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Many land investors get confused about what kind of loan documents they need to use when selling properties with owner financing.
To get to the bottom of this, there are a couple of issues that need to be sorted out.
Issue #1: What's the appropriate loan instrument to use in the closing process (Land Contract? Promissory Note & Deed of Trust? Mortgage? Something else?)
Issue #2: If a borrower stops paying, how does the foreclosure process work in each state? What's the standard procedure? How much does it cost? How long does it take?
These are two separate issues, but they go hand-in-hand for several reasons.
The loan instrument used in a seller-financed transaction (along with the state's laws and statutes that govern these types of financing arrangements) has EVERYTHING to do with how the foreclosure process will work, how easy it will be, how much time it will take, and how much it will cost.
If a borrower defaults on their loan payments to you (which is bound to happen eventually), these are some very real issues you will be confronted with.
If you choose the right document, with the right language included, and the state's laws work in the seller's favor, the process can be relatively fast, straightforward, and inexpensive.
On the flip side, if you chose the wrong document, without the right language, and/or if the state's laws don't allow for a non-judicial foreclosure under any circumstance… then the process can be slow, difficult, and costly. It might even be impossible if the loan documents weren't drafted properly.
Why It Matters
Understanding how seller financing works in one state is usually not difficult.
With a quick phone call to a local real estate foreclosure or creditors rights attorney, you can get a pretty good idea of the proper documents and the foreclosure procedure in the state where you work.
On the other hand, if you're buying and selling properties in several states (all of which have different laws and statutes), things can get confusing quickly because the rules in one state won't necessarily apply elsewhere.
This is why it's essential to proceed with caution when you're venturing into the realm of seller financing. Don't try to learn the process in a dozen different states simultaneously. Get intimately familiar with every aspect of seller financing in ONE state, and once you know it inside and out, you can start exploring other areas.
Using The Right Loan Documents
When a seller is offering owner financing for a piece of real estate, there are at least three types of loan documents to choose from:
What's the right choice for your deal? It depends mostly on what state your property is in because every state has different laws, statutes, and procedures that come into play if a buyer defaults on their payments.
It's also worth mentioning that some of these options aren't used or recognized in several states, so it's important to do your homework and understand the boundaries you need to work within.
Giving the Seller Maximum Control
When talking strictly about seller financing (where the seller is also the lender), one of our inherent goals is to give the seller maximum control over the property until the loan is paid off. One way to accomplish this is to make the foreclosure and forfeiture process as simple as possible if the borrower ever defaults on their payments.
We need to use a loan document that works harmoniously with the state's laws and includes the correct language that gives the seller/lender maximum control in a default situation.
In some states, a Deed of Trust (aka – Trust Deed) is the clear winner because the state laws make it much easier for the seller to have the Sheriff or Trustee hold an auction to sell the property, so the lender can recoup their losses if the borrower defaults on their payments. If the property doesn't sell at this auction, the lender can eventually get the property back in foreclosure. While it may not be the shortest, simplest path to regaining control of the property, some states simply won't all you to do it any other way.
In other states, a Mortgage is the most common instrument because if those states require a judicial foreclosure process, a mortgage will give the lender the right mechanisms to get through this process as painlessly as possible (even though a judicial proceeding is required).
And in some states, a Land Contract (aka – “Contract for Deed,” “Land Installment Contract,” or “Installment Sale Agreement”) is a commonly used loan instrument for seller financing because it allows the seller to repossess the property with relative ease if the borrower defaults on their payments.
How a Deed of Trust Works
With a Deed of Trust, there are three parties involved…
- The Buyer (Borrower)
- The Seller (Lender)
- The Trustee
When a Deed of Trust is closed, the property's equitable title (i.e., the right to obtain full ownership) is transferred to the borrower, while the legal title is transferred to a third-party trustee.
If the borrower ever defaults on their payments, the Trustee (usually designated by the lender as a title company or attorney) is empowered to step in and handle the foreclosure process non-judicially.
A Deed of Trust is also paired with a Promissory Note, and both documents work together to provide security for the Lender to protect their interests in the property until the loan is paid off.
How a Mortgage Works
With a Mortgage, there are two parties involved…
- The Borrower (Buyer)
- The Lender (Seller)
A Mortgage is very similar to a Deed of Trust. The most notable difference is that if the borrower stops paying, the lender will have to go through a judicial foreclosure instead of using a Trustee to take the property through a non-judicial foreclosure process (this is why mortgages are typically used in judicial foreclosure states because, in those states, a non-judicial foreclosure isn't an option).
How a Land Contract Works
With a Land Contract (aka – Contract for Deed), there are two parties involved:
- The Borrower (Buyer)
- The Lender (Seller)
When a Land Contract is closed, the seller continues to hold legal title to the property for the entire term of the loan (i.e., the deed doesn't transfer to the buyer until after the loan is paid in full). However, even though the buyer doesn't hold legal title, they can still take possession of the property and start using it immediately after signing the land contract.
A Land Contract generally offers more benefits to the seller because of how the title is held during the term of the loan. It arguably provides more security for the seller and less for the buyer. However, fundamentally speaking, even though the legal title doesn't transfer to the buyer until the loan is paid in full, both parties still have the same general rights to the property during the loan term.
In some states, using a Land Contract (assuming the proper language is included) will allow the lender to repossess the property without going through court, following a state-specified notification process.
However, not every state will allow the lender to do a non-judicial foreclosure with a Land Contract, and that's why, in many of those states, a Deed of Trust may be a better option.
Knowing Which Documents To Use
So which option should you use when selling a property with seller financing?
