Contract for Deed vs. Owner Financing vs. Lease-Option in Texas

Updated 12/28/17, Originally published 3/7/16

Takeaways

• Don’t do Contract for Deeds.  They are bad.
• Lease Options are possible but extremely difficult to do under Texas law
• Owner Financing deals can be difficult to find, but can be a competitive advantage for sellers who offer it.

Note: I am a real estate professional, not a lawyer.  Nothing herein should be construed as legal advice or instructions.

Most residential sales in Texas, and all that are done with the assistance of a Realtor, are done on the Texas Association of Realtors contracts.  The below methods are more rare and irregular methods of buying real estate, and that are often confused.  These three methods of buying/selling real estate share some things in common, but are wildly different in practice.  It’s important to know the differences!

Contract for Deed

Legitimate? No

Also known as a land contract, executory contract or installment sale, these were once very common investor tools in residential sales. That is, until 2005 when the Texas legislature came down hard on Contracts for Deeds and Lease Options in Texas.  As a result, neither are frequently performed in Texas, and legitimate contract for deeds are almost unheard of (rightly so).

A contract for deed is just a contract, usually with a larger upfront down payment (10% – 25%), with set monthly payments until all the payments are concluded and the buyer receives the deed.  On the surface, it looks similar to a typical mortgage or owner financing deal.  However contract for deeds is just a contract – a piece of paper between buyer and seller.  If a buyer ever wanted to enforce their rights, it would require an expensive lawsuit.  If a seller wanted to take back the property, it would only take the slightest infraction on the buyer’s part and as little as a three week eviction process.

This structure made it very easy for investors to prey on “buyers”, who would lose the home and their money invested if the owner could find even the slightest excuse to shred the contract.  The investor would get the house back, and the opportunity to sell it to someone else.  Some investors would sell the same house several times in the same year, collecting $10,000s in down payments for each sale.

Nowadays, Contract for Deeds are hazardous to both sellers and buyers in Texas.  Hazardous to the seller because the Texas regulations passed in 2005 make it very painful for sellers if anything goes afoul.  Hazardous for buyers for the reasons described above.  If someone is offering you a Texas residential property with contract for deed terms, run in the opposite direction.

Who Might Use It

Nobody.  No one.  Nadie.  This is essentially not a legal residential agreement in Texas and, if you are the buyer, you have zero protections.

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Owner Financing

Legitimate? Yes

Also known as seller financing, is when the seller is also effectively the buyer’s lender.  The seller must own the property free and clear (paid off any mortgages).  The seller would collect monthly mortgage payments (instead of installment payments in contract for deed, or rent in the case of lease options), and have the house as collateral in the case of default.  The terms are usually more generous to the seller than traditional financing, and it might be a way to get a higher price for the property, or get a better cash flow than renting the property out.

Hey, isn’t that the same as Contract for Deed described above?  Monthly installment payments until the “loan” is paid off?

No.  The difference is that an owner financed deal is recorded with the County.  It is a legitimate deal and the buyer’s interests are protected.  An additional protection is that a trustee has the deed instead of the seller, so if the seller dies or flees to Mexico or conveniently forgets that there is a contract, the Deed of Trust in an owner financed deal will show that the buyer is the rightful owner.

Also, if a buyer is late on a payment with an owner financed deal, the seller must go through the foreclosure process.  In a contract-for-deed deal, they can simply evict you in a week.

Lastly, a buyer can also can sell the property when owner financed, because the deed is with the trustee.  If it were a contract-for-deed, then the seller has the deed and the buyer has no evidence that they even own anything to sell.

This is the only method of these three that you can (and should) use a Realtor as either the seller or buyer.  A seller can simultaneously advertise for conventional buyers and buyers seeking owner financing.  An otherwise credit-worthy buyer may have circumstances that prevent them from getting a traditional loan.  An advantage of selling your home with owner financing is you will likely get more generous terms – higher price, above-market interest rates, and larger down payments – but of course you are getting paid in monthly mortgage installments and not one lump sum.

While legitimate, owner financed deals are very uncommon in the Fort Hood area because the seller must completely own the property (a lot of turnover and therefore mortgages in the Fort Hood market) and also few sellers are interested in collecting mortgage payments for 15 or 30 years (though there are programs to help manage collecting the mortgage and make it less painful than it sounds).  Only 3 listings are actively advertising that the owner is willing to owner finance on the MLS as of this writing.

Who Might Use It

Anyone, especially buyers having a hard time getting approved for a traditional loan, but have money for a significant deposit (20% or more), or sellers having a hard time getting the price or cash flow they need for their house.

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Lease Option

Legitimate? Maybe

Also known as rent-to-own, it is similar to the other two methods above in that you are making regular payments – in this case rent instead of a mortgage.  A renter signs a typical lease, but also an option to buy the property at a specific price, and a length of time that the buyer/renter has that option (maybe a year).  Unlike the other methods above, you do NOT have to buy the home.  You can rent and choose later during the term whether or not to buy the home.  Depending on the agreement, the rent you already paid might go toward the purchase price once you exercise your option.

Also, unlike the other two methods, a lease option ends with traditional financing.  Generally, you will rent until you can get a traditional lender with an FHA loan, or conventional loan, or whatever, and then buy the house.

Lease options are tricky.  Texas frowns on them.  There have been many cases of buyer-tenants being cheated by sellers, and Texas laws are built to try to discourage lease options.  But they do still exist.

You are not going to be able to find lease-options on a Texas MLS or from real estate agents.  Instead you would have to approach one of the few real estate investment companies that offer lease options.  It is important to find a reputable one, and you would likely do well for yourself to bring along a lawyer, too.

Who Might Use It

Buyers who can’t yet get approved for a traditional loan, but are close (6-12 months away).

Conclusion

If you are buying a home, you are probably best off using conventional financing like VA, FHA, USDA and conventional loans. If you can’t qualify for these loan types, consider waiting until you do. You will get better interest rates and terms and are less likely to run into complicated situations or even legal pains.

If selling a home, owner financing can be an option in certain circumstances. But it also makes you the lender for years, responsible for collecting mortgage payments and potentially foreclosure and reselling the home if a buyer fails to make payments.

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