December 4, 2012, Revised October 30, 2015
"You have written articles
about lease-to-own contracts, but never about land
contracts, which I am told may work better.”
Lease-to-own contracts (LTOs) and land contracts (LCs) are
different legal ways to accomplish the same objective:
transferring occupancy of a property from an existing owner
who no longer wishes to occupy it to someone else who does
want to occupy it, but who cannot afford to purchase it
outright – usually because they can’t qualify for the
financing required. Both LTOs and LCs offer wannabee buyers
the right to occupy a house for a period during which they
can improve their capacity to qualify for the financing they
need to complete the deal.
The Essential Differences
With an LTO, the new occupant becomes a tenant and the current owner becomes a landlord who offers the tenant an option to purchase the house within a specified period. The tenant will need a purchase mortgage when t he time comes.
With an
LC, the new occupant purchases the property with financing
provided by the seller, who becomes a lender. Legal title
does not pass until the loan is paid off, which requires the
new occupant to refinance.
Here
are examples that assume a house appraised for $100,000 that
cannot be sold at that price but can be sold under an LTO or
LC. In both cases, the buyer is betting $1500 that he will
be able to complete the deal.
Under
the LTO, a renter/buyer has the right to occupy the house
with an option to buy anytime within 18 months for $100,000
in exchange for a non-refundable option fee of $1500 and
monthly rent of $900 for 18 months. If the wannabe buyer cannot
qualify for the mortgage required to exercise the option
within the 18 months, her option lapses and she must
vacate at the end of the period.
Under
the LC, the wannabe buyer pays $100,000 for the house, including
$1500 in cash as a down payment, with the seller providing a
loan for $98,500. The monthly payment of $900 covers the
principal and interest plus taxes and insurance, with the
loan balance of $96,658 after 18 months due at that time. If
the wannabe buyer cannot refinance, the owner does not transfer
legal title and can take steps to have him evicted.
LTO Versus LC to a Seller
A home seller may prefer
an LC because “for sale with seller-financing” is a potent
marketing message that may make it possible to attract
buyers without having to pay a real estate sales commission.
The LTO message of “rent with an option to buy” is less
potent and the seller is more likely to need help in
attracting buyers.
On the
other hand, the seller who has an existing mortgage will
have to pay it off to do an LC, since mortgage contracts
require payoff when title passes. An LTO is not subject to
this problem because title does not pass at that point,
In
addition, the seller with serious reservations about the
capacity of a potential buyer to fulfill the terms of the
deal might prefer an LTO because it is easier to get rid of
a tenant than an owner. Eviction
upon the expiration of a lease that is not renewable is
usually simple whereas unwinding an LC is more akin to a
foreclosure and can be costly and time-consuming.
LTO Versus LC to a Buyer
A buyer
will prefer a land contract for a variety of reasons: Sale
takes place immediately rather than being contingent upon
fulfilling payment obligations. The buyer is not vulnerable
to loss of the option to buy through failure to meet these
obligations, which in some LTO contracts can be extremely
rigid.
In
addition, less cash is required to refinance an existing
loan under an LC than to obtain the purchase mortgage
required by an LTO.
·
The down payment on an LC
gives the borrower some equity at the outset, which the
option fee does not.
·
Closing costs are lower on a
refinance than on a purchase mortgage.
·
The appraisal will probably
be higher in the LC transaction because the option price
sets a de facto ceiling in the LTO deal. Further, any
property appreciation during the period will result in a
higher appraisal on the refinance, but not on the LTO.
On the
other hand, the buyer who is not sure of his capacity to
complete the transaction might prefer an LTO, where failure
means loss of the purchase option and the monies paid, but
nothing else. On an LC, failure leaves the buyer on the
legal hook for the unpaid loan balance, which will result in
a recorded judgment against him and seriously damage his
credit.
Bottom Line
Both buyers and sellers will find the LC
more advantageous if they are fully confident that the
transaction will be completed, and both will prefer the LTO
if they fear that it won’t.
