Q: "You have written articles about lease-to-own contracts, but never about land contracts, which I am told may work better."
A: 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 he can’t qualify for the financing required.
Both LTOs and LCs offer wannabe 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.
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 at that time.
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 cannot be sold at that price but can be sold under an LTO or LC. In both cases, the buyer is betting $1,500 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 nonrefundable option fee of $1,500 and monthly rent of $900 for 18 months. If the renter cannot qualify for the mortgage required to exercise the option within the 18 months, the option lapses and the renter must vacate at the end of the period.
Under the LC, the buyer pays $100,000 for the house, including $1,500 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 buyer cannot refinance, the owner does not transfer legal title and can take steps to have the buyer evicted.
The pros and cons of LTOs versus LCs have to be assessed separately for buyers and sellers. 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 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.
A buyer will prefer a land contract for a variety of reasons: the sale takes place immediately rather than being contingent upon fulfilling payment obligations; and 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.
It is interesting that 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.
Thanks to Jack Pritchard.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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