In a contract for deed transaction, the buyer skips the traditional mortgage lender and works out a deal directly with the seller.
I’ve done a contract for deed deal as the seller, and it has worked out well for both the buyer and me so far. They got financing without the credit checks or lender fees while I collect some interest income. But these deals can fall apart in a hurry, even when both parties act in good faith — which they don’t always do.
If cutting out the lender sounds great on paper, these deals come with plenty of pitfalls. Make sure you understand both the risks and benefits before you sign on the dotted line.
What Is a Contract for Deed?
Also known as an installment purchase contract, installment land contract, or bond for deed, a contract for deed involves the seller financing the home. However, unlike traditional owner financing, the seller doesn’t transfer the deed ownership until after the buyer has made their final payment.
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The two parties work out the purchase price, down payment, interest rate or other monthly payment structure, and loan term as part of the contract for deed arrangement. Once agreed, the buyer moves in and starts making payments. When the buyer makes their last payment, the seller records the deed with the local public records office and officially transfers the property to the buyer.
How a Contract for Deed Works
As a real estate investor, I sometimes do installment contracts for raw land parcels. Here’s a quick example of how they work.
I own a piece of undeveloped land, and recently offered it for sale two ways. A buyer could pay me $3,000 for a traditional purchase, or $3,600 in installment payments over the next three years. Someone took me up on the installment contract, and we signed a deal where they agreed to pay me $100 per month for the next three years. In exchange, they’d get immediate access to use the land.
The deed stays in my name for now, and I don’t have to transfer ownership or record a mortgage lien. Instead of a traditional real estate settlement, we just signed and notarized a contract for deed.
If the buyer defaults on payments, I don’t have to go through the long, expensive foreclosure process. I can remove them with the simpler eviction process. That said, residential real property laws differ from raw land, and in some jurisdictions, the seller must foreclose if the installment sale deed agreement is recorded.
When the buyer pays off the property in full, I’ll deed ownership to them, and our transaction will be complete.
As you can imagine, contracts for deed are far more common when selling raw land. They’re relatively rare in the world of residential real estate.
Contract for Deed Pros
Installment purchase contracts have their uses and upsides. They work particularly well for buyers with weak credit, or those looking for lower fees and faster closings.
Here are a few reasons why buyers sometimes opt for them over a traditional closing.
Helps Buyers Who Can’t Qualify for a Traditional Mortgage
Not everyone can qualify for a home loan.
Some would-be buyers have bad credit. Others have little or no credit history at all. Still other homebuyers have trouble documenting their income to qualify for a conventional mortgage, such as small business owners and other self-employed workers.
That said, borrowers with credit scores as low as 500 can qualify for an FHA loan. In most cases, if you can’t qualify for a traditional mortgage, you probably aren’t ready to buy a house.
Lower Fees & Closing Costs
Mortgage lenders are notorious for their fees — thousands and thousands of dollars’ worth of fees. They love to stack up not just discount points, which can be useful for buyers, but also junk fees like “processing fees,” “application fees,” “underwriting fees,” “document preparation fees,” and anything else they can plausibly invent.
I would know. I used to work for a nationwide mortgage lender.
In contrast, it’s tempting to avoid padding corporate profit margins and just work something out directly with the seller. Some sellers don’t charge any fees at all when they work out a contract for deed, just an interest rate that both parties agree is fair.
Traditional mortgage lenders typically take 30 to 60 days to close a loan. The word that comes to mind to describe their sense of urgency is “glacial.”
When you work out an installment contract with the seller, you skip all that. You sign a simple contract rather than a small forest’s worth of paperwork.
Contract for Deed Cons & Risks
In spite of those upsides, installment contracts come with real risks for buyers. They offer few or no protections for buyers, high fraud and scam risk, and higher interest rates. Plus, the buyer takes on responsibilities such as repairs even as the seller retains legal ownership of the property.
Bottom line: Proceed with caution.
Property Often Sold As-Is
Yes, you could hire a home inspector to verify the condition of the property, and demand that the seller make needed repairs or lower the sales price before moving forward.
But most contract for deed buyers don’t do that.
Instead, they typically buy the home as-is, sometimes without fully understanding its condition. That could be a mistake. A home is the most expensive item you’re likely to buy — ever — so it’s well worth paying for a professional home inspection before you commit to buying one.
No Buyer Protections
If the seller fails to honor their agreement to transfer ownership to you at the end of the installment period, the onus falls on you to take them to court over it. That could in turn require hiring an attorney, paying for court fees, and battling the legal landlord of your home.
And the risks compound from there.
What if the seller isn’t the only owner of the property, and didn’t get the other owners’ consent to sell? What if there are liens, encumbrances, or other “clouds on the title”? What if the seller doesn’t own the property at all, and is simply a scam artist?
When you don’t run a full title report, you don’t know. And even if you do run one, the seller could still muck up the title after you move in but before the deed transfers to you.
Seller Retains Title to the Property
How could the seller muck up the title, you ask? They could borrow money against the home or fail to pay their property taxes, for starters. Or they could do something really underhanded, like transfer the title to a relative without your knowledge.
The delay in ownership transfer comes with some other implications as well. If you fail to make payments as promised, the seller could evict you from the property in some states, rather than going through the more time-consuming foreclosure process.
