Overview: Real Estate Contract / Deed for Land / Contract for Deed
A Real Estate Contract, also called a Deed for Land or a Contract for Deed, is an agreement between the seller (Vendor) and the buyer (Vendee) for the purchase of real property in which the payment of or a portion of the selling price is deferred. The purchase price may be paid in installments (of either principal and interest or interest only) over the period of the contract, with the balance due at maturity. When the Buyer meets the required payments, the Seller must deliver good legal title to the buyer by way of a deed or assignment of lease (if the property is a leasehold property). Under the terms of the contract for deed, the buyer is given possession of the property and equitable title to the property, while the seller holds legal title and continues to be primarily liable for payment of any underlying mortgage. The features of the buyer’s equitable title and obligation to purchase distinguish a contract for deed from a lease-option.
The contract for deed document must meet the requirements for any contract and will also contain a lengthy statement of the rights and obligations of the parties, similar to those under a mortgage, including use of premises, risk of loss, maintenance of the premises, payment of taxes and insurance, and remedies in case of default. Specific rights, such as acceleration of the right to prepay without penalty must be expressly written in to the agreement. The contract is usually signed by both parties, acknowledged, and recorded.
The contract for deed is used extensively in many areas, where it may be called a land contract, agreement of sale, installment contract, articles of agreement, conditional sale contract, bond for deed, selling under contract, or real estate contract. They are useful in tight money markets (such as the one we are in right now) where it is difficult to qualify prospective buyers for conventional or FHA financing, the contract for deed is frequently the best method to sell or purchase a property. Others who benefit are first- time home buyers or immigrants, who might have difficulty qualifying for a bank loan at the time of entering into the contract for deed, but who’s income will increase before maturity of the agreement, enabling them to refinance and pay off the contract for deed.
Sellers may prefer to sell on a contract for deed because it can create an installment sale, which enables them to defer payment of a portion of tax. In addition, if the buyer defaults, the seller can sue for strict foreclosure, something he or she cannot due with a mortgage. However, a seller who chooses this remedy is rescinding on the contract and cannot seek a deficiency judgment for the unpaid balance.
Essentially, when a buyer purchases a property on a contact for deed or Real Estate Contract, they are putting down a sum of money (the down payment) that will be reduced from the purchase price to give a dollar amount that is to be financed at a certain interest rate for a specific period of time. Example, $100,000.00 purchase price with $20,000.00 down payment will leave the amount financed to be $80,000.00. The buyers payments will be based on the $80,000.00 outstanding balance. The seller will receive $20,000.00 at the closing of the Real Estate Contact, and will deduct any fees associated with the transaction (Realtor commission, title fees, recording fees, and escrow set-up fees) from that $20,000.00. This is VERY IMPORTANT to understand because the down payment that you are offering the seller must cover these fees in order for the seller to not have to come “out of pocket” at the closing. “Out of pocket” is a term used by Real Estate Professionals for “bringing money to the closing, rather than receiving money at the closing.” Lets look a the last example but with a $5,000.00 down payment. If the buyer brings the seller $5,000.00 at the closing, but the expenses to sell the house are $10,0000.00, the seller must come “out of pocket” $5,000.00 to settle the transaction. The buyer would then have an outstanding balance of $95,000.00 that would need to be financed, and the seller would walk away -$5,000.00.
When making an offer to a seller using a Real Estate Contract, it is important to understand the costs associated with selling a home. Typical costs that a seller will pay when selling on a Real Estate Contract are:
- Both Buyer Agent and Listing Agent commissions. Typically 6% of the negotiated purchase price of the home unless other arrangements have been made when the home was first listed. For example, a $100,000.00 purchase price will yield $6,000.00 in commissions to be paid.
- Recording Fees – fees that are collected to record the contract and make it official. Varies from state to state.
- Title Search – provides assurance to the buyer that the seller is going to convey a clean title at the time the contract comes to terms. This also gives the buyer a detailed list of the encumbrances or liens on the property. Varies from state to state.
