Homeownership Without a Net

Despite some new reforms, low-income households buying homes outside the traditional mortgage market are still at tremendous risk—and often legal limbo.

Photo Courtesy of WiLLiam waynE Justice Center for Public Interest Law

In 2000, Clara and Jose Carrera bought a home for their family in the small Texas town of Edna. Unable to obtain bank financing, the Carreras joined thousands of other Americans in obtaining financing from the seller via a risky instrument called a contract for deed. This meant that the Carreras could obtain the title only after they completed all the payments. But in the Carreras’ case, after they completed their $53,000 in payments, instead of receiving the title, the family received a bank foreclosure notice. The seller, unbeknownst to the family, had pledged the property as security in 2006, and the bank was calling the note due. The Carreras’ $53,000 investment, their home, and all the home improvements they had made — a new addition, remodeling work, a carport — were lost.

Policy discussions precipitated by the recent collapse of the home mortgage market have largely ignored the growing number of low-income homebuyers who, like the Carreras (whose story was reported in the Victoria Advocate on Sept. 1, 2009), do not participate in the mortgage market, opting instead to buy “informally” via seller financing. However, between 2008 and 2010 alone, the number of seller-financed transactions that were tracked (and many are not, given their informal nature) rose by 56 percent. They accounted for 1.5 percent of all homebuyer transactions in 2010. To better understand these transactions and to assess the impact of a series of legislative reforms in this area, we recently led a year-long study of seller financing practices in Texas, along with Peter Ward at the University of Texas. The study has broad implications in states across the country where low-income consumers are buying their homes outside the mortgage market.

Contracts for Deed: The Poor Man’s Mortgage

Homebuyers who are barred from obtaining bank financing — whether due to bad credit, insufficient income, or other barriers — often turn to seller financing for their purchase. Homebuyers have two options for seller financing. One is similar to bank financing, in which the seller issues a deed and the buyer signs a deed of trust or mortgage agreeing to make payments over time on the home. A second option is a contract for deed, or the closely related lease-option contract.

Both forms of seller financing are inherently risky for buyers, who often end up buying from unscrupulous private land investors or unsophisticated sellers. In contrast to bank-financed transactions, seller-financed transactions with prior residents or private land investors are often handled at the kitchen table, without the benefit of title searches and title insurance, government regulatory protections, and standardized legal documents. The lack of any type of scrutiny of the title dramatically increases the chances that a buyer will acquire property with title defects such as preexisting liens or interruptions in the chain of title.

Of these two forms of seller financing, the contract for deed is by far the riskiest. This form of financing has had “a long track record of taking advantage of poor and minority homebuyers,” says John Henneberger, co-director of the Texas Low Income Housing Information Service, an Austin-based housing research and advocacy group. Contracts for deed have also been referred to as “poor man’s mortgages,” given their popularity among low-income homebuyers. (It should be noted that some nonprofits use contracts for deed and lease-purchase contracts in ethical ways.)

With a contract for deed, the seller promises to issue title to the buyer only after the buyer has paid the entire purchase price. A common feature of these contracts is the forfeiture clause, although many states now restrict the use of these clauses. Under a traditional forfeiture clause, if a buyer is even just slightly late on a single payment, the seller can declare the contract terminated, regain possession, and retain all of the buyer’s prior payments as liquidated damages.

Contracts for deeds are still actively used in many states, including Texas, Illinois, Michigan, Minnesota, West Virginia, South Dakota, Ohio, South Carolina, and Florida. A land investor in Florida selling with contracts for deed boasts, “Assuming you’re not creditworthy and have cash, we are your avenue for buying a home.” This particular investor requires 20 percent downpayments, along with 9.95 percent interest rates and balloon payments due after seven years.

Advocates around the country report a rise in the use of contracts for deed in areas where mortgage credit is hard to come by and with this rise, an increase in abusive sales tactics. For example, Minnesota Public Radio reported, “As credit continues to be tight, unregulated contracts for deed are fueling housing fraud in areas like north Minneapolis, where foreclosed homes come cheap.” “Landlords are using these deals to avoid [health and safety] regulations and rent without a license,” says Henry Reimer, acting director of regulatory services for the City of Minneapolis.

