Recently, while performing our duties as a servicing agent for promissory notes and contracts, we have noticed a proliferation of transactions involving; taking title to property “subject to” an existing loan, all inclusive notes wrapping around an existing note and Contracts of Sale (sometimes referred to as Contract for a Deed or Land Contracts). While the role of a servicing company is viewed by most as an indispensable ingredient to the success of these kinds of transaction and represents a significant percentage of our business, I believe it is important to address risks and rewards intrinsic to the structuring these kinds of non-traditional transactions.
The Contract of Sale: A Contract of Sale is an Agreement for a Deed. That is, to give a Deed sometime in the future upon something happening. Usually that something is the payment of a certain amount of money. The title is held by the seller (vendee) and is not conveyed to the buyer (vendor) until the agreement is fulfilled. However the buyer takes possession, agrees to make payments and the seller remains responsible for the loan. In this case the seller retains Title to the property.
The All Inclusive: Also known as a “wrap around”. Now, title is transferred by Deed to the buyer who executed a note in favor of the seller secured by a trust deed and/or mortgage that “wraps around” the senior loan(s). This transaction usually results in a higher yield to the holder of the note.
The “Subject To”: You buy sellers home, leaving the loan in place. You don’t assume the loan; that would require bank qualifying, closing costs, delays, etc. You and the seller sign agreements giving you possession of the home (you get the deed) and another agreement saying you’ll make future loan payments. BUT, the loan stays in the seller’s name.
The common denominator in all the above structuring is the property is transferred (conveyed) leaving the original sellers loan in place. There is no assumption of the existing loan and it stays in the sellers name without a release of liability. The buyer and seller sign agreements stating the buyer will be making future loan payments and a Deed is recorded from the seller to the buyer. (In the Contract for a Deed, the Contract is recorded but the seller retains the Grant Deed until the agreement is fulfilled) However in all the above transactions the “due on sale” provision in the Trust Deed and/or Mortgage is ignored.
The “due on sale” clause is contained in almost all State and Federally Chartered Institutional Trust Deeds and/or Mortgages secured by real property. The following is a brief thumbnail history and explanation for the purpose of familiarizing readers with the “due on sale” clause. This explanation is not meant to be a legal dissertation, rather a simple explanation to readers not familiar with the concept.
Two significant court rulings commenced the movement toward this bank objective. One of these cases was Wellenkamp which involved a California State Chartered Bank and the other was De la Questa involving a Federally Chartered Bank. Both of these cases involved the then due on sale clause in the lending agreements. The Wellenkamp case the court ruled the “due on sale” clause unenforceable. In De La Questa the clause was upheld. Needless to say this situation caused mass confusion in the industry, which was cleared up in the Garn St. Germain Act, which is the legislation supporting the “due on sale” under which we now operate.
A lot of confusion and opinions swirl around these kinds of non-traditional transactions. My advice is simple: “Read the Trust Deeds Document and/Or Mortgage” this will clear up about 99% of the questions and confusion. There are a few events when the lender Cannot Call the loan “all due”. In all other transfers of property the lender can call the loan. Take a look below and review these exceptions:
Sec. 701j-3. Preemption of due-on-sale prohibitions
With respect to a real property loan secured by a lien on residential real property containing less than five dwelling units, including a lien on the stock allocated to a dwelling unit in a cooperative housing corporation, or on a residential manufactured home, a lender may not exercise its option pursuant to a due-on-sale clause upon –
(1) the creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property;
(2) the creation of a purchase money security interest for household appliances;
(3) a transfer by devise, descent, or operation of law on the death of a joint tenant or tenant by the entirety;
(4) the granting of a leasehold interest of three years or less not containing an option to purchase;
(5) a transfer to a relative resulting from the death of a borrower;
(6) a transfer where the spouse or children of the borrower become an owner of the property;
(7) a transfer resulting from a decree of a dissolution of marriage, legal separation agreement, or from an incidental property settlement agreement, by which the spouse of the borrower becomes an owner of the property;
(8) a transfer into an inter vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property; or
(9) any other transfer or disposition described in regulations prescribed by the Federal Home Loan Bank Board.
My first experience with the “due on sale” transaction(s) occurred in the late 1970’s during the Carter administration. The prime rate soared 22% and it was almost impossible to obtain a loan. There was no “due on sale” on the existing low interest loans originated back in the 50’s and 60’s. So the standard method of purchase financing simply involved buyer assuming or taking title subject to the existing loan, executing a 2nd in favor of the seller together with a cash down payment. It cost about $100.00 for a formal assumption and release of liability for the seller. A great solution, right? But wait! The institutional lenders, whose loan was being assumed, were paying 22%+ to get money and had all these old low interest loans being assumed on the books. The banks wanted a legal way to get these old loans rewritten at a higher rate upon transfer of the real property
No, It’s not a crime.
