What is a land contract, and how does it work?

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Those who want to buy a home but can’t qualify for a mortgage — or perhaps don’t want one — can sometimes find a path to homeownership via a land contract. Land contracts offer a streamlined and often less expensive way to buy or sell a home or land. However, there are enough risks involved that it’s a smart move to explore all of your mortgage options before committing to one.

What is a land contract?

A land contract goes by a variety of names. You may also hear it called a contract for deed, bond for title or installment land contract. In essence, it’s a legal agreement for a seller-financed purchase that doesn’t involve a bank or other mortgage lender. Instead, the buyer makes monthly or periodic payments directly to the property owner until the sale price is paid in full.

Those whose credit has been damaged by a short sale or foreclosure may be able to use a land contract to buy another home. It might also be an option for buyers who don’t have enough money saved for a down payment and closing costs, or for forward-thinking sellers seeking to spread out the gains from the sale for tax purposes.

Generally, the use of land contracts tends to increase when credit is tight. They are more common in low-income neighborhoods, where public agencies and nonprofit housing groups use them to help families attain homeownership and to stabilize communities. If the seller is a nonprofit or public agency, there might be some protections for buyers who miss a payment, but that’s not always the case.

“Credit has been tightening as interest rates and economic uncertainty have both increased, so qualifying for a loan is a shifting landscape,” says Greg McBride, CFA, Bankrate chief financial analyst. “Borrowers with weak credit histories or that lack a sufficient credit history are the most directly affected, though small business owners and borrowers lacking income documentation have been caught up as well.”

How do land contracts work?

Because there is no traditional lender and no loan-related fees or closing costs, a land contract is a faster, cheaper process than getting a traditional purchase mortgage.

Instead of the buyer borrowing money from a lender, the seller finances the purchase of the house. The buyer and seller negotiate a contract that includes details such as the sale price of the house, interest rate, loan term, down payment and amount/cadence of the monthly or periodic payments.

After a few years of installment payments, the buyer often has to make a balloon payment, or a large lump sum payment. In addition, the buyer is usually responsible for paying for the home’s maintenance, insurance and property taxes.

Traditional land contract vs. wraparound land contract

In a traditional land contract, the seller retains legal ownership of the property until the buyer completes payment. In a wraparound land contract, however, the buyer immediately gains ownership through a warranty deed. In this case, the seller continues to pay their existing mortgage and keeps the difference between their mortgage payment and what they receive from the buyer each month. Such agreements must be approved by the seller’s mortgage lender.

Land contract vs. mortgage

A land contract is a financing agreement with terms that have been negotiated between a buyer and seller. As such, the provisions of a land contract can vary widely based on the situation, and aren’t subject to any conforming requirements or other criteria, like mortgages.

In contrast, mortgages are structured in standard ways (for example, a hybrid adjustable-rate mortgage or a 30-year term). They also come with a relatively predictable interest rate based on the market. With a land contract, the seller can set the rate at their discretion.

In addition, with a traditional land contract, the seller retains legal title to the property until the final payment is made and all conditions of the contract have been met. (This is not the case with a wraparound.) At that time, the buyer is usually responsible for filing the property deed with the new owner’s name with the appropriate government office. Prior to the final payment and title transfer, however, buyers can protect themselves by filing a “lis pendens,” or notice, with their local office. This serves as evidence of the land contract in the event a seller attempts to enter into contracts with more than one buyer.

Can a land contract be converted into a traditional mortgage?

It’s possible to convert a land contract into a conventional mortgage if the buyer meets qualifying criteria to get a loan from a traditional lender and seeks refinancing. Converting a land contract to a traditional mortgage could result in better loan conditions and can potentially eliminate the balloon payment commonly associated with a land contract. Refinancing requires getting a new mortgage and using the funds to repay the balance of the land contract.

What should a land contract contain?

The laws governing land contracts vary from state to state, and because buyers and sellers negotiate their own terms, each contract can be a little different. However, any land contract should lay out all the terms and responsibilities of both parties, including the following:

• Sale price of the property
• Interest rate the buyer will pay
• Down payment amount
• Monthly (or periodic) payment amount
• Amount and due date of balloon payment at the end of the contract, if applicable
• Loan term, or how long the buyer has to pay off the purchase price
• “Equitable title” for the buyer, which prevents the seller from reselling to a third party or taking out liens on the property (the seller retains “legal title” until the buyer takes ownership)
• Who’s responsible for paying property taxes, insurance and upkeep (the buyer usually pays these costs, since they live at the property)
• Assurance that there are no taxes owed or liens/encumbrances on the property
• Default clause in case the buyer stops making the payments
• Requirements to record the land contract with the appropriate government entity

The National Consumer Law Center also recommends that a land contract contain requirements for an independent inspection of the property, including an estimated cost of repairs, and a third-party appraisal to verify the fair market value. This is mostly for the buyer’s protection. As the buyer, you should also enlist a title company to perform a title search, and obtain title insurance.

What are the risks involved in a land contract?

A land contract is not without risk, especially for the buyer, and laws governing their use vary by state. With this arrangement, it’s smart for the buyer and seller to each consult a real estate attorney to protect their interests.

One of the main risks of land contracts is the possibility of contract cancellation if a buyer fails to meet their obligations, such as making timely payments. This is in stark contrast to a more traditional mortgage, in which the loan is entered in the county public records and the borrower has a long time to pay down the principal balance. Land contracts often require a balloon payment to be made at the end of the contract, which can be a challenge for a buyer who doesn’t have the financial means to pay it.