The Texas Reforms

By the mid-1980s, stories similar to what happened to the Carreras had begun to reach the ears of Texas legislators. The abusive use of contracts for deed had become especially widespread in informal settlements, communities located not far outside the city limits that used to consist of agricultural or scrub land. These communities have also historically been shut off from mortgage financing due to their lack of infrastructure and substandard housing conditions, in addition to poverty. Well-known along the Texas-Mexico border as “colonias,” informal settlements are also quite common in other parts of the state, even in areas just a few miles outside large urban areas such as Austin and Houston.

The Texas legislature in 1995 began adopting a series of laws bringing contracts for deed under stricter regulation in response to alarms raised by housing advocates. These regulations were originally limited to counties along the Texas-Mexico border, but were extended statewide in 2001. The legislature also extended the regulations to lease-option contracts. One of the most significant reforms was the requirement that sellers convert the contract for deed into a deed and deed of trust upon request of the buyer. Legislation also required that contracts for deed be recorded in the deed records, to put lenders and other future lien holders on notice of a buyer’s interests in the property.

Among the other reforms, the new legislation mandated pre- and post-contractual notices and disclosures — which must be in Spanish when the negotiations are conducted in Spanish — and imposed very strict penalties on sellers who ignored the requirements. And, crucially, upon default, buyers under contracts for deed no longer automatically forfeit all prior payments. Instead, if a buyer has paid less than 40 percent of the amount owed, the buyer has at least 30 days to pay. In cases where the buyer has reached either 40 percent or 48 months of payment, the buyer is entitled to a foreclosure process, including the right to recapture any equity in the home.

Throughout the reform efforts, sellers’ representatives decried the new burdens placed on land developers and predicted the abandonment of seller financing and the end of homeownership for low-income families. In contrast, affordable housing advocates heralded the protections as ending the most abusive sales tactics while ensuring safer pathways into homeownership by the poor. “After more than 40 years of abuse, the contracts-for-deed system has finally been fixed once and for all,” a Texas housing advocate said at the time.

We set out to examine the impact of the legislative reforms on contracts for deed and to explore new trends in seller-financed transactions. As part of our year-long study, we surveyed close to 1,300 households in areas historically shut out of mortgage financing.

The Impact of the Reforms

In 2006, Mary Zavala and her husband (names have been changed to preserve confidentiality) were renting a half lot and trailer in Webb County, Texas, from the owner, who was also their friend. The Zavalas entered into an oral agreement to purchase the half lot and trailer and then proceeded to build a home on the lot, which is nearly complete today. After paying $11,000 toward the lot purchase, they still lack a written contract of any kind. The Zavala family is now unable to set up utility services in their new home because the property is not in their name. And when the seller recently got divorced, the Zavalas were forced to go to court to prove their ownership interest.

The Texas legislative reforms appear to have been quite successful in steering most land investors away from contracts for deed and to safer forms of seller financing. In recent land investor sales, at least three out of four sellers used a deed of trust with title issued at the time of sale via a deed. The study also found that the reforms have not shut down seller financing or homeownership opportunities for low-income families. Of the residents we interviewed in 2012, the ones who had moved in since the reforms were still quite poor (56 percent of recent arrivals were living on less than $1,600 a month), but nonetheless, more than 65 percent of the new arrivals were homebuyers as opposed to renters, with three-quarters of the buyers utilizing seller financing.

However, the Texas reforms did little for families like the Zavalas, who are buying their homes from prior residents. Residents are increasingly replacing developers as the predominant sellers in older informal settlements, as some of the residents obtain title to their properties over time and decide to move. Those residents are relying by and large on contracts for deed to sell their homes.