- Escrow Set-up Fee: This is a fee that the title co., or escrow co., collects up front in order to close the transaction and place the deed in escrow. This will varies from state to state, as well as from title co. to escrow co.
If you are unsure of the amount that your specific state charges for some of the above fees, you can safely assume that a down payment of between 7% and 8% of the purchase price will cover the costs associated with closing. There are ways to manipulate this amount and we will be discussing this in a different section.
Escrow and the role they play in Real Estate Contracts
What is escrow? Defined simply, an escrow is a deposit of funds, deeds, or other instrument(s) by one party for the delivery to another party upon completion of a particular condition or event. In some cases, escrow is short-term, such as the deposit of earnest money pending the closing of a real estate sale. In other cases, escrow is long-term, where an instrument—such as a deed—is held for an extended period while installment payments are made against the purchase of an asset (this is the case with an REC). The escrow is not closed and documents released until all conditions of the escrow agreement are met.
When a REC is used, transfer of legal title is delayed until all of the payments have been made. When the Purchaser fulfills his/her obligations under the agreement, the proper deed is released by the Escrow Agent and can be recorded, giving the Purchaser legal title to the property. If the Purchaser fails to meet the obligation as outlined in the Real Estate Contract, then the Seller may, at his/her option, forfeit the Purchaser’s interest in the property without court action, or declare the entire unpaid balance due and payable and file suit to collect.
With Real Estate Contracts, the Purchaser does not have legal title to the subject property until the deed held in escrow is released. Instead the Purchaser has what is called “equitable title.” Equitable title is the interest held by the buyer/purchaser in a contract for deed or real estate contract; the equitable right to obtain absolute ownership to property when legal title is held in another’s name. This interest is transferable by deed, assignment, subcontract, or mortgage and passes to the buyers heirs and devisees upon death. Though the seller retains the bare legal title, the buyer has the right to demand that legal title be transferred upon payment of the full purchase price. In other words, the buyer can sue for specific performance if the seller refuses to sell once a contract of sale is signed and the buyer tenders performance. In such cases, the courts say that the buyer becomes “the owner of the land in equity”. The buyer benefits from any increase in value between the date of the purchase agreement and delivery of the deed.
Payments on Real Estate Contracts are made to the Escrow co that was selected when the purchase agreement was accepted. If the property is purchased subject to an underlying mortgage, the real estate contract usually calls for the escrow agent to make disbursements to the mortgage company from the buyers total payment. While the mortgage company will continue to send payment coupons to their obligor of record, the purchaser must use the escrow company coupons because the mortgage is usually just part of the total obligation on the real estate contract. Payments made to Escrow are applied to Principal, Interest, Taxes, Insurance, Escrow Fees, and any remaining monies are distributed based on the original purchase agreement. This insures the seller is making timely payments on the debts owed on the property.
Parties involved in a Real Estate Contract
It is important to know the parties that are involved in a Real Estate Contract and in Real Estate in general. By knowing who plays what role in the transaction, you can more effectively negotiate and solidify a transaction. Here are several key players in Real Estate:
- Buyer: Individual or individuals, groups, corporations, or non-profits that seek to purchase property
- Seller: Individual or individuals, groups, corporations, or non-profits that seek to sell their rights in real property
- Buyers Broker: A broker who represents the buyer in a fiduciary capacity. Some buyers brokers practice single agency, in which they represent either buyers or sellers, but NEVER both in the same transaction. Some buyers brokers represent only buyers and refer prospective sellers to other brokers – these brokers are referred to as exclusive buyer brokers.
- Listing Agent: Real Estate broker or salesperson who obtains the listing on a particular property.
- Escrow Agent: Neutral third-party that ensures accuracy, reliability, and proper contract administration.
- Real Estate Attorney: Specialized Attorney that advises clients in matters of Real Estate.
