Owner Financing:
Mortgage vs. Contract for Deed

Owner Financing.  Because of recent credit tightening, sellers are finding it difficult to find buyers who qualify for conventional financing and are forced to offer owner financing.  Alternatively, a seller may want to receive the proceeds from a sale over time to defer taxes and to receive a good return on the money until the owner needs it.  Sometimes the buyer puts little or nothing down.

Owner financing can also have fewer closing costs for buyers than conventional financing, since owners commonly do not require origination fees, application costs, title searches and title insurance, appraisals, termite and building inspections, and surveys.  This speeds up the transaction.  Of course, forgoing many of these costs results in great risk to the buyer.

The time period of owner financing is often short, followed by a balloon payment.  The buyer agrees to this, thinking that satisfactorily making the payments will repair the buyer’s credit in time to refinance the balloon.  However, sellers do not report to credit reporting agencies, and the owner financing will have no effect on the buyer’s credit.  On the other hand, the owner financing will allow the buyer to build equity before the buyer has to refinance the balloon.

Typically, the buyer becomes responsible for paying taxes and insurance.  If the buyer does not pay the taxes and insurance, the seller can put the buyer in default in the same manner as if the buyer did not make his regular payments under the loan.

Mortgage or Deed of Trust.  In cases when an owner provides financing to a buyer of real property, the seller typically sells the property to the buyer by way of a deed, and simultaneously the buyer executes a promissory note and mortgage in favor of the seller.  The promissory note is a promise to pay money to finance the purchase.  The mortgage puts the real property up as collateral to secure the promissory note.  The buyer becomes the legal owner of the property, but the seller has a lien on the property.

This is the same as when the buyer obtains conventional financing from a third party lender.  When a deed and mortgage are part of one transaction, the mortgage is known as a purchase money mortgage and takes priority over preexisting judgment liens against the buyer.

If the buyer defaults under the promissory note or mortgage, the seller may accelerate the promissory note, which has the effect of making the entire amount of the promissory note immediately due and payable, and foreclose on the property.  A foreclosure is a legal proceeding through which the property is sold at public sale and the proceeds of the sale are used to pay the costs of the sale and then are applied to the debt secured by the promissory note, then to other secured debt and, if anything is left over, to the debtor.

In Arkansas, creditors may opt for a deed of trust, rather than a mortgage.  Practically, the only difference between a mortgage and a deed of trust is in how the property is foreclosed on.  A deed of trust contains a power of sale clause, which permits a foreclosure sale without the intervention of a judge.  There are very stringent notice requirements before the sale can take place.  A mortgage, on the other hand, requires a judge to enter a judgment of foreclosure.

In either case, a foreclosure in Arkansas takes approximately 120 days, assuming the borrower does not contest the foreclosure and does not file bankruptcy.  There is a one year right of redemption under judicial foreclosure that is typically waived in the mortgage document.

If a mortgage or deed of trust is used with owner financing, it is important that an Arkansas attorney draft the documents in order to be sure that the appropriate language is included in the mortgage or deed of trust and promissory note.

Quite often, property sold in foreclosure is not sold for enough money to satisfy the costs of the sale and the debt owed on the mortgage.  In such cases, the creditor can pursue a deficiency judgment, which is a personal judgment against the debtor for the remaining amount due, which can be satisfied by seizing other property owned by the debtor.

Contract for Deed.  In cases when an owner provides financing to a buyer of real property, a “contract for deed” (also known as a “land contract” or an “installment sale agreement”) is an alternative to a mortgage.  A contract for deed is a contract whereby the seller retains legal title, and the buyer agrees to make payments over a specified period of time while being in possession of the property.  At the end of the term of the contract for deed, the seller delivers legal title to the buyer by way of a deed.

The payments are generally the same as mortgage payments, part being interest and part being principal.  The portion attributable to principal reduces the amount owed to the seller.  However, equity does not build in the sense that it builds when there is a mortgage on the property, because if the buyer defaults, the contract is forfeited, and the buyer loses all the money that the buyer has paid up to that point.  Also, there is no legal equity that can serve as collateral for a second mortgage.

On the other hand, if the buyer is permitted under the terms of the contract to prepay, the amount that the buyer will need to prepay will have been reduced by the principal reductions made by the periodic payments.

The buyer is permitted by the IRS to deduct the interest portion of his or her payments as mortgage interest.  The IRS considers a contract for deed to be an installment sale, so the seller can spread his or her capital gains over the term of the contract for deed.  However, though the seller still owns legal title, the seller cannot claim depreciation or any other tax benefits on the property.

