Purchase-money mortgage vs. Contract for deed
Both types of financing involve seller carryback financing; the difference is that legal title remains with the seller in a contract for deed.
Purchase-money mortgage — A mortgage given as part of the buyer’s consideration for the purchase of real property, and delivered at the same time that the real property is transferred as a simultaneous part of the transaction. It is commonly a mortgage taken back by a seller from a purchaser in lieu of purchase money. A purchase money mortgage is usually used to fill a gap between the buyer’s down payment and a new first mortgage or a mortgage assumed, as when the buyer pays 10 percent in cash, gets an 80 percent first mortgage from a bank, and then the seller takes back a purchase money second mortgage for the remaining 10 percent.
A purchase money mortgage has certain priorities. For example, suppose Fred Wilson buys a small farm for $50,000, pays $10,000 down, and gives the seller or lender a $40,000 mortgage. At the same time, Wilson has a $10,000 judgment lien outstanding against himself. The judgment lien, even though prior in time, is inferior in right to the security lien of the seller/mortgagee. This is because the mortgagee made it possible for Wilson to own the land against which the judgment creditor now claims a lien. Delivery of the deed and the taking back of the purchase money mortgage are deemed one transaction in which there is no time for any other lien to intervene.
A person giving a mortgage on one piece of property to raise money to buy another piece is not giving a purchase money mortgage. Where a developer purchases land and then obtains a construction mortgage loan to build structures, the transaction is not a purchase money mortgage.
When a seller agrees in a contract of sale to take back a purchase money mortgage for part of the purchase price, the terms and conditions of the mortgage (such as interest rate and duration) must be set forth in detail; otherwise, the contract might not be enforceable due to incompleteness or uncertainty.
Depending on state law, a deficiency judgment may or may not be permitted upon default of a purchase money mortgage. In some states (e.g., New York), a purchase money mortgage is exempt from the state’s usury ceiling.
Technically speaking, any mortgage on real property executed to secure the purchase money by a purchaser of the property contemporaneously with the acquisition of the legal title thereto is a purchase money mortgage. Thus, the fact that a mortgage is made to a person other than the seller does not prevent its being a purchase money mortgage.
Contract for deed — An agreement between the seller (vendor) and buyer (vendee) for the purchase of real property in which the payment of all or a portion of the selling price is deferred. The purchase price may be paid in installments (of either principal and interest or interest only) over the period of the contract, with the balance due at maturity. When the buyer completes the required payments, the seller must deliver good legal title to the buyer by way of a deed or assignment of lease (if the property is leasehold property). Under the terms of the contract for deed, the buyer is given possession of the property and equitable title to the property, while the seller holds legal title and continues to be primarily liable for payment of any underlying mortgage. The features of the buyer’s equitable title and obligation to purchase are what distinguishes a contract for deed from a lease-option.
The contract for deed document usually contains the names of the buyer and seller, the sales price, the terms of payment, a full legal description and a lengthy statement of the rights and obligations of the parties, similar to those under a mortgage, including use of premises, risk of loss, maintenance of premises, payment of taxes and insurance and remedies in case of default. Specific rights, such as acceleration or the right to prepay without penalty, must be expressly written into the agreement. The contract is usually signed by both parties, acknowledged and recorded.
The contract for deed is used extensively in many areas, where it may be called a land contract, agreement of sale (Hawaii), installment contract, articles of agreement, conditional sales contract, bond for deed or real estate contract. In a dynamic and rapidly appreciating real estate market, the contract for deed enables buyers to purchase property on reasonable financial terms and thereby benefit from the appreciation of the property values. Many buyers then sell the property at a profit before their final payment becomes due. In a tight money market where it is difficult to qualify prospective buyers for conventional financing, the contract for deed is frequently the best method to sell or purchase a property. Especially benefited by the contract for deed are young couples, who would have difficulty qualifying for a bank loan at the time of entering into the contract for deed, but whose incomes will increase before maturity of the agreement, enabling them to refinance and pay off the contract for deed.
Some sellers prefer to sell on a contract for deed because it can create an installment sale, which will enable them to defer payment of a portion of tax. In addition, if the buyer defaults the seller can sue for strict foreclosure, something he or she cannot do with a mortgage. However, a seller who chooses this remedy is rescinding the contract and cannot seek a deficiency judgment for the unpaid balance.
Use of a contract for deed is not without some disadvantages. From the buyer’s viewpoint:
- Because the seller need not deliver good marketable title until the final payment, the buyer must, at the risk of default, continue to make payments even when there may be a doubt whether the seller will be able to perform when all payments are made. This can be especially serious when the seller is a corporation, because its directors and shareholders have only limited liability. Some attorneys try to minimize this problem by inserting a clause to the effect that “the property is to be conveyed free and clear of all encumbrances except (those specified herein) and to remain free and clear except for the above-stated encumbrances.” The seller is then discouraged from placing further mortgages and encumbrances on the property during the period of the contract for deed.
- The buyer may have difficulty getting the seller to deed the property upon satisfaction. By withholding a large enough final payment, the buyer often can persuade a seller to pay the costs of drafting the deed. In addition, at the time of final payment, the seller might be suffering a legal disability or be missing, bankrupt or dead, and the property might be tied up in probate.
- The buyer might be restricted from assigning his or her interest in the contract for deed by covenants against assignment.
- Liens that arise against the seller could cloud the title.
- Unless a collection account is used, problems could arise if the seller does not apply the buyer’s payments to the underlying mortgage.
From the seller’s viewpoint:
- If the buyer defaults, the process of clearing record title may be time consuming and costly, especially if the buyer is under a legal disability or is bankrupt, is a nonresident or has created encumbrances in favor of persons who might have to be joined in any quiet title action.
- The seller’s interest in the contract for deed is less salable than a mortgagee’s interest would have been had the seller sold under a purchase-money mortgage.
- The seller’s lender may attempt to call in the loan if it has an enforceable ‘due on sale’ provision in the underlying mortgage.
- By its very nature, the contract for deed is a contract, and all contracts are subject to differing interpretations with the possibility of disputes and litigation.