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For many homebuyers, the most cumbersome part of the process of buying a home is getting a mortgage. While a small percentage of buyers are able to afford the purchase in cash, without needing financing, others choose an alternative known as land contract. That is in essence an agreement between the seller and the buyer, in which the buyer makes periodic payments until a certain set price is met.
Besides avoiding the involvement of a lender, a land contract means skipping all the other parts of getting a mortgage such as credit checks, getting the home appraised, and paying closing costs and taxes.
Buyers can enter into land contracts when they don’t qualify for a traditional mortgage. For people who would have a hard time getting a loan, because of bad credit or low income, land contracts offer a path toward homeownership.
But land contracts are rife with potential pitfalls.
Because they can exist in a legal gray area, land contracts do not give a buyer the same clear terms and rights, as well as obligations, as a traditional mortgage. And in some parts of the United States, they have often been used to take advantage of low-income buyers, who end up getting evicted.
“There are more cons than I can even list” to entering a land contract, says Deb Tomaro, a real estate agent in Bloomington, Indiana.
Here’s why you should avoid that route to homeownership, and focus instead on building your credit and saving for a down payment.
What Is a Land Contract?
A land contract is a written agreement between a homebuyer and the owner selling the property.
“The buyer occupies the property and makes monthly payments to the seller,” says Elizabeth Whitman, an attorney and real estate broker in Potomac, Maryland. “The seller retains the title to the property until all payments are made.”
When you take out a mortgage and close on the transaction, you own the home. With a land contract, you do not — and will not until you’ve met the conditions specified in the contract, which can take many years.
Unlike with a mortgage, a down payment is not needed, and the seller generally does not perform a credit check on the buyer.
How Is a Land Contract Different From a Mortgage?
Unlike a mortgage, a land contract is “a private loan between two parties, not a bank. It’s not regulated by any federal guidelines or laws designed to protect consumers,” Tomaro says.
Because a third-party lender is not involved, it’s just the buyer and seller agreeing to terms and conditions. Because the uncertainty also affects the seller, who has no guarantee the buyer won’t stop making payments and disappear, interest rates on a land contract are normally higher than mortgage rates.
Prices can be higher, too. “The seller can mark the price up. For example, a seller may sale a home worth $80,000 for $100,000” says Dr. John A. Kilpatrick, chairman of Greenfield Advisors, a real estate consultancy in Seattle
A land contract also does not require appraisals, surveys, and title insurance, which a traditional lender would demand. And land-contract properties can have issues that the buyer does not know about.
“A property in poor condition might not qualify for a mortgage loan,” Whitman says. “With a land contract, the buyer accepts the property as it is.”
How Interest Rates Work on a Land Contract
“Usually a land contract resembles a mortgage, with a regular monthly payment and a proviso that the borrower pay the taxes and insurance,” Kilpatrick says.
Like with price, sellers have ample discretion when it comes to interest.
“The property owner sets whatever rate they want,” Tomaro says, “often much higher than what a bank rate would be, because they are taking a chance on a buyer that a bank won’t.”
However, this cannot be higher than the maximum interest rate set by each state, to prevent exploitation of the buyer — so be sure to look up the maximum interest rate in your state before agreeing to a contract.
Beware, though, that land contracts often include a “balloon payment.” That means that after a number of years of regularly paying interest and principal each month — three, five or 10 years in most cases, according to an amortization schedule over 15 or 30 years — the buyer must come up with the remainder of the balance.
The assumption is that the buyer will have had enough time to improve their credit and income by then, and can find a regular loan from a conventional lender to finance the balloon payment, which is also known as buyout amount. But if that is not the case and financing cannot be found, the buyer is out of luck.
“If they can’t make the payment, the house is lost,” Whitman says.
The interest and principal paid on the property will have been lost too, while they could have been salted away over the years to afford a down payment.
What Are the Pros and Cons of a Land Contract?
The only factor in favor of a land contract is that you can step on the path to homeownership with little to no money down, even if your credit is poor.
But the cons are plentiful. “Buyer really beware,” is how Kilpatrick sums them up.
- A higher interest rate, which increases the total amount you’ll spend on the home.
- The buyer in a land contract rarely obtains title insurance, so there is no assurance that the seller actually owns the property. The buyer may make payments for years without actually ending up as the owner.
- The seller may have a mortgage on the property. If they default on their mortgage, their lender can foreclose on the home and may evict the buyer.
- In most states, buyers are less protected from eviction in case of nonpayment. If a borrower with a traditional mortgage faces financial hardship, they can negotiate mortgage forbearance, but buyers under a land contract may not have that option. They can also be evicted for nonpayment more easily than a mortgage company can foreclose on a property.
- If liens are placed on the property, for example because the seller has taxes due, they can “become the buyer’s problem” once the title deed is transferred, Whitman says.
- Because a land-contract property is usually sold as is, a buyer might have to spend money on unforeseen repairs, possibly extensive ones.
Steps to Take if You’re Considering a Land Contract
If you decide to enter into a land contract, make sure you understand what you’re agreeing to.
Based on expert advice, take the following steps to protect yourself:
- Ask a local real estate broker for an opinion on the property’s price.
- Recommend that the agreement be recorded at the local courthouse, since this is not mandatory.
- Make sure you understand who is responsible for paying property taxes — the buyer or the seller.
- Ask for an amortization schedule, detailing how much will be paid in interest and principal.
- Perform a title search to confirm ownership status.
- Get a lawyer, or go to a free local law clinic, to review your contract.
A land contract may seem like a shortcut to homeownership, but the risks associated with it are daunting.
“A buyer is typically better off holding off on buying a home and doing what they need to do to repair their credit,” Tomaro says, “and get a traditional mortgage that affords them more security and protections.”