No, writing a sale on a Wrap Around, a Contract or with a Subject To is not a crime. But the buyer needs to understand, and the seller needs to disclose in the selling agreement, that there is, or may be, a right on the part of the lender to “call” the note due if the property is sold without express written consent of the lender.
Even when all the parties recognize the risk of the lender calling the loan due if they find out the property has been sold and the loan has not been paid off, the parties may still wish to move forward with the deal. Typically, the seller is so motivated to sell that he will agree. The buyer/investor is motivated to move forward because the deal may be extremely profitable.
The parties are not obligated to wave a large red flag in the lender’s face; the practice is not a crime. Just be aware the lender may indeed call the loan due and if they do, an alternative financing plan should be in place, so that the buyer doesn’t lose the property and the seller doesn’t get sued on the note.
It could even be argued that selling a property “Subject To” is really not a very smart thing to do. Just think, you have transferred your ownership interest in the property to someone else (usually someone you do not know); however, you have remained responsible for the underlying loan on the property. If they don’t make the payments, guess whose credit is ruined? You’re right, yours!
On the other hand, what if I was a seller about to loose my property if I didn’t sell. Then someone came along willing to bail me out by selling on a wrap or a “subject to”, I would be willing to sell this way. But I would make sure to have the buyer sign off that he understands his risk and releases me of any and all liability in the event the lender does call the note. Also, I would take a hard look at the buyer to make sure he had strong enough credit and cash flow to make the payments. Getting a good down payment wouldn’t hurt either.
Seller remains on “Hot Seat”
We received a call from a motivated note seller with a note secured by property owned by Richard (Trustor). Upon reaching an agreed upon purchase price the deal was consummated. The note did not contain a “due on sale clause”; therefore, there was no problem if Richard ever wanted to sell the property. Richard made his payments on time for several months. We noticed the payments were now coming from a different party who informed us there had been a change in ownership.
Then, the payments stopped coming and the loan became delinquent. We notified Richard. Why, Richard? Well, when good ‘ol Richard told us he had sold the property and he was no longer responsible for the loan, Surprise! Surprise! I had to inform him there had not been a release of liability arranged for when he sold and he was still liable for the loan even though he did not own the property. Furthermore, if the payment was not made, a notice of default would be filed and foreclosure would follow. Of course, this would all go against his credit, not his buyer, as the buyer had no responsibility to pay me. What a terrible position to be in. Think about it! Richard did not own the asset, but did owe the money.
The Lender won’t call the loan – Dream On!
If you think a lender will not enforce the “due on sale” provision in a trust deed, here’s a story that will curl you hair. It happened to me. I made a loan to a couple secured by a second trust deed. After making payments on the loan for a year, they ceased making payments. However, they kept the first loan current.
After discussion and failed promises, I filed a notice of default and subsequently completed a foreclosure. My payments on the first were kept current on my new property while attempting to sell. The bank accepted a few payments, then notified me they were calling the loan because there was a change of ownership and gave me 30 days to pay them off. The interesting part is: the interest rate on the loan was 10% and the market rate at the time was 8%. Made no sense at all … but the point here is, lenders do enforce the “due on sale”.
I realize some who read this can make a point that the lender could not call the loan because I received the property back through foreclosure. I tend to agree, but think of the cost, time, headache hassle, attorney costs, and time getting through the court system. Been there, done that – not for me. Rather then go through all this we just paid off the bank, and then sold the property.
Many appear almost cavalier in their thinking these days because interest rates are so low, the chances of lender calling a loan is nil. After all, why would they want to call a loan only to replace it with another loan of lower rate? Even if they don’t (as they did above) may I caution you not to bury your head in the sand. Do you really think lenders will allow the low interest loan to remain on the books, when they have the lawful option to replace them on transfer of the property to a higher rate loan? Think about it!
The Sleeping Giant
The “Subject to” transactions are very popular these days. With interest rates low, investors, buyers and sellers seem lulled into thinking the lender has gone to sleep. When interest rates rise again, will the Sleeping Giant awaken? If you think there is a probability, you had better cover the bases now. It would be prudent for anyone involved in doing transaction that are “Subject To” to do your homework and completely understand the risks and take proper safeguards to protect yourself and all parties in the transaction including full disclosure of the risks as well as the rewards.
History does repeat itself. I was talking to a lender just the other day who indicated this time around, banks are already preparing for the opportunity to increase their yield using the window of the “due on sale”. I can envision where a lender hires an entry level employee and instructs them to look through the loan portfolio(s) to find evidence of transfer of ownership for violation of the “due on sale”. It wouldn’t take many loans “called” to justify the salary and result in an increased yield to the lender.