Risks and Realities of the Contract for Deed

While contracts for deed offer some advantages over a traditional mortgage, such as speed and simplicity, they can offer advantages and disadvantages.  In a contract for deed, the purchase of property is financed by the seller,  rather than a third-party lender such as a commercial bank or credit union. The arrangement can benefit buyers and sellers by extending credit to buyers who would not otherwise qualify for a loan. 

Facts and features

A contract for deed, also known as a land contract or installment contract is a transaction in which the seller provides the financing for the buyer.  In a contract for deed sale, the buyer agrees to pay the purchase price of the property in monthly installments. The buyer immediately takes possession of the property,  while the seller retains the legal title to the property until the contract is fulfilled.

The contract for deed is a much faster and less costly transaction to execute than a traditional, purchase-money mortgage. In a typical contract for deed, there are no origination fees, formal applications, or high closing and settlement costs. Another important feature of a contract for deed is that seizure of the property in the event of a default is generally faster and less expensive than seizure in the case of a traditional mortgage. If the buyer defaults on payments in a typical contract for deed, the seller may cancel the contract, resume possession of the property, and keep previous installments paid by the buyer as liquidated damages. Under these circumstances, the seller can reclaim the property without a foreclosure sale or judicial action. However, laws governing the contract-cancellation process differ from jurisdiction to jurisdiction and the outcome may vary within any one state, depending on the contract terms and the facts of the situation.  The buyer in a contract for deed does not have the same safeguards as those afforded a mortgagor in a purchase-money mortgage. For instance, in the event of default, there is no redemption period.  The buyer is given notice of default and the buyer has 60 days to cure any delinquent amounts owing.  It is commonly known as a 60 day time bomb.  However, in a typical contract for deed, the buyer becomes responsible for the obligations of a mortgagor in possession, such as maintaining the property and paying property taxes and casualty insurance. In addition, unless prohibited by the contract, either party may sell his or her interest in the contract.

Speed, simplicity appeal to buyers

Buyers may be attracted to a contract for deed purchase for several reasons. This method may be especially appealing to buyers who do not qualify for a mortgage, such as people who work cash jobs and are therefore unable to prove their ability to make payments. Since the contract for deed process is significantly shorter than the mortgage-approval process, it may attract buyers who face time constraints or have limited options.

The risks for buyers

Despite favorable changes in the legal enforcement of forfeitures, contracts for deed pose distinct risks for buyers. One major risk stems from the short time period required to cancel the contract in the event of default. For example, in Minnesota, when a buyer falls behind on payments, the seller can file a Notice of Cancellation of Contract for Deed with the county and serve the buyer with the notice. The buyer has only 60 days from the date of the filing to address the items of default and pay the allowable attorney fees to "reinstate" the contract. It is commonly known as a 60 day time bomb. This is a short time span in comparison to the six months or more afforded mortgagors who face foreclosure.

Another major risk for the buyer is the balloon payment. Unlike most traditional mortgages, the majority of contracts for deed are not fully amortized. Instead, the contract is most frequently structured to require monthly payments for a few years, followed by a "balloon payment" that completes payment on the property.  To make this balloon payment, the buyer will almost inevitably need to obtain a traditional mortgage. If a buyer is unable to qualify for a mortgage at the time the balloon payment is due, he or she is likely to face cancellation of the contract.

Another risk for contract for deed buyers stems from the fact that the seller retains the title to the property during the life of the contract. Since the seller retains the title, he or she may continue to encumber the property with mortgages and liens. The seller is only obligated to convey good title when the purchase price is fully paid and it is time to deliver the title. He or she does not need to have good title at the time the contract is executed nor during the life of the contract. Depending on state law and whether the contract is recorded in a timely manner, the buyer's interest may be junior in priority to these pre- and post-contract encumbrances placed on the property by the seller.

Ensuring a positive outcome

It is important to note that despite their risks and sometimes negative consequences, contracts for deed are not intrinsically bad. When used wisely, they can be a good fit for some consumers. They can offer a swift, streamlined option for people who do not qualify for traditional mortgages or would prefer not to deal with mortgage lenders. In many situations, contracts for deed can also be a tool for building credit, .

To protect their interests in contracts for deed, sellers and buyers must do their homework, so to speak, by making sure they learn and understand what specific provisions and risks the contracts entail. Buyers in private contracts for deed should take additional steps. These include assessing the condition of the property, confirming that the seller has clear title, and recording the signed contract at the appropriate government office. By being informed and prepared, the buyer and seller in a contract for deed can help ensure a positive outcome for both parties.