Why Installment Land Contracts (ILC) and Lease/Option Agreements Are Risky
Co-Author: Zac Grey
This article was last updated on November 5, 2024.
For buyers, using an installment land contract (ILC), also known as a “contract for deed,” or a lease with an option to purchase can be risky. Often, these methods are used when buyers struggle to secure traditional financing due to poor credit, recent bankruptcy, or lack of a sufficient down payment. Here are the major risks for buyers:
- Title Complications: During the pendency of an unrecorded ILC or lease, the seller’s title could become compromised by a lien (either consensual, like a new deed of trust, or non-consensual, like a tax, judgment or mechanics lien), which may prevent the seller from transferring ownership later.
- Mortgage Default by Seller: Sellers may stop paying their mortgage on the property, jeopardizing the buyer’s position.
- Limited Buyer Rights: Buyers do not have clear redemption or cure rights with an ILC or Lease/Option Agreement, unlike with third-party financing. In reality, those rights do exist but enforcing them can become a costly legal process.
Sellers also face risks when using ILCs or Lease/Option Agreement. These include:
- Compliance Issues: In an ILC or Lease/Option Agreement lasting longer than 180 days, a Colorado statute[1] requires the public trustee to act as the escrow agent for property taxes, which may lead to double escrow if the seller’s lender is already doing so. This statute also calls for notification to the county assessor of the “transfer.” Non-compliance with this statute allows the buyer to void the contract, demanding a refund with interest and reimbursement of legal costs.
- Claims of Equitable Interest: Buyers may claim an equitable interest, forcing the seller to undertake a judicial foreclosure or quiet title action, which can substantially delay resolution and cost thousands of dollars. In the meantime, the buyer may get to stay in the property, sometimes without payment to the seller at all until the action is completed. Even a deed back from buyer to seller held in escrow by a third party, prepared at the outset for protection, doesn’t defeat an equitable interest claim.
A Safer Alternative: All-Inclusive or “Wrap” Deed of Trust
A wrap-around mortgage, or “wrap,” offers a safer way to structure owner-financed transactions without immediately paying off the existing mortgage.[2] In this setup, the seller can retain their mortgage while allowing the buyer to make payments toward the property’s purchase. Here’s how it typically works:
- Example Scenario: A property worth $800,000 has an existing $600,000 mortgage at 6% that requires a $3,600 monthly payment. The buyer can put down $80,000 but cannot finance the balance. The seller then finances the $720,000 balance on a Colorado form note at 6% and a custom “wrap” deed of trust, but with a one or two-year balloon.[3] The seller’s proceeds from closing aren’t enough to release the first deed of trust, so that lien moves from the “requirements” section of the title commitment (Schedule B-1) to the “exceptions” section (Schedule B-2).
- Monthly Payments: The buyer pays the seller $4,315 monthly, and the seller uses these funds to cover their $3,600 mortgage payment, keeping the difference. If the seller does not pay the lender, the wrap documents allow the buyer to pay the lender directly.
- Refinancing: On the balloon date, the intent is for the buyer to refinance the property then pay the seller the balance due on the wrap note, who in turn pays the balance of the underlying note.
- Default Options: If the buyer defaults, the seller can initiate a public trustee foreclosure, a faster and less costly process than the judicial foreclosure that may be necessary with an ILC or Lease/Option Agreement. This way, the seller avoids long legal battles and regains control of the property more quickly.
Main Risk with Wraps
One risk with wrap mortgages is the “due on sale” clause in seller’s mortgage, which most Colorado deeds of trust include. If Seller’s lender discovers the transfer, they may demand full payment. Still, using a wrap may allow the seller to handle buyer defaults faster and with less expense than alternatives like an ILC or a Lease/Option Agreement. It is not illegal to breach a deed of trust by selling the property without paying off the underlying mortgage (although it’s not recommended for FHA- or VA-insured loans as referenced in footnote 2) – it’s simply a breach of that “contract” which then allows that lender to foreclose. Either the buyer or the seller (by earlier agreement between them) would then have the obligation to re-finance, to avoid foreclosure.
Conclusion: Use Wraps for Safer Owner Financing
When considering owner financing in Colorado without paying off an existing mortgage, wraps offer both buyers and sellers a more secure and manageable option than ILCs or Lease/Option Agreements. By hiring an attorney to prepare the appropriate documents, both parties can proceed with greater confidence and peace of mind.
[1] C.R.S. § 38-35-125.
[2] If the seller owes on an FHA-insured (post March 1, 1988) or a VA-insured (post December 15, 1989) note and deed of trust, wrapping either of those types of loans in considered improper – possibly even fraudulent – by HUD, and is not recommended.
[3] The Dodd-Frank Wall Street Reform and Consumer Protection Act may restrict the type of property and seller eligible for a wrap and require certain loan terms. Please refer to Mike Smeenk’s more detailed article on this subject for more information.