Beyond the faster timeline in booting you from the property, it also means you could lose your down payment and all the other money you’ve paid to the seller to date.
Unfortunately, the onus falls on you to take the seller to court if they don’t honor their side of the contract.
Few sellers would simply refuse to transfer ownership after you made all your payments on time, leaving you with a black-and-white case. However, many cases are less clear-cut.
For example, what if the seller fails to pay property taxes and the property goes into tax foreclosure? If the property has already sold at a tax sale, you’d have to sue the seller to try and recover your money.
Higher Interest Rate
For all their faults, traditional mortgage lenders offer loans at the cheapest rates available on the market.
They do that because the federal government backs the loans, whether directly (as with FHA and VA loans) or indirectly through quasi-government entities Freddie Mac and Fannie Mae. Mortgage lenders also get protection by forcing you to buy private mortgage insurance (PMI) if you borrow more than 80% of the home’s value.
Your average home seller isn’t in the business of lending money, and doesn’t want to lend you money at 3% interest. They’d just as soon invest in the stock market and earn an average historical return of around 10%.
In most cases, sellers only consider a contract for deed if they can earn a pretty penny on interest. At your expense.
Some installment contracts come with a balloon payment. If you didn’t graduate from mortgage finance school, that means that even if the monthly loan payment is calculated as if it’s a 30-year loan, it comes with a full payoff deadline within the next few years. In most cases, that balloon deadline falls within three to seven years.
For example, say you buy a home for $220,000, put down $20,000, and agree to pay the seller 8% interest on a loan amortized over the next 30 years. But it comes with a five year balloon payment: even though your monthly payment is $1,467.53, just like a 30-year fixed mortgage would be, you have to pay off the remaining balance as a lump sum at some point within the next five years.
Unless you win the lottery or inherit a boatload of money over the next five years, that usually means you have to take out a conventional mortgage loan at some point in the next five years to pay off your remaining balance with the seller. Failure to do so means defaulting on the terms of your installment contract. If this happens, you could potentially lose the property and everything you’ve paid to the seller.
Predatory Behavior & Scams
The real estate industry is rife with scams and predators. There’s just too much money to be made when you’re working with assets worth hundreds of thousands of dollars.
And scammers love to target the most vulnerable, because they make for easier prey. In this context, that includes first-time home buyers who can’t qualify for a conventional loan. People who also may not have the money or savviness to buy home inspections and title reports.
That leaves them open to outright scams, such as entering contracts to buy a property that the seller doesn’t actually own. By the time the buyer realizes they’ve been had, they’ve already forked over five digits.
Must Remember to File the Contract for Deed
You can file contracts for deed with your local county recorder, which makes them easier to enforce if one party breaches the terms later.
Eventually, when you take legal ownership of the property, you’ll need to make sure the seller records the new deed titling the property in your name. If that doesn’t happen, you don’t legally own the property, and you’ll need to take the seller to court to force the issue.
Doesn’t Help Your Credit Score
Unlike banks, Harriett Homeseller doesn’t report monthly payments to the credit bureaus. That means your on-time payments don’t help boost your credit score.
If you don’t regularly use credit cards or other credit products, that could make it more difficult for you to qualify for a conventional mortgage loan in the future. It’s a particular risk for if you have a balloon payment due in the future, who will likely need a traditional mortgage to pay off their remaining loan balance when it comes due.
Contract for Deed vs. Rent-to-Own
A contract for did is similar to a lease-to-own arrangement, but not identical. Both contracts involve a potential buyer taking possession of the property and making payments to the seller that go toward their purchase of it. But the real estate transaction happens differently for the two types of contract.
To begin with, a rent-to-own agreement gives the tenant the opportunity to buy at a certain price within a certain time frame. Installment contracts obligate both parties to the change in ownership.
In most lease-to-own contracts, the landlord remains liable for maintenance and repairs. In most installment contracts, the buyer takes on those responsibilities.
The flipside is that buyers in a contract for deed typically get more freedom to modify the property as they see fit, whereas renters in a lease-to-own remain tenants and must get written permission from the landlord before making any alterations.
Should You Enter Into a Contract for Deed?
For the average homebuyer, contracts for deed come with more risks than rewards. The risk of scams is high, and even when the seller has honest intentions, there are just too many ways the deal can go wrong.
No one likes to hear it, but tenants with bad credit are typically better off continuing to rent while they shore up their credit and finances. Just because you could finagle a way to buy a home doesn’t mean you should.
Going through the traditional mortgage settlement process, onerous as it is, comes with some protections for buyers. From home inspections to title reports, and even bank appraisals and underwriting, you can close on the house knowing that you have clean title on a property with a known condition and value.
Shortcut that process at your own peril.
If you don’t currently qualify for a mortgage, but you’re interested in buying a home, consider two alternatives to installment contracts.
First, consider a rent-to-own agreement. It doesn’t leave you on the hook for repairs or maintenance, and it typically leaves you with less money invested in the property if you choose to pull out of the deal.
Alternatively, talk to sellers about owner financing. In that case, legal title transfers to you immediately, and the seller holds a promissory note and lien against the property. You own it, and can do whatever you want with it. The seller simply becomes your lender, and if you default, they have to foreclose rather than simply evicting you.