The same contract cancellation risk applies to the seller, too, should the buyer default.

Unlike other contracts, with a traditional land contract the buyer does not automatically receive the title to the property. Instead, the seller holds the title until the buyer pays the entire contract price in full. This means the buyer cannot take out a loan against their equity or sell the property to a third party.

Unfortunately, it’s common for purchasers to forfeit their land contracts, which means they lose everything they’ve put into the home. They may still be responsible for the remaining balance, too, which can damage their credit.

What protections can a buyer seek when negotiating a land contract?

• Consult a real estate attorney to ensure the terms are negotiated properly and legally binding, so that you fully understand what you’re getting into and you’re protected if anything happens.
• In your offer, specify the desired closing costs as a specific dollar amount or a percentage of the purchase price.
• Request a title search to confirm the seller’s ownership rights and determine if there are any liens on the property.
• Make sure the contract includes written confirmation that the property’s legal ownership will be transferred to the buyer upon full payment of the principal amount.

Do land contracts impact the buyer’s credit?

Land contracts can provide an opportunity for individuals with poor credit or no credit history to purchase a house. However, they involve the seller, rather than a bank or lender, assessing the buyer’s creditworthiness. That means payments made on land contracts are typically not reported to credit agencies, so they do not help improve the buyer’s credit as on-time mortgage payments would.

Land contract pros and cons

Land contracts have advantages and disadvantages for both the buyer and the seller. Don’t sign one until you are fully aware of all the risks and have consulted a real estate attorney.

For buyers

Pros

• Buyers with poor credit or no credit history have an opportunity to buy a home because the seller, not a bank or lender, decides who’s creditworthy.
• The down payment and closing costs, if there are any, are much lower compared to a mortgage.
• Like buyers with a mortgage, a buyer with a land contract gets to enjoy the use of the property while making payments to the seller.

Cons

• Buyers don’t build up equity with their payments.
• They might not improve their credit with their payments either, because sellers typically don’t report the payments to credit agencies.
• A buyer who can’t make the balloon payment risks losing the property, and all the monthly installments paid to date.
• Buyers who can’t qualify for a mortgage are unlikely to qualify for a loan to pay for property repairs, if needed. Defects could increase the chances of the buyer defaulting and losing the home.
• A buyer faces risk if the seller defaults on their mortgage or encumbers the property with mortgages and liens.
• A land contract buyer who defaults may have little time to remedy the default and reinstate the contract, so they could potentially be kicked out of the property abruptly, whereas a mortgage foreclosure process can take months.

For sellers

Pros

• The seller can charge more than a bank or lender would, thereby pulling in extra income.
• If the buyer defaults on payments, the seller can keep the property and all the payments made up to that point.
• It takes much less time to finalize a land contract than it does to close a mortgage.
• Sellers usually don’t need to pay off any underlying mortgage on the property. Instead, they can make mortgage payments with the buyer’s installments and pocket any profit.

Cons

• Sellers have the risk of the buyer defaulting or not paying property taxes. The seller, as legal titleholder, is ultimately responsible for the property taxes until full ownership is transferred to the buyer.
• If the seller has a mortgage on the property, their lender could conceivably “call in” the loan and demand full payment. (It’s written into so-called mortgage “acceleration clauses,” but in reality, it’s rare for a lender to call in a loan.)
• The seller doesn’t receive the full purchase price of the property upfront like they would with a buyer who takes out a mortgage.
• The seller could end up with a buyer who can’t or won’t make payments or who damages the property, and have a hard time evicting the buyer if it comes to it.

Land contract tips

• Land contracts are legitimate alternatives to mortgages, but fraudsters have been known to prey on buyers who aren’t financially savvy, so exercise extreme caution.
• A real estate agent can help you find sellers who are willing to finance, or you can check for local for-sale-by-owner listings online.
• Both sides must retain a real estate lawyer to oversee the details. You’ll need a purchase agreement and a contract containing the legal description of the property, the payment schedule and payment dates.
• If the contract calls for a balloon payment, a buyer typically will need to take out a mortgage to cover it. This is something a buyer should consider, because if the lump sum can’t be paid, the buyer can lose everything they’ve put into the home.
• The balloon payment is also important for the seller to consider, because if the buyer’s credit isn’t in good enough shape to get a mortgage now, that might not change when it comes time to get a loan later.
• Ideally, the contract should include a “right to cure” protection. In the event of default, this allows the borrower the opportunity to remedy the problem by catching up on payments within a certain time frame. Laws vary by state, so be sure to have a local lawyer look this over.
• The deed should be signed by the seller at closing and held in escrow by a lawyer or title company until the last payment is made, at which point ownership is transferred to the buyer.

Bottom line

Land contracts offer an alternative to conventional mortgages, but they are risky, and there are other ways for those who can’t qualify for a mortgage to become homeowners. If you’re a first-time buyer, you might be eligible for a low- or no-down payment loan or other first-time buyer program instead, which offer assistance and grants to help cover some of the upfront costs of homeownership.

You might also decide to hold off on buying a home in order to work on your credit and save for the right moment. Check out Bankrate’s guides to improving your credit score and saving for a down payment to prepare for homeownership.