Is this type of agreement legal if the seller does not own the house? She (seller) still makes mortgage payments on the property. I was told by a family member that this type of agreement is no good if the house isn't rightfully hers yet (it is still owned by the mortgage company).

Please advise... thank you.

Despite jokes to the contrary, the mortgager does not "own" the property. They have a primary lien on the property. So yes a contract for deed would be legal. In fact, when entering a contract for deed it is YOU who would not have an ownership interest until the contract is fulfilled. A mortgage is a loan that uses the property as collateral, but the purchaser using a mortgage IS the owner.

But I would include a clause in the contract that requires the seller to maintain the mortgage on the property and that if the seller defaults on the mortgage, that you are entitled to your down payment back and maybe a portion of what you have paid towards the contract or other penalties.

In other words, have your attorney look over the contract and make sure you are protected in case the seller default on the mortgage.

Agree, a mortgage holder does not OWN the house, the person whose name is on the deed owns the house, the lender merely has a lien on the home that has to be paid prior to transfer of property.

It is very common, I do it all the time, to make a contract to sell a house that I have a lien on. I do a contract for deed and they make payments to me, and I pay my loan, and of course make a little money in return.

Normally but not always people are buying on a contract because they have poor credit and can not get a normal loan, It is common in a contact for deed for the house to be somewhat over priced and higher than normal interest rates.
Most contracts for deed ends in default where the seller takes the house back. Because of those factors.