Contracts of sale come up modernly when fix-and-flippers sell their recently renovated houses to buyers who lost their prior home during the Great Recession. These receivables are a terrific source of cash flow and wealth, and in my next blog article we are going to talk about how to value them, how to sell them, and how to borrow against them.
A contract of sale is simply a contract to transfer title to real estate or goods once the purchase price has been paid in full. The key words here are, "... once the purchase price has been paid in full." In other words, bare legal title to the renovated house remains in the name of the seller until the buyer pays him off.
When the buyer of a renovated home signs his contract of sale, he enjoys all of the other rights in the bundle of rights that is fee title. Think of the bundle of rights as a quiver of arrows. One arrow is the right to occupy the property. Another arrow is the right to exclude other. "Get the heck off my property!" Another arrow is the right of quiet enjoyment, free from obnoxious noises and unwanted intrusions by others. Another arrow is the right to rent out the property and keep the proceeds.
The last arrow is the right to own the property in fee simple. Fee simple absolute title to real estate, according to Wikipedia, is "a permanent and absolute tenure (length of occupancy of a position) of an estate in land with freedom to dispose of it at will, especially in full fee simple absolute a freehold tenure, which is the main type of land ownership." You and I want to own our real estate in fee simple absolute.
This last arrow is kept by the seller in a contract of sale until he is paid off. The seller is known to hold bare legal title. The seller may have a claim to the property until he is paid in full, but he does not have the right to occupy the property, to trespass on the property, to exclude others, or to collect the rents. The seller no longer possess those rights.
Modernly there is very little difference between a normal mortgage and a contract of sale. In the old days, sellers would write their contracts of sale so that if the buyer fell behind in his payments by as little as 45 days, the seller could declare the buyer in breach of the contract of sale and reclaim the property (evict the buyer).
This is still true today if you buy a vacuum cleaner using a contract of sale. If you fall behind by even one day, the store can knock on your door and repossess your vacuum.
The courts, however, could not allow such injustice to stand. Imagine a buyer under a contract of sale who had spent many tens of thousands of dollars fixing up his home, only to lose it in 45 days when his employer went bankrupt and failed to pay his wage.
In every state, courts have ruled that the foreclosure of a contract of sale must be conducted in a manner identical to that of a mortgage, and most states have actually codified this ruling.
So why do sellers still use contracts of sale? In many cases, neither the seller, nor the buyer, knows the law. In addition, the buyers, who cannot qualify for a home loan from a conventional lender, are usually very anxious to close the deal and are unwilling to "rock the boat".
Sophisticated sellers will often use contracts of sale as a hammer with which to extract monthly payments out of their borrowers. "Listen, Bucko, it says right here in our contract of sale that I could evict you from the property right now, so you better send in your payment today!"
But if push comes to shove, the seller can foreclose no faster under a contract of sale than a mortgage.