A land contract is an alternative to a traditional mortgage. Rather than obtain a home loan from an institutional lender, the buyer finances a home directly from the seller. A land contract is also known as a contract for deed.
The seller and buyer agree on an interest rate and installment payments, which are generally higher than rates and payments offered by traditional lenders and may be subject to legal limits. Buyers who opt for land contracts usually can't qualify for regular financing due to bad credit, hence the higher interest rates charged on a land contract. Calculating interest rates on a land contract requires basic math skills.
Land Contract Interest Rate Basics
Monthly payments consist of principal and interest. The buyer and seller agree upon an interest rate when making the installment agreement. The seller keeps the interest, therefore, the higher the interest rate, the higher the portion of monthly payments a seller pockets. The remainder of the monthly payment goes toward paying off the principal balance on the seller-financed loan.
To prevent predatory lending practices, some states limit the interest rate on land contracts. For example, Vermont law allows a seller to charge up to 18 percent for a real estate land contract, while Michigan limits the interest rate to 11 percent.
Delayed Principal Payoff
Principal payoff is usually due several years later, such as two to five years. This is when the sale is finalized and the property deed transfers to the buyer. The buyer usually must obtain other financing by this deadline to cover the purchase price of the home.
Plugging in the Numbers
Multiply the interest rate by the principal balance due. Then divide by the number of installments made over the course of the year — usually 12 monthly installments. The result is the amount of interest you owe the seller for a given month.
For example, a $100,000 loan with an 8 percent interest rate has an initial payment of $666.67.
- $100,000 * .08 = $8,000
- $8,000/12 = $666.67
The principal balance goes down after each payment, reducing the amount of subsequent interest payments. Therefore, the seller receives a smaller portion of your total monthly payment month after month, and more of your payment goes toward reducing the principal balance.
Figures Needed for Online Calculator
Although a land contract may last only a few years, the loan may be amortized, or spread out, over a longer period, such as 30 years. Amortizing the installment loan over a longer period helps keep the monthly payments relatively low and manageable.
You can also use an amortization calculator — handheld or online — to calculate interest on a land contract. You need the:
- Interest rate
- Amortization period
- Principal balance
The initial principal balance is the difference between the purchase price and any down payment. Buyers on a land contract are often required to put 10 percent to 20 percent down.
Land Contract Items to Include
A land contract should include payment-related information such as:
- A purchase price
- Interest rate
- Down payment amount, if required
- Monthly payment amounts
- Term or length of the contract
- Number of payments
- Any balloon payment required