These consumer-to-consumer sales are quite improvised and highly informal, with one out of three transactions involving an unrecorded contractual agreement, as in the case of the Zavalas. During our survey we came across several handwritten contracts for deed and receipts from oral agreements. The informality in these transactions is not driven by bad intentions as much as by lack of education about the importance of formal legal documents and lack of access to affordable legal assistance.

Title Without Security

In 1995, Dominic Garza and his family bought their lot from a Central Texas development company. After they missed several payments, the company representative asked Garza to sign a deed in lieu of foreclosure. Garza didn’t understand the form, but the representative told him he needed to sign it in order to refinance his property and keep his lot. Even though the Garza family is now making their payments on time, their principal never goes down. Garza is thinking about making larger payments, but his neighbors have cautioned him that the developer will not like this and may harass him for trying. On the street where the Garza family lives, at least three other families have abandoned their homes, leaving their money behind, tired of the fact that what they paid “never showed in their account.”

Our study found that many low-income homebuyers obtaining seller financing from land investors today in Texas receive their titles up front. Yet, like the Garzas, they still face a range of exploitative practices as a result of participating in a market that lacks adequate oversight and consumer protections. These practices include land investors requiring residents to sign “deeds in lieu,” thereby waiving their rights to foreclosure protections; high interest rates (15Ð18 percent is typical, but we found rates as high as 20 percent); excessive late fees; strict balloon payment requirements; and failure to run title searches.

In several areas in particular — all newer subdivisions home to some of the state’s poorest residents — we uncovered a disturbing pattern of rapid and aggressive repossession by land investors. In one such newer development, for example, where interest rates ran as high as 20 percent, at least 45 percent of the 100 lots sampled in our study had been foreclosed upon at least once by the seller or related finance company, with 32 percent of the lots foreclosed upon within four years and 20 percent foreclosed upon within a year of sale.

As a result, paradoxically, even though the lots in newer subdivisions are coming with title up front at sale, buyers’ possessory rights are still highly unstable, leading to a pervasive lack of security and inhibiting investment in the homes. As a result, these newer subdivisions also contain some of the poorest housing conditions in the state.

Revising Strategies

Policy advocates looking to assist the growing number of homebuyers in seller-financed transactions face two overarching questions. First, what kinds of reforms could bring more security to buyers facing abusive seller-financing practices? Second, what kinds of reforms could better reach families like the Zavalas, who buy from other consumers, to bring more formality to these transactions without depriving residents of the opportunity to sell their homes?

As for the first question, in addition to the Texas-style reforms of contracts for deed, we believe reforms should include stricter caps on the interest rates and fees that buyers can be charged in seller-financed transactions, along with extension of federal consumer lending protections to buyers of vacant lots that are being used for residential purposes. Despite their sweeping nature, several of the recently enacted consumer finance protections in the national Dodd-Frank bill do not reach buyers obtaining financing for vacant residential lots to be occupied with a trailer or mobile home. Providing affordable and accessible legal services to prospective low-income homebuyers utilizing seller-financed transactions is equally as important.

Finally, nonprofit community-based lending institutions have an important role to play here: to provide buyers with safer alternative forms of mortgage financing.

Assisting buyers purchasing from other consumers is more daunting. To help these unsophisticated buyers and sellers enter into more formal transactions, massive amounts of community education and access to standardized legal documents and legal assistance are critical. Among our recommended reforms is a proposal for state legislation promulgating a simple deed and deed of trust template (in Spanish and English) that could automatically substitute for the handwritten notes and other informal documents used in consumer-to-consumer transactions.

Finally, victims of abusive seller-financing practices, in addition to buyers in well-intended transactions gone bad, need somewhere to turn when their rights under applicable state laws are violated. Beefed up enforcement and access to legal services is badly needed through attorneys general and low-income legal services offices. These programs could be funded in a variety of ways. In Texas, we have recommended the addition of a small fee on all recorded documents to finance more of these services.

While these proposed reforms come too late for the Carrera, Zavala, and Garza families, they should help the increasing number of other low-income homebuyers who are financing their purchases outside of the formal mortgage market.

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