What you need to know about using an installment contract for deed. From closing on the sale to monthly interest payments, here’s what you can expect.
Q: I am selling a commercial building and giving the buyer financing through a contract for deed. In the purchase agreement, the buyer asked about a prepayment penalty, but I told the buyers there would be no prepayment penalties.
The contract requires the buyers to pay off the balance of the loan at 5 percent interest rate over 5 years. The buyers would also like to pay me the first year of monthly payments at closing in addition to the down payment on the contract. I told them they should include the interest that they would have paid me in the lump sum they want to give me.
Also, if they walk on the deal at any point, do I get the interest on the purchase price that remains?
A: We always worry when someone enters into a specific type of sale without fully understanding it. Your letter indicates you’re unsure of all the details and how they might play out, so let’s go through it.
An installment contract for deed (for practical purposes) is a way for a buyer to finance the purchase of a property. Once the contract is closed, the buyer gets the use of the property and the seller gets payments on the purchase price until the contract price is paid in full. The essential difference between an installment contract for deed or giving the buyer financing for the purchase of the property is that the seller retains title to the property until the buyer has made all the payments on the contract.
When a seller finances the property with a mortgage, the seller conveys title to the buyer and the seller takes back a mortgage. The buyer is the owner of the property and the seller becomes the lender. If the buyer fails to comply with the terms of the mortgage or misses payments, the seller — now lender — has to foreclose on the property to get the title back to satisfy the debt owed by the buyer.
In either case, the buyer has a contractual obligation to pay the seller the sum owed on the contract or mortgage, as the case may be.
We sense from your letter that you are looking at the installment contract for deed as an obligation by the buyer to pay a certain amount of interest without regard to the debt owed. Your buyer appears to want to pay more money upfront than what you were expecting. Say your contract price is $700,000, with the buyer putting down $100,000. The buyer would owe $600,000 for the next 5 years. To repay that amount, the buyer would pay you $10,000 per month for the next 60 months.
But, that doesn’t include interest. You want 5 percent on the remaining money the buyer owes you under the contract. In this example, you’d need to set up an amortization schedule for the repayment of money to you over the next 60 months.
But, your buyer doesn’t want to make any loan payments for the first year of ownership. In this situation, your buyer will pay you the $100,000 down payment plus the first years’ monthly payments of $120,000. The way we see it, your buyer is paying you $220,000 at closing, making no payments for the first year and then starting to repay the amount owed on year two.
Again, many online amortization programs can help you figure out the monthly payment owed by the buyer to you. The buyer would not pay interest on the amount paid to you as the down payment and would owe you a monthly payment starting on the first month of the second year. The buyer doesn’t pay you interest on the $220,000 as the buyer has not “borrowed” those funds from you and has paid you that amount at the closing.
Now, on the issue of the buyer defaulting down the line, you are entitled to interest on the amount owed you until it is paid. If the buyer defaults on the payments, the interest on the amount owed will continue until you get paid in full or take the property back. You should talk to an attorney to help you out with your transaction and should understand that while the buyer may default down the line, the buyer may still have some protections under state law in case of default.
Consulting with an attorney is important because state law will dictate what might happen if the buyer defaults near the end of the contract term and have built up a substantial amount of ownership interest (the equity) in the property. It is inherently unfair to have the buyer lose the property at that point and lose all his or her interest in the property if, for example, the buyer fails to make the last payment on the contract.
Given all of this, you would get interest on the money you are owed at any point in time but you may be restricted by some laws in taking back the property with the buyer losing out entirely on all the money they have put down on the home. The buyer can be penalized for his failure to buy the property, but the law doesn’t like unjust outcomes.