Land-contract deals: Shaky ground or solid as a rock?

This week’s column is the first in a series written by Andrea S. Alford, deputy executive director for the Arkansas Real Estate Commission.

Despite the variety of lending products available in the real estate industry today, some buyers may still find themselves unable to qualify for a mortgage as a result of poor or insufficient credit, a high debt-to-income ratio or the inability to secure a down payment. In many cases, these would-be buyers remain renters and wait for more favorable conditions — both in their own financial situations and in lending requirements.

In other cases, however, buyers may seek to purchase a home through something called a land contract. A land contract may also be known as a contract for deed, an installment land sales contract or a privately held mortgage, among other things. Many consumers will also recognize the terms “owner financing” or “seller financing,” which are frequently used in connection with land contracts.

In a land contract, a seller agrees to “finance” the purchase of the property for the buyer by entering into a financing agreement with the buyer.

The financing terms of a land contract are often very similar to those of traditional financing — the seller can require a down payment, charge interest and collect monthly payments. However, a land contract differs from traditional financing in that the fee simple title to the property in a land contract remains with the seller until the buyer has satisfied the seller’s financing terms, and the buyer’s debt is paid in full. In the more typical real estate contract, the fee simple title passes immediately at closing.

The Arkansas Real Estate Commission has seen its fair share of cautionary tales involving land contracts. While these contracts can certainly be used legitimately and legally, it has been our experience that land contracts can also lead to misfortune for those involved.

In this week’s column, we will consider the implications of land contracts for buyers, and we will take a look at potential pitfalls for sellers in the coming weeks.

The first step buyers can take to protect their interests when considering a land contract is the same advice we will give sellers: Engage the services of an Arkansas attorney.

Land contracts are very complex instruments and are often fraught with peril. A qualified Arkansas real estate attorney will have the expertise and resources to guide buyers and sellers in navigating these transactions.

The next step buyers can take is preventative. Before entering into a land contract, a buyer should obtain a title search on the property to discover any encumbrances that may be present, including existing financing or any outstanding liens. A title search will also confirm that the seller is the owner, and whether the seller holds clear title to the property.

When purchasing property on which the seller has existing financing, the buyer may wish to request an “estoppel” from the seller’s lender. An estoppel will confirm the seller’s monthly payment amount, the remaining balance of the loan and any taxes or insurance currently held in escrow. To that end, if the seller’s monthly payment amount is $800 per month, the monthly payments proposed in the land contract should be sufficient to cover that amount. Similarly, the total purchase price of the land contract should be equal to or greater than the seller’s remaining balance on the loan.

An estoppel should also affirm that the lender will not make any future advances (such as a home-equity loan) to the seller under the existing loan. Such an advance could increase the amount owed by the seller, and potentially prevent the buyer from claiming free and clear title once the buyer has fulfilled his obligations to the seller. The buyers should also know what relationship they will need to have with the seller’s lender, including a possible right to protect their interest should the seller default on the existing loan.

As an added layer of protection, a buyer may consider having monthly payments (or the portion that will cover the seller’s existing mortgage payments) paid directly to the existing lender. The same care should be taken with regard to real estate and special-assessment taxes to ensure that these are paid on time.

For these reasons, many buyers choose to make all payments through a reputable escrow agent, attorney or real estate broker with express instructions to pay monthly payments on the underlying loan, taxes, assessments and other charges before paying any excess to the seller. Such an arrangement, also known as an escrow agreement, often includes a deed from the seller so that when the buyer has made all required payments, the deed is recorded, and a title policy is issued.

Regarding the property itself, buyers should exercise diligence in ascertaining the property’s boundaries, condition and value, just as they would if they were paying cash or obtaining traditional financing. Surveys, inspections and appraisals should not be viewed as “extras” in land contracts; rather, they should be considered essential to properly evaluating the terms of the land contract and protecting the buyer’s interest in the transaction.

Once a land contract is entered into, the buyer should record the land contract or a “memorandum” thereof to put the world on notice of the buyer’s interest in the property. Recording a memorandum of the land contract prevents any future mortgages the seller may take out on the property from having priority over the buyer’s interest and helps to ensure that the buyer will receive free and clear title to the property upon fulfillment of the financing terms.

As mentioned at the beginning of this column, land contracts can be viable avenues to homeownership. What’s more, sometimes a land contract is a buyer’s only viable avenue to homeownership. Nevertheless, the AREC strongly encourages buyers, sellers and real estate licensees to involve a qualified real estate attorney to assist in these matters.

Stay tuned for the AREC’s next installment in this series, when we will examine land contracts from a seller’s viewpoint.