Contract for Deed – Part 5 of 5 From the Buyer’s Perspective

Buyers should be extremely cautious about entering into a contract for deed to purchase a property. There are two main reasons. First, it is possible for the seller to lose control of the property while the buyer is making his payments according to the contract. Second, if a buyer defaults he will likely lose any equity developed in the property.

This first reason may seem counterintuitive. But, sellers are allowed to borrow against the same property they are selling under a contract for deed. In other words, a seller can go to a bank and obtain a mortgage on the exact property they have contracted to sell. They are also allowed to borrow against the property without notifying the contract-for-deed buyer.

The lien that a bank would place on the property would be superior to any rights that a buyer would have under an unfiled contract for deed.[1] Thus, if the seller defaults on his loan to the bank while the buyer is making his payments, then the buyer is in trouble. The bank would foreclose on the property, and the contract-for-deed buyer would lose all rights under the contract for deed, including the right to possess the property.

There is another risk that arises if the seller borrows money against the property. That risk is that the buyer may pay all that is owed under the contract for deed, but the seller may not have paid all that he owes to the bank. If this occurs, then the buyer’s rights are – again – inferior to the bank. This would require the buyer to pay off the bank’s lien to own the property “free and clear.”

Second, if a buyer defaults on a contract for deed, it is likely that he will not have the ability to obtain any equity in the property. Under a traditional mortgage, when a borrower defaults, a foreclosure auction takes place on the courthouse steps. This auction allows the borrower to retain any equity in the property. Let me use an example.

If one borrows $50,000 using a traditional mortgage on a property worth $500,000 and then defaults, the property goes up for a foreclosure auction. Assuming that the property is auctioned for $500,000, the owner would receive $450,000 after the lender is paid in full. This auction process was developed hundreds of years ago in England because it was deemed unjust to allow the lender to obtain more than the amount lent.

In a contract for deed, however, the seller can simply rescind and evict if a borrower defaults (see article 2 and 3 for a discussion on remedies). This functions as a forfeiture and any equity the borrower developed in the property is lost.

For these two reasons, a contract for deed is extremely dangerous to buyers. Buyers are recommended to use a traditional mortgage to finance the purchase of a property. Anyone considering a property transaction using a contract for deed should retain an experienced attorney in this area.

Disclaimer: The information contained in this article is for informational purposes only and is not legal advice or a substitute for legal counsel. It does not constitute advertising or solicitation. The information in this article may not reflect the most current legal developments; accordingly, this article is not guaranteed to be perfect, and should not be considered an indication of future results.

[1] Most contract for deed agreements expressly state that the contract for deed cannot be filed of record. If the contract for deed was filed of record, it would prevent the problems outlined in this paragraph.