I love owner financing. Heck, my entire company’s investment model is built around it. In my opinion, it is truly a great real estate investment tool that should be used by everyone. I’m not suggesting you need to base your entire model around it like myself; however, having a few owner financed homes in your portfolio isn’t going to hurt anything.
The term “owner financing” is a very broad term. Maybe you’ve heard it used as exactly that, or heard one of the various other terms for it. Here in the great state of Michigan, we call these transactions land contracts. Other terms you may have heard are seller financing or contract for deed. The IRS categorizes these types of transactions as installment sales.
Point being, there are all sorts of terms thrown around for what the IRS classifies as an installment sale. For the sake of this article, I will be using the term land contract instead of installment sale due to the simple reason, that’s the term I use in my day-to-day business. Don’t let it confuse you though, whether you call it a land contract or a contract for deed or owner financing, they are all viewed the same way by the IRS (Form 6252 to be exact).
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What is a Land Contract?
Simply put, a real estate land contract is an alternative way to sell real estate by capturing the demographic of buyers who cannot get traditional loans. They are the people who want to be homeowners, but for whatever the reason, can not walk into a normal bank and qualify for a loan.
Your Position As an Investor in a Land Contract?
The easiest way to look at your position within this type of real estate transaction is instead of “Bank of America”, look at it as Bank of “insert your company name here”, because that is exactly what is going on: You are playing the role of the bank. In my case, I am the Bank of Huber Property Group, LLC.
What do you mean “play the role of the bank”? You get to set the terms. You get to do the screening. You get to say ‘yes’ or ‘no’. Bottom line, you are in total control just like a traditional bank is when you go in to try and get a loan. You can require as much (or little) information from the potential buyer as you want.
How is a Land Contract Structured?
Land contract’s divide the title into two parts: legal and equitable.
- Legal title remains with the seller ( in my case, Huber Property Group, LLC) until the terms of the land contract are met by the buyer.
- Equitable title is given to the buyer at closing. Meaning, they are deemed the owner of the real estate and must insure the property, pay property taxes, and eventually, pay for it.
You may be thinking, “this sounds like a mortgage”, which is somewhat accurate. The most important difference between a mortgage and a land contract is that with a mortgage, the deed (a legal instrument transferring the property rights) is transferred to the buyer immediately upon purchase of the home. HOWEVER, with a land contract, the deed does not transfer until all the payments have been made. Although the buyer will live on the land, the property remains under the title of the seller until all installments have been paid.
What are the Components of a Land Contract?
There are five critical areas of a LC that create the terms. Again, this will sound like a mortgage, and in many ways it is, with the difference being what was discussed above.
- Purchase Price – the selling price of the property. Due to the fact the seller is providing the financing, the purchase price received is often higher than prices for homes being sold via traditional methods receive.
- Down Payment – the non-refundable amount the buyer must bring to closing. Usually between 10-20% of the purchase price.
- Interest Rate – the rate the buyer must pay on their principle amount which is stated in annual terms. Typical rates are between 8-11%.
- Monthly Payment – the combined total of the principle + interest payment, property tax payment, and homeowner insurance payment.
- Balloon Period – the period in which the land contract expires and the entire principle becomes due. This period usually lasts from 3-5 years while the buyer either fixes up their credit – or builds credit.
Again, you are probably thinking, “this sounds just like a normal bank loan, minus the balloon period” and you are exactly right. The balloon period and the deed NOT transferring to the buyer upon closing are the two attributes that separate it from a traditional mortgage. Other than that, hopefully the whole “you play the role of the bank” thing is becoming more clearer.
Who decides all these components? You do! It is all in your hands. Having control over all these dynamics is one of the main reasons why I am in love with land contracts.
Interest Gauge for Land Contracts
I am very aware that this is a pretty black and white article of simply explaining “what is” a land contract, opposed to sharing the pro’s and con’s. I figured I’d first see what kind of response and interest from this article before I dive into other land contract topics.
With that being said, if you would like to learn more or have questions, please leave comments below or contact me. If there appears to be genuine interest for this real estate investing tool, then I will share more about how it can be used and all the benefits it has.
Photo: Phillip Merritt