The forfeiture resulting from a buyer’s default is done without a foreclosure sale or any judicial action.  Generally only one or two certified mailings and a passage of time is involved, after which the seller owns the property free and clear of the contract for deed.  This is contrasted to a default under a mortgage, where a foreclosure sale is required.  Therefore, the many protections, and time, afforded to a borrower under a foreclosure are not afforded to a borrower by a forfeiture of a contract for deed.

One caveat to a seller should be made at this point.  Forfeiture should not be made under a relatively minor failure of performance.  “[A] court may refuse to enforce a forfeiture provision in a contract for deed when there are substantial equitable circumstances….  The right of forfeiture can be a harsh remedy producing great hardships, and therefore, before a forfeiture is enforceable, equity requires strict compliance with the important terms of the contract even where there is an express provision for forfeiture.”  Harness v. Curtis, 87 Ark.App. 337, 192 S.W.3d 267, 270 (Ark.App. 2004).  Sellers should also make sure that the default provisions of the contract are substantially complied with.  It is recommended that an Arkansas attorney be retained to ensure that the contract for deed is properly forfeited.

After the buyer has satisfactorily performed under the contract for deed, the seller conveys the property to the buyer by warranty deed and generally provides evidence of good title at that time.

Often the seller has a mortgage on the property that contains a due on sale clause.  A contract for deed will violate the due on sale clause.  Therefore it is important to get the lender’s consent to the contract for deed.

If the lender consents to the contract for deed, the buyer will want to make sure that the seller’s lender is being paid on a monthly basis.  Generally, the parties hire an escrow company to hold a warranty deed from the seller to the buyer and a quitclaim deed from the buyer to the seller.  The escrow company receives the buyer’s monthly payments and pays the seller’s lender out of those payments.  At the end of the contract for deed, the escrow agent delivers the warranty deed to the buyer.  If the buyer defaults before the end of the contract, the escrow agent delivers the quitclaim deed to the seller.

Presumably, the seller’s lender would be paid off by the end of the contract for deed.  However, when there is a balloon, the balloon pays off the seller’s lender.  The buyer generally pays the balloon through a refinancing.

At the end of the contract, the seller and the buyer will incur some closing costs, such as deed stamps, recording costs and title insurance premium.  The seller’s costs can be deducted from the last of the buyer’s payments.

Farm real estate is often purchased through a contract for deed.  Though, upon the buyer’s default, a contract for deed is easily forfeited, that is not the case with farm real estate.  In the case of an indebtedness of $20,000.00 or more, the Arkansas Farm Mediation Act applies to a contract for deed (and to a mortgage) on agricultural property.  That Act provides that a farmer may demand mediation with his or her creditor and the Arkansas Farm Mediation Office and that a release must be obtained from the Farm Mediation Office before a creditor may pursue its remedies, such as forfeiture of a contract for deed or foreclosure.

Many people think that a contract for deed is the same as the old “bond for title,” which has actually fallen into disuse.  A contract for deed is an “executory contract of sale with a forfeiture clause where time is of the essence” (a contract for deed must have the appropriate language and should be drafted by an Arkansas attorney).  A bond for title recites that the seller has sold the real estate to the buyer.  Therefore, a bond for title is not executory, or “designed or of such a nature as to take effect on a future contingency,” i.e., punctual payment.  Nor does a bond for title have a forfeiture clause.  A bond for title is accompanied by bonds or notes.  For those reasons, the courts treat a bond for title like a mortgage and require foreclosure.

In summary, owner financing by way of a contract for deed has the following pros and cons for the seller and buyer:

            Pros for Buyers.

• Alternative to conventional financing
• Less closing costs
• Interest payments deductible as mortgage interest
• Equity builds up before the balloon must be refinanced

Cons for Buyers.

• Forfeiture vs. foreclosure
• No equity for a home equity loan
• No protection if no inspections, appraisal, title search, or survey are obtained
• Potential inability to refinance a balloon payment

Pros for Sellers

• Installment sale for capital gains purposes
• Good return on the money lent to the buyer
• Ability to sell to buyer who cannot obtain conventional financing
• Forfeiture vs. foreclosure
• No financing contingency in the purchase contract
• Faster sale

Cons for Sellers

• Getting money over a period of time rather than immediately
• Cannot claim depreciation or other tax benefits on the property
• May violate a due on sale clause in the seller’s mortgage