There are several other players in Real Estate that are not essential for the execution of a Real Estate Contract such as appraisers, mortgage bankers, mortgage brokers, termite inspectors, GB98, and warranty providers. The reason these individuals are not essential to a Real Estate Contract will become evident in the next few sections.
The Real Estate Contract Process
Why Purchase on a REC? Now that we have a basic understanding of what a Real Estate Contract is, we can now begin to understand how and when a Real Estate Contract can be used to take advantage of seller offered financing.
Individuals that are in need of seller financing often times have one of the following situations that hinder them from obtaining financing through conventional means.
- Often a low credit score will not permit the individual to obtain a mortgage loan through Fannie Mae, Freddie Mac, or FHA. Each of which have strict guidelines that an individuals FICO score must meet.
- A High Debt-to-Income (DTI) Ratio, often over 38%, will result in a decline from a Lender due to the fear that the borrower will lack the ability to pay the mortgage if additional debt were to arise. In the past, Lenders would allow for a Stated Income, Stated Asset, or both a Stated Income and Stated Asset loan, which essentially allowed the borrower to place a dollar amount on the application that would lower the DTI to acceptable standards. This is no longer the case, and in the future, the DTI ratio may actually be lowered, hindering more potential buyers.
- Lack of acceptable employment history can also contribute to a decline by a mortgage lender. Lenders want to see stability. Often asking for 2 or more years of continuous employment in the same field of work.
- 1099 or Self Employment is a major contributor to the number of individuals that seek to use Real Estate Contracts to purchase property. Self Employed individuals often have the ability to take advantage of many more tax write offs than the W-2 employee, thus lowering their Adjust Gross Income on their tax returns. A lower Adjusted Gross Income will limit the dollar amount that a borrower can qualify for when applying for a mortgage. So, the bank may only allow for the purchase of a $150,000.00 home, when the buyer knows they can afford (based on their monthly income and expenses prior to deductions) a $250,000.00 home.
- Not enough credit will also disqualify a person from obtaining a mortgage loan. Lenders would like to see multiple trade lines (each creditor that has issued credit to an individual will report to the credit reporting agencies the timeliness of payments and payment amounts). Most times a minimum of 3 trade lines are required for approval.
- Low Down Payment will make obtaining mortgage financing difficult as well. Although FHA only requires a 3.5% down payment, the borrower must meet additional criteria such as DTI, Employment History, Credit Score requirements. If not all or one are met, the likelihood of denial is high.
With the large number of guidelines that must be met or adhered to, Real Estate Contracts offer an alternative to conventional financing. Here are some of the benefits that Real Estate Contracts have to offer over traditional real estate purchases.
- No Credit Check Necessary
- No Debt to Income Ratio (DTI) Calculation Needed
- No Employment History Required
- Self Employed – OK
- No Credit History Required
- No Appraisal Required
- No Inspections Required
- Can Close in less than 10 Days
- Negotiable Terms
- Negotiable Interest Rate
- Balloon Payments Negotiable
- Ability to purchase more properties than allowed by Underwriting Guidelines without rental history
- Can Purchase Multi Unit / Multiple Properties
The Real Estate Contract can be a powerful tool that allows access to home ownership where at once there was none. Whether you are seeking to purchase a home on an REC for one of the reasons listed above, or for other reasons, you will find that there is a vast array of homes available for you to do so.
How Much Can You Afford?
Although this is pretty basic, I think it is actually one of the most important factors that one needs to consider when writing an offer on a home. Home ownership can cause an abundance of wealth due to rising home prices, but it can also cost some individuals large amounts of money if not taken seriously. Payments that are made on a Real Estate Contract effect not only they person that purchased the home, but also the seller of the home. If the payments are not made on time by the buyer, the seller MUST “come out of pocket” the payment on the mortgage loan in order to stay current. So, there are two parties involved in this transaction, whereas in a conventional purchase the buyers payments (or lack thereof) only effect the buyer. In short, try not to over extend yourself. If you miss payments and do not rectify the situation based on the terms of the contract or with the seller, you could lose your down payment and any equity you have accumulated.
