

For example, if a buyer pays down $100,000 of a $300,000 property they’ve purchased through a land contract, then defaults, they lose the $100,000 they’ve invested in the property. Much like how a debtor who defaults on a bank loan would lose their place within the credit market. In a traditional mortgage, the borrower can usually reinstate the mortgage by paying the past due amounts and keeping the property.

‍Another disadvantage for buyers in a contract for deed sale is that they don’t own the property. The property still legally belongs to the seller and is considered part of the seller’s assets. This dynamic can create some strange scenarios. For instance, if the seller buys a different property through a mortgage and defaults on their loan, the lender – perhaps even the same bank the buyer is familiar with – may have the right to take the buyer’s home as collateral for the seller’s defaulted loan. The buyer can take legal action in these scenarios. Still, they may be removed from their homes despite making all their payments on time.

‍Another consideration for buyers using a contract for a deed is the lack of borrowable security in the property. For example, if the buyer wants to borrow money and use their home as security, lenders will likely deny them because they don’t legally own the property. Since the buyer doesn’t own their home, it’s not valid collateral to secure additional financing from the bank.

Disadvantages for the Seller

In a traditional mortgage, the buyer makes monthly payments. These mortgage payments slowly pay down the amount borrowed on the mortgage. However, the payments are directed toward the lender, significant in an area where housing prices are on the rise. The seller in this situation receives the total purchase price of their home in one lump sum payment when the borrower’s mortgage loan closes (less any seller costs).‍

In a contract for deed sale, the seller receives payment for their property through monthly installments, similar to a bank receiving consistent interest payments. The payments on a contract for deed sale may not reduce the contract price as quickly as a mortgage payment throughout the term.

Advice for Sellers and Buyers Before Entering into a Contract for Deed

If you still plan to move forward with a contract for a deed buying or selling opportunity, consider the following points of advice just as you would think through the terms of a bank loan or the administration of a bustling property market:

Advice for buyers:

  • Hire a real estate agent to help you with your home purchase
  • Hire a housing counselor to help guide your buying process
  • Hire a real estate attorney to review the contract you’re looking to sign
  • Hire an inspector to evaluate the property you want to purchase
  • Hire an appraiser to give you a current market value of the property you want to purchase

Advice for sellers:

  • Hire a real estate lawyer to create your deed contract
  • Review the buyer’s financial situation
  • Prepare to pay appropriate taxes and insurance
  • Prepare to handle situations in which your buyer defaults on their monthly payments

Summary

A deed for the contract is a mortgage alternative many may consider when buying or selling a home. It’s an attractive alternative to some, but it also has noticeable disadvantages to a traditional mortgage.

From a buyer’s perspective, you don’t legally own your home and may lose all your equity should you default on property payments. Furthermore, your home isn’t considered security you can borrow against; if your seller defaults on their loans, you may lose your home.

From a seller’s perspective, you don’t get the total cost of your house paid for at once. You have to wait for the total duration of the contract to get paid for your home. Furthermore, you have to deal with the risk of your buyer defaulting on their payments.

When all is considered, a contract for deed may be an available way to buy or sell property, whether that new place is in an area you’re familiar with, an area that excites you, or one that banks recommend for investment opportunities. But it comes with several disadvantages. Before agreeing to it, consider this financing option’s pros and cons. Learn more at Wesley Mortgage, the official mortgage provider of the Tennessee Titans.

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