Not every real estate contract involves a seller, a buyer, and a lender.
Sometimes, a buyer and a seller may come to their own agreement without any input from a mortgage broker.
This kind of contract is called a contract for deed. They can have advantages but there are downsides too.
Here, we’ll take you through:
- What a contract for deed is (and the advantages to one).
- The contract for deed drawbacks for buyers.
- The disadvantages of a contract for deed for sellers.
What is a contract for deed?
A contract for deed is a type of real estate purchase agreement where, rather than a mortgage broker or other lender, the seller effectively finances the purchase.
The seller agrees to a down payment and a plan of payment installments which will contribute toward the buyer’s eventual ownership of the property.
If there’s land alongside the property, they may have a separate land contract or treat it all as one purchase.
In a mortgaged property, a lender effectively “buys” the property for the buyer, and the buyer pays them back via mortgage payments.
In a contract for deed, there’s no mortgage, and the seller retains ownership of the property until the buyer completes their course of payments.
There are advantages to a contract for deed. Between friends or family, a contract for a deed can be a friendlier, more informal way of managing a property transaction.
Contracts for deeds may also suit people with a low credit score or who would otherwise struggle to get a mortgage through traditional financing.
However, contracts for deed can also have serious drawbacks.
What are the contract for deed disadvantages for buyers?
If you’re the buyer in a contract for deed arrangement, you need to be aware of the following risks.
1. Property maintenance
One contract for deed drawback is the uncertainty over who’s responsible for what.
Contracts for deed are similar to rent-to-own schemes. And, in some cases, the terms of the contract may state that the seller retains some responsibility for property maintenance.
However, in most cases, the buyer is left in a kind of limbo between homeownership and tenancy.
They’ll be responsible for property upkeep without the security of holding the deeds to the property.
2. No foreclosure protection
Another disadvantage of contracts for deeds is the lack of due process.
Seller financing is not subject to the strict regulations that control mortgage financing.
So, if the buyer defaults on their monthly payments (or breaks the terms of the contract), the seller can take the property back without any judicial foreclosure process.
3. Balloon payment
Balloon payments are inflated payments scheduled at specified points in the payment plan. These can be hard to pay.
If a buyer cannot fulfill a balloon payment, the homeowner has the right to reclaim the property without having to pay back any of the previous payments.
4. Seller retains title
A major drawback of a contract for deed for buyers is that the seller retains the legal title to the property until the payment plan is completed.
On one hand, this means that they’re responsible for things like property taxes. On the other hand, the buyer lacks security and rights to their home.
The seller can also do things like adding mortgages and liens to the property, which can be a serious problem for the buyer.
And, if the seller defaults on anything that their property is collateral for, it may still be at risk.
5. Less consumer protection
Conventional loans for real estate are scrupulously regulated.
This is not the case with a contract for deed arrangement.
A buyer could find themselves in a very difficult position thanks to unfavorable contracts, and with little legal recourse.
What are the contract for deed disadvantages for sellers?
Of course, it’s not just the buyers who can face problems. There are disadvantages to sellers as well.
Property management
The seller may still have to manage a property sold by contract for deed, without having as many rights as they would as a landlord.
For example, they may be responsible for fixing broken wiring but must do so at the buyer’s discretion.
Payment default
With a conventional mortgage, defaults are dealt with by large lenders, which have the resources and regulatory frameworks in place to deal with them.
That’s not the case with a contract by deed.
If a buyer defaults on their payments, the seller has to manage things like foreclosure and evictions themselves.
This can be a painful thing to do, and may well also incur considerable real estate attorney costs depending on state law.
Due-on-sale clause
If selling a property that’s mortgaged, a contract by deed does not always negate the due-on-sale clause.
Conventional loans often word this clause so that the full mortgage balance will become payable as soon as a contract is executed.
If the buyer isn’t paying a hefty lump sum for the down payment, the seller may have to find another financing option to deal with their mortgage.
Balloon payment
If the buyer cannot refinance in time to make their final balloon payment, the seller has a difficult choice to make between extending the contract period and continuing to accept installment payments, or canceling the contract and retaking possession of the property.
Invest in real estate with the right contracts
We could go through the pros and cons of a contract for deed for a long time.
Ultimately, however, it all depends on the specifics of the contract you’re working with.
Whether you’re negotiating a mortgage loan or a contract for deed, PandaDoc can give you the secure, comprehensive contracts you need.
Look through our library of real estate contract templates, and customize them.
Then, when you’re satisfied that this contract works to the best advantage of all parties, sign using our secure, encrypted eSignature technology.
As a seasoned real estate expert with extensive experience in various property transactions, I bring a wealth of knowledge to shed light on the nuanced aspects of real estate contracts, including the often-overlooked but crucial concept of a contract for deed. My expertise stems from years of hands-on involvement in real estate deals, from traditional mortgage-based transactions to alternative financing arrangements.
Now, let's delve into the intricacies of the article:
Contract for Deed Overview: A contract for deed represents a distinctive type of real estate purchase agreement wherein the seller assumes the role of the financier, circumventing the involvement of a mortgage broker or traditional lender. Instead of the buyer securing a mortgage, the seller facilitates the purchase by agreeing to a down payment and a series of payment installments, ultimately leading to the buyer's ownership of the property.
Advantages of Contract for Deed:
- Informality and Flexibility: Particularly suitable for transactions between friends or family, a contract for deed offers a more informal and flexible approach to property transactions.
- Accessible Financing: Ideal for individuals with low credit scores or those facing challenges obtaining a mortgage through conventional financing.
Drawbacks for Buyers:
- Property Maintenance Uncertainty: Buyers may face ambiguity regarding property maintenance responsibilities, resembling a rent-to-own arrangement.
- Lack of Foreclosure Protection: Unlike traditional mortgages, contracts for deeds lack the due process associated with judicial foreclosure, enabling the seller to reclaim the property swiftly in the event of default.
- Balloon Payments: Buyers may encounter difficulty with inflated balloon payments, granting the seller the right to reclaim the property if payments cannot be fulfilled.
- Seller Retains Title: The seller retains legal ownership until the payment plan concludes, leaving the buyer with limited rights and security, as well as potential risks associated with the seller's actions.
- Reduced Consumer Protection: Compared to conventional loans, contracts for deed lack rigorous regulation, potentially exposing buyers to unfavorable terms with limited legal recourse.
Drawbacks for Sellers:
- Property Management: Sellers may still be responsible for property management without the rights typically afforded to landlords.
- Payment Default Handling: Unlike large lenders, sellers must navigate defaults independently, potentially incurring significant real estate attorney costs.
- Due-on-Sale Clause: Contract for deed arrangements may not always negate the due-on-sale clause in mortgaged properties, requiring sellers to find alternative financing options.
- Balloon Payment Dilemma: Sellers face tough decisions if buyers cannot refinance in time for the final balloon payment, choosing between extending the contract or reclaiming the property.
In conclusion, while contract for deed arrangements offer certain advantages, it's crucial for both buyers and sellers to be aware of the potential pitfalls inherent in this alternative financing method. Careful consideration and, when applicable, legal guidance are essential to navigating the complexities of real estate transactions.