Simplified Example (Using Net Income not Gross – Very Conservative)
First we need to look at your expenses. What is it that you owe out on a monthly basis? Gas, Food, Electricity, Heat, Car Payment/s, Credit Card Payments, Alimony, Child Support, Social Security, etc….. Jot all of this down on the left side of a sheet of paper.
Now lets look at what income you have coming in. What do you make per month? Do you get Child Support, Alimony, Pension, Benefits, etc..? Jot all of your income down on the right hand side of the same sheet as above.
Add everything up and place the totals under the corresponding columns. Here is an example of what your sheet should look like.
Car Payment $300.00 Monthly Paycheck $3200.00
Gas and Food $250.00 Alimony $500.00
Credit Cards $200.00
Car Ins. $100.00
Total $850.00 Total $3700.00
Now figure out what 50% of your Total Income per Month is. In this case it is $1850.00 (or 3700 divided by 2). Now, subtract your Total Monthly Expenses from the figure you got above. In this example it would be:
$1850.00 – $850.00 = $1000.00
Out of the $1000.00 that you have available to you for a new housing payment, you need to factor in the taxes on the new home and the cost of homeowners insurance. This portion will vary from house to house, so you will need to run this portion of the calculation for each home you select. I will use $100.00 ($1200.00 per year / 12 months) for Taxes and $50.00 ($600.00 per year / 12 months) for insurance. Subtract the tax amount and the insurance amount from the $1000.00.
$1000.00 – $100.00 – $50.00 = $850.00
This is the amount of the principal and interest payment you can safely afford on a monthly basis. With taxes and insurance the amount is the $1000.00 per month.
To figure out how much the purchase price of the home should be, you need to look at the interest rate and the term of the loan. This chart should help you out.
Based on 7% Interest and a 30 Year Mortgage (http://www.bankrate.com/calculators)
Purchase Price Principal and Interest Payment
Based on this chart, and the principal and interest payment calculation of $850.00, this buyer should look at homes in the $125,000.00 range.
Here are some alternative financing solutions that you may want to consider when purchasing:
- Interest Only Payment Options
These payments are not based on a typical amortization schedule where a portion of the payment is allocated to principal and interest. They are simply based on interest on the outstanding balance owed to the seller. For example: $100,000.00 owed to the seller at 7% interest. Payment would be calculated as follows:
$100,000.00 x .07 = $7,000.00
$7,000.00 / 12 months = $583.33 Interest Only
This payment method will allow the buyer to purchase a larger home than he/she could based on a 30 year amortization. Remember, we said that our payment couldn’t exceed $850.00 with out taxes and insurance? Well, lets see what he/she can afford with an interest only payment. Assuming a 7% Interest Rate:
$145,000.00 x .07 = $10,150.00
$10,150.00 / 12 months = $845.83 Interest Only
So, by utilizing the Interest only payment method the buyer can afford a home that is $20,000.00 more expensive than previously.
KEY POINT: Interest Only means exactly that, INTEREST ONLY. You will not reduce your outstanding principal balance owed to the seller if you opt to only make the Interest Only Payment. In other words, you will owe out the same amount that you started with when the contract comes to terms.
- Balloon Payments
Balloon payments can make up the difference for a lack of sizable down payment. A balloon payment is a payment at a certain point in time that is applied to the outstanding principal. For example, the seller may want $60,000.00 as a down payment on a piece of property. The buyer could offer terms such that at the closing they will provide the seller with $10,000.00 and after 180 days an additional $20,0000.00 then at day 360 the remaining $30,000.00. After the $30,000.00 payment to the seller, the buyers will have fulfilled the down payment requirement that the seller requested.
As you can see, by being creative with your financing terms, you can easily increase the amount of you can afford on a monthly basis. People selling homes on Real Estate Contracts are very open to unconventional types of financing. The best way to see if the seller of the home you have selected has an open mind, is to open the doors for negotiation by putting something on paper (Letter of Intent).