The answer hinges greatly on which state your property is located in. When you talk with a foreclosure/creditors rights attorney and you explain what you're trying to do, there will almost always be one clear choice to use for seller financing.
For the average investor, it's easy to speculate what the best option might be, but it's not easy to know the correct answer with total confidence until you speak with someone who understands the laws in the state where your property is located.
It is very important to do this research before you close a seller-financed deal.
Knowing how each state works is crucial to handling seller financing correctly. One of the biggest underlying advantages of seller financing is the presumption that the seller can get their property back with relative ease if/when the borrower decides to stop paying… but if the wrong instrument is used (or if the proper language isn't included in the right document), this whole benefit can go right out the window.
Getting the Right Answers
If you aren't sure what to do, the easiest way to get these answers is to call a foreclosure or creditors rights attorney in the state where you're working and ask these questions…
“If I'm selling a parcel of vacant land in this state with seller financing, what type of loan instrument would you recommend I use?”
They may ask for clarification on the type of property you're selling. When they respond with their thoughts and opinions, then ask,
“If I use your recommended documentation and the buyer ever stops paying, is it possible for me to do a non-judicial foreclosure in this state to repossess my property? If so, will I need to include any specific language in order to take advantage of this option?”
Note: Some states simply won't allow this at all, because they are judicial foreclosure states. Other states will allow for a non-judicial foreclosure, but only if you use the right documents and include the right language.
If they say, “YES, non-judicial foreclosures are allowed here,” ask them,
“Can you explain what the foreclosure process looks like? How long does it typically take and what costs are involved?”
“Who can I enlist to be the Trustee? Is that something you can help with? If so, how much would this typically cost (and how much time would it take) to complete the foreclosure?”
If they say, “NO, this is a judicial foreclosure state,” ask them,
“How much does it typically cost (and how much time does it take) to get through the foreclosure process and get my property back in this state? Is this something you can help me with?”
However they answer these questions, this information should give you a good idea of the consequences (in terms of time and money) if/when you ever encounter a borrower who defaults on their payments. This should also help you decide whether offering seller financing on the property you're working with is worth the risk.
Sometimes, regardless of what your foreclosure options are, the risk will be worth it because you will significantly increase your profits over the long term… and even if the borrower does default, the cost of foreclosing or repossessing the property will be nominal compared to the value you'll gain by selling the property with owner financing.
Other times, the risk won't be worth it because if the foreclosure process is time-consuming and expensive, and if you're only making a tiny profit from the deal in the first place, it could easily chew up all the profit you stand to make (and possibly even more).
The only way to assess this is to have these conversations with a foreclosure or creditors rights attorney in your state and understand what's involved. Then you can determine if seller financing is worthwhile for the properties you're selling.
Note: There is a difference between a “real estate attorney” and a “foreclosure attorney” or “creditor's rights attorney.” Not all real estate attorneys have practical experience with seller financing, and they won't always be transparent about their lack of expertise in this specialized subject. However, if you contact an attorney specializing in these issues in your state, you'll be much more likely to get the right answers from someone who knows what they're talking about.
A Note on Non-Judicial Foreclosures
In many states around the country, it is perfectly legal to use a Land Contract, a Deed of Trust, or a Mortgage, but even though they're all “legally permissible,” there's a reason why one is more commonly used than the others.
As I mentioned earlier, it usually comes down to whether a state is a judicial or non-judicial foreclosure state.
If a buyer ever stops paying and the seller wants to repossess the property (so they can sell it to another buyer) or get paid off altogether (so they can take their cash and move on), many states will allow the lender to avoid working through the court system as long as they prepared their loan document correctly and followed the correct procedures to terminate the borrower's interest in the property.
A non-judicial foreclosure still requires that specific steps be carried out (and of course, these steps differ from state to state). Even so, in states where a non-judicial foreclosure is an option, it tends to be the preferred method over working through the courts.
Legal Disclaimer: The information on this map was pulled from several sources, both online and offline. If you want to explore the sources we used, each one will be linked within each state. This map isn’t intended to be the authoritative answer on how each state works, but simply the most educated assessment we could make based on the information we were able to gather. If you have evidence to show that our assessment is incorrect in any particular state, feel free to contact us and point out any sources to support your claim.
In the states where non-judicial foreclosures are allowed, this non-judicial process will only work if the correct loan documents are used, AND those documents include the precise language that gives the lender the legal right to take this route.
In a Land Contract, this language is typically referred to as the “Right to Forfeit” or the “Remedies on Default” section, while this language is often referred to as the “Power of Sale” clause in a Deed of Trust or a Mortgage.
This special language states that if the borrower stops paying, the lender can take the property back (or auction it off) if the borrower doesn't meet their obligations within a specified period. These parameters vary from state to state (and some states don't allow this option at all), but the language conveys the same basic concept in the areas where it's relevant.
If you want to take full advantage of whatever powers your state laws and statutes will afford you, talk with a lending attorney in your state and ask them a few questions:
- Which document should I be using?
- Will this allow me to do a non-judicial foreclosure? If so, how does the non-judicial foreclosure process work in this state?
- How does the judicial foreclosure process work in this state if I cannot do a non-judicial foreclosure?
- What specific language must be included to give the lender a straightforward path through foreclosure?
Do Your Homework
Again, knowing what documentation to use has everything to do with understanding what is allowed in the state where you're working and getting the right legal help from an experienced attorney who has dealt with their share of seller-financed transactions in your state.
Sometimes it will require more than one phone call to find the answers you're looking for. In my experience calling real estate attorneys in all 50 states, I found that some are MUCH less helpful, knowledgeable, and experienced than others.
Be your own advocate, and don't put the phone down until you're confident in what it will take to move forward with your transaction correctly.