Lease Option vs. Land Contract
Wednesday, September 08
How to use a land contract to counter the problems associated with lease options
Often times, lease option sellers fail to see what could be a more beneficial sales technique for their particular deal: a land contract sale. There are times when a land contract is actually a more beneficial sales vehicle than selling using a lease option contract. In certain cases, a land contract can actually be used to speed up the process of cashing a home out.
The reason why some sellers prefer to sell a home using a lease option is because the seller stays in an ownership position until the lessee-buyer pays the seller off (usually with a mortgage). If a lessee-buyer stops paying their monthly obligation for whatever reason, the seller can just evict them because the lessee-buyer is just a tenant. With a land contract, the seller is actually transferring ownership of the home before being paid off in full by the buyer. The sale gets recorded at the registrar of deeds office in the county where the property is located in and the sale becomes public record. In order to protect the seller’s financial interest, a mortgage is drawn up and recorded as a lien (a stake in) against the property, which gets discharged when the mortgage is paid.
So why would a seller want to sell by means of a land contract? Because the face value of the land contract can be discounted by the seller and quickly sold to a note buyer or other mortgage lender who elects to receive payments long term on the note (mortgage). For example, a seller decides to sell his home on land contract, and creates a mortgage with a buyer at 7.5% interest over 30 years for $200,000. The buyer puts $10,000 down and moves in. Shortly after the land contract gets recorded, the seller gets antsy and wants to cash the land contract out to receive a lump sum of cash rather than the monthly payments as stipulated in the mortgage note. The seller discounts the mortgage down to $160,000 (to create attractive terms) and sells it on the open market to a note buyer. In this scenario, the seller was able to access $160,000 by selling his mortgage note. This cannot realistically be done with a lease option deal. The drawback to selling the mortgage note however, is that the seller had to kiss $40,000 in note face value away; not to mention the nearly 30 years of monthly payments which would have netted hundreds of thousands of dollars in interest to the seller of the home.
Land contract sellers should have their buyers sign an addendum to the land contract stating that if they fail to pay the seller-held mortgage, then the seller can take possession of the house back within 90 days. Commonly called a deed in lieu of foreclosure, this addendum keeps sellers from having to foreclose on buyers which can take up to one year in some states and is the major drawback to selling a home on land contract.
Perhaps the best part of a land contract is that the interrelated “seller financing” aspect creates excellent financial options for both buyer and seller. Generally, it is harder for a buyer to obtain purchase financing than it is for an established property owner to perform a rate/term refinance. When a seller acts as a bank, as in the case of a land contract sale, by creating a formal mortgage and then recording it against a property, the buyer (who is now the owner of the subject property) can then go to a bank and apply for a rate/term refinance rather than applying for a purchase loan. This means the buyer does not have to show a down payment; the equity in the property is the down payment! In other words, the equity-bearing land contract deal has a far better chance to close than a similar lease option deal requiring a buyer’s down payment as stipulated by the buyer’s qualifying lender. In order to execute a rate term refinance for the buyer, the seller must do several things:
- Form a limited liability company (LLC) and get a business address such as a suite at UPS or a PO BOX with the US Postal Service. The LLC should have a name that mirrors a bank’s name. For example, Michigan Mutual Funding Corporation or Washington Mortgage Funding (be sure to choose a name that is not already in use within the state you are selling the home in). Selecting a corporate name that sounds like a bank creates the image that the buyer already has a mortgage through a bank. This builds credibility and adds a dimension of professionalism to the transaction. Get an Employer Identification Number (EIN) and corporate bank account in the LLC’s name so that when the refinance takes place, the funds can be wired from the new lender to directly to your account.
- Prequalify the buyer’s loan based on the equity to be gifted and their credit/financial scenario. A mortgage broker should evaluate the buyer’s creditworthiness and proceed to communicate funding options to both parties.
- Assuming the buyer can refinance based on their creditworthiness, the seller should draw and record a real mortgage with the land contract if it has not already been done. Make sure the recorded mortgage is for the amount that the rate/term refinance will cover later or for the amount agreed upon between both parties. Working through an attorney to draw and record this paperwork is advised.
- Use the mortgage coupon template provided and accept monthly payments as any bank or mortgage lender would, based on the information stated on each month’s coupon. Remember to amortize the loan and reduce the loan principal each month based on the amortization.
- The buyer can then refinance when their financial and credit situations allow for it. Rate/term refinances allow for the use of equity as a down payment because the buyer of the home already owns the home. This is far easier for buyers versus having to save or season a borrowed down payment; it also allows sellers to advertise their houses as true zero down houses. This helps attract more buyers which means there is a greater chance of getting a good buyer who pays, then closes.
The main point to remember is that with a land contract, the seller sells the subject house, then turns into a “lender”; collecting payments based on an official mortgage contract. This is a position of power because these contracts, referred to as a note, can be sold. If the seller has enough equity in the house and opts to sell the note at a discount, the home can be cashed out quicker. Good luck trying this with a lease-option contract, where the buyer is nothing more than a tenant.