04/22/2021
REAL ESTATE TIP: BEWARE OF LAND CONTRACTS.
Many times over the years I've heard stories from rental applicants about the house they were "buying on contract". These stories are usually similar and typically end with them losing both the house and their money. Then, they are forced to start over and look for a place to rent. Buying a house on contract can be risky for both buyers AND sellers. Having said that, a land contract (or "contract for deed") can actually be a great tool for both parties IF executed safely and properly. For the seller, land contracts can generate long term income without the hassle of being a landlord. As for the buyer, this purchase method can ultimately give them ownership of a home while eliminating the initial need for a bank loan. Land contracts can be powerful investment tools for real estate investors as well. I have personally bought several properties this way over the years. In this post, my focus will be on land contract risks for buyers. Before we dive in though, I need to prepare you with some tidbits of basic knowledge. Remember, this information is general in nature, should not be considered legal advice, and applies primarily to my home state of Indiana.
Tidbit #1...Recording:
Real estate information is public which means that anyone can look at it. Information is made public through a process called "recording" and is performed by the county government where a property is located. The PURPOSE of recording as it relates to real estate is to tell the world something important about the property or its owner. For example, if I sell you my house a document called a "deed" is sent to the county (for recording) which tells the world that YOU are the new legal owner (generally speaking). You don't have to record the deed but until you do the world still thinks I own it. If you DON'T record the deed and your dog eats it then you're going to have lots of expensive problems to deal with if you ever decide to sell that house. Why? Well, before you sell it you have to prove that it's actually YOURS to sell. Recording helps accomplish that but is an important legal process related to far more than just buying a house. For this post however, you now understand enough to move on to the next tidbit.
Tidbit #2...Liens:
A lien is a type of debt that "attaches" to any real estate you own and must be paid BEFORE you are when that real estate is sold. There are numerous types of liens but one of the most common is a bank loan on your house (mortgage lien). Indiana is a "race-to-recording" state meaning that liens are generally prioritized in the ORDER they were recorded. So, if you take out two loans on your house then whichever one is recorded first is generally considered "the first lien" (think of the pole position in racing). If you don't pay a first lienholder as required, they can take your house from you AND wipe out all the other lien holders behind making them the sole owner. If you pay off the first lienholder then whichever lien was second in line moves to first position and so on, get it? Some types of liens jump straight to the front of the line but we're keeping it simple for this post. So, with that in mind you now know enough to continue.
Tidbit #3...What is a land contract?
A land contract is an agreement in which a property owner agrees to sell their property to you for payments over time. It grants you a stake (or interest) in the property. The seller is also essentially replacing the bank. If you honor the contract terms and pay as agreed then you eventually become the new owner. Until then, the seller REMAINS the owner and appears as such in public records (assuming they recorded their deed). This brings us to land contract pitfall #1.
Pitfall #1...The contract is never recorded:
Most buyers don't know to record their land contract and many sellers simply don't do so for various reasons. Without recording, the world has no way of knowing that YOU have a stake in the property. Other liens can be still be filed and potentially attach to the property ahead of you. You don't want to risk your stake being wiped out by one of them, do you? I didn't think so. The seller could also potentially sell the property fraudently on contract multiple times to different people (and keep their downpayment money). Or, they could get a bank loan on the place AFTER they sign a contract with you. Hmmm...imagine for a moment that you made $25,000 in payments to the seller over 5 years but they stop making their payments to the bank. Oh yeah, and you never made it to the Recorder's office but the bank did. What's the worst that could happen? Ummm...legal stuff? You betcha! So many possible bad scenarios...how can you possibly protect yourself? Hey, I know...RECORD THE CONTRACT!
Pitfall #2: The home has an existing mortgage.
So, the seller already HAS a bank loan but sells to you on contract after that. It's not illegal to do so the last time I checked but remember, that bank has a first position lien ahead of your stake even if you DO record your contract. We just kinda touched on what could happen didn't we? "Hey, what are these official documents in my mailbox that say this house is being foreclosed on? Hey, what are these other documents that say I have to move?" Well, those are your "you just lost all your money and are about to be homeless" papers. But, let's say the seller is an upstanding citizen and is actually paying the mortgage like they're supposed to. Did you know that nearly ALL banks have a clause in their mortgage documents that says if the owner transfers a stake in the property to ANYONE then the bank can call the loan due and payable IN FULL immediately? Oooops. The seller sold you "an interest" in the house and accidentally triggered what's known as a "demand clause" in their loan agreement. What...you don't think the big bank will notice? I bet you they will. How? I'll give you a hint about one method used...your insurance company. "Hey, what are these official documents in my mailbox?" Yep, there's your "get lost" papers again.
Pitfall #3...Not having the home inspected. Many would-be homeowners are so eager to get the keys to a house that they bypass a major step...KNOWING WHAT THEY ARE BUYING". Long term income could be the motivation for the contract seller sure but it could just as easily be due to some powder-post beatles that tore the crawlspace apart (they are less obvious than termites but can be just as destructive). You could give the seller money up front and make an awful lot of payments before you notice those little bugs. If the seller is reluctant to let you closely examine the property there may be a reason. When I was a young and aggressive buyer I skipped this step too because "I just wanted that house". Well, I assure you, I paid the price for that more than once.
Pitfall #4...Skipping Titlework. Please, don't do this. Buying a house is NOT like buying a car. You not only need to know about the property; you also need to know about the OWNER. Titlework is basically the investigation of whether or not the property can be sold free and clear. Part of that investigation includes determining whether or not the person claiming to be the owner CAN sell it. Just because someone has keys and a deed does not mean they didn't lose all or part of their ownership rights in a nasty divorce. There are LOTS of other possible title problems as well so this critical job is best performed by "title companies". They do the research then issue you a report as to their findings. Do yourself a favor, don't make thousands of dollars worth of payments only to find out later that the property wasn't transferable.
Pitfall #5...Not hiring professionals. I know a person that got locked out of his car and didn't want to hire a locksmith so instead he used a pry bar to open the door. The resulting body damage was over $1,000 but hey, at least the pry bar was free. Too many people foolishly lose a dollar trying to save a nickel. I know professionals are expensive but there is a REASON for that. Why go it alone and risk buying a bad home or losing a good home worths tens of thousands of dollars just to save a few hundred? Respectfully, if money is that tight for you then perhaps you aren't yet ready to take on home ownership. If you are ready however, then get professional help. The upfront cost can easily save you long term pain.
Finally, if you think I've discussed all the negative possibilities think again. I've touched on just some that come to mind. Don't get the wrong idea, this post isn't intended to turn you against the idea of land contacts. As I said earlier, they can be great tools. This post is, however, intended to make you more aware of things to consider and questions you should be asking before diving in. There is risk in all things but take your time. Make sure that the deal works for you and not just the seller. If you don't have a reasonable amount of certainty about what you're doing then find someone that does. You don't have to know everything but risk-taking should be calculated, not crazy. Ultimately, if you've done your homework and are still unsure then you might consider a mantra that has served me well many times: "When in doubt, don't".
