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Buying Property with Little or No Money Down
Part 4
Agreements for Deed (Land Contracts of Contracts for Deed)
This form of seller financing is
quite popular in some parts of the country, yet practically unheard of in others. It calls
for the purchaser to pay for all or most of the property before he or she receives legal
title. In its simplest form, an agreement for deed works like a mortgage, except that
legal title does not pass until a predetermined and stipulated number of payments have
been made.
Theoretically, it provides
additional protection for the seller because in the event of default, where the purchaser
does not make the payments as agreed, the agreement for deed usually stipulates that the
money paid to the date of default is deemed to be rent for the period from the term of
possession to the date of default. No foreclosure is necessary. Technically if default
occurs, to clear the title especially if the agreement for deed or an affidavit and
memorandum of agreement have been recorded in the public records, a quit claim deed should
be given by the purchaser to the seller to release the purchaser's equitable interest in
the property.
When an agreement for the deed is
used, the contract will call for specific dollar payments, usually monthly, with the money
applied first to interest on the purchase price, then to charges such as real estate
taxes, insurance and special assessments, if any, then to the unpaid principal balance of
the purchase price. The contract may call for these payments to be made for any agreed
upon time, such as a year or even thirty days, before legal title will pass. If the
contract states that the legal title will pass before the principal balance is paid in
full, a "balloon" payment will usually become due, although the seller could
take back a note and mortgage in lieu of the balloon payment.
Some people believe that an
agreement for deed provides a legal way around due-on-sale clauses found in many
mortgages. Not so. The due-on-sale clause is triggered by any transfer of legal or
equitable title to real estate. While legal title is not transferred with an agreement for
deed (until the stipulated number of payments have been made), equitable title has passed.
From a practical standpoint though, the due-on-sale clause is not triggered because no
deed has been conveyed and recorded and insurance continues in force in the name of the
seller. It is unlikely (but not impossible) that the lender would learn of the
transaction.
Lease Options
A lease option gives you an
opportunity to enter into a contract with the seller/lessor where you pay rent, but a
portion of your rent payment will be credited towards the purchase price. A down payment,
if required, is not necessary until the lease option ends. By then you should have had
enough time to obtain the money for a down payment or decide against purchasing the
property. If you decide against exercising your option, it could be sold to another
purchaser for cash.
In its simplest form, a option is
nothing more than a legal right given by a seller to a buyer for purchasing property at a
predetermined price. An option must be in writing and consideration must be present to
make it legal. Consideration refers to something of value (usually money) that serves to
induce one to enter into a contract. It is only binding on the seller.
- Benefits to the Seller
- Price of property is at the top of market value range.
- Option money received is tax deferred.
- When the option is exercised, money from the buyers is taxed at ordinary income rates.
- The tenant has "pride of ownership" and an incentive to take better care of the property.
- If the rent is not paid on time, the option is forfeited (so the rent is always paid on time).
- The rent, including option payments, is usually set at or above the fair market rent.
- Benefits for the Purchaser/Optionee
- Usually the option consideration
paid by the purchaser is relatively small compared to the value of the property.
Therefore, very little risk is involved in controlling a large property. The purchaser is
betting that the property will increase in value beyond the agreed-upon option price. If
the buyer is wrong, they can walk away from the contract with no obligation.
- An option gives the purchaser control and in the case of a lease option, possession as well. The purchaser gets the
benefits of occupying the property and perhaps even improving it to create more value. The
purchaser could even generate profit from the property by leasing it to someone else.
Option Consideration
While an option contract must
have consideration, it need not be money. It can be a mortgage on a property you already
own or an unsecured promissory note. It can even be equity that you have in some other
property that may be a dead asset to you or an asset, you no longer want.
Lease Option to Purchase a Personal Residence
Assume that you are a renter or you are living in a home that you own and you would like to have a nicer home, a larger
home or a better neighborhood. You come across a seller who is willing to sell or rent his
or her property. The home has a fair market value of $60,000 which is also the amount that
the seller is asking. On the other hand, the seller is willing to rent it on an annual
lease for $500 per month.
When you talk to the seller about
lease optioning the property, he or she agrees to apply $50 of the $500 monthly rent
payment toward the $60,000 purchase price. You learn that the property has a mortgage in
the present amount of $38,000 with an interest rate of 9% and payable at the rate of $338
per month. The seller is asking for a $15,000 cash down payment and would be willing to
take back a $7,000 mortgage.
The first thing you should do is
contact the bank that holds the mortgage to determine whether it is assumable. In this
case, the bank informs you that it is not, but would be willing to rewrite the mortgage at
a blended interest rate representing half the difference between the current rate of 9%
and the market rate of interest which is 11%. The new blended rate would be 10%. Be sure
to ask if this is a standard bank policy and will apply in the future. Assume you are told
that the policy will remain the same but the then-current market rate of interest will
apply. The blended rate could be higher or lower depending upon the level of the current
market rate at that time. Ask the loan officer to summarize the bank's policy in writing.
In addition, make sure that the loan officer to whom you are talking has the right to
legally commit the bank.
Reapproach the seller with an
offer to lease option the property, but with slightly different terms. Do not offer the
$60,000 the seller is asking, but rather a premium of $65,000. In return, however, you
would like to have the option period extended from one year to three years. Further, offer
to make a monthly rent payment of $600 rather than $500, but in return ask that the seller
give you a monthly credit of $300 toward the purchase price. Then proceed to explain all
of the benefits to the seller for entering into an arrangement like this.
The seller is going to have a
positive cash flow over the three year option period of $4,500 ($600 minus $475 equals
$125 per month multiplied by 36 months). While you, the purchaser, are paying $600 per
month, $300 of that is a credit toward the purchase price.
When the option period is over,
you will have a total of $10,800 as a credit toward the $65,000 purchase price ($300 per
month multiplied by twelve months multiplied by three years). By that time, assuming just
5% rate of inflation based on the property's current fair market value of $60,000, the
property should be worth $70,000. You will only need $54,200 to buy the property ($65,000
minus $10,800).
The existing mortgage principal will be decreased to approximately $37,000 due to payments made over the three year
period. It will provide a good portion of the money needed to buy the property. You also
know that you will be able to get a blended interest rate from the lender and will have
immediate equity in the property of $15,800 ($70,000 value minus $65,000 purchase price
minus $10,800 option credit). You need to obtain only the $17,200 difference between what
you owe and the first mortgage balance $65,000 minus option credit of $10,800 less first
mortgage of $37,000. Because the value of the property at the end of the option period is
$70,000 a bank will finance 80% of that value to provide all the necessary money (80% of
$70,000 fair market value = $56,000!). Another alternative is to sell the property at the
end of the option period for a profit.
As a result of this transaction, you will have lived in the property for a net cost of $300 per month. The yearly total of
$3,600 represents just 5.5% of your option price; in effect, a "no money down"
transaction with an interest rate of 5.5%
Take into account the fact that
the property will probably increase from the $65,000 option price to $70,000. The $5,000
increase in value, divided by three years or $1,667 per year, really belongs to you. If
you credit that increase against your net out-of-pocket cost of $3,600 per year in rent,
your actual net cost was $1,933 per year or only 3% of the option price. This is a perfect
example of how a lease option to acquire property in which you will live can be powerful
for the purchaser and yet still be an attractive proposition for the seller.
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