Summary: Real Life Example
Assuming someone else's low-interest loan can be a legal and financially beneficial move. It can lead to significant financial benefits in the form of lower payments, making it an attractive opportunity for savvy investors. However, it's important to note that this may not always be the most prudent course of action.
Most trust deeds and mortgage documents contain an alienation clause, also known as a due-on-sale clause, which provides for the acceleration of the debt upon transfer of ownership. This means that if the property is sold or transferred to a new owner, the lender has the right to demand immediate repayment of the loan. Many purchasers will refinance to avoid this, but others want the benefit of the low interest rate on the first lien.
Most trust deeds and mortgages provide for a "due-on-sale" or "alienation clause." If the security document does not contain this clause, the loan is considered "assumable." A new owner has the right to take over the loan due to the absence of an acceleration provision.
https://www.investopedia.com/terms/a/acceleration-clause.asp
If the lender discovers the undisclosed transfer of ownership, they have the right to call the loan due and payable, putting the property owner in a precarious financial situation.
Given the complexities and potential legal implications of such transactions, the proposed new property owner must seek professional counsel or a qualified lawyer. This is not just a recommendation, but a crucial step that can provide reassurance and ensure all legal aspects are handled correctly, instilling confidence in decision-making.
Article:
Consider this scenario: a borrower acquires a single-family property without a formal bank loan assumption as the first lien. The title to the new property now belongs to the new owner. However, a first lien remains in the previous owner's name, with the original lender having a recorded security instrument against the property. This transaction, known as 'taking the title subject to' without lender approval, means the new owner has assumed ownership of the property and its associated financial obligations without the lender's consent. This action carries significant risks, as we'll explore further, and it's crucial for all parties involved to be fully aware of these potential pitfalls, which could have severe financial and legal implications.
The procuring mortgage broker said....
"My clients want to borrow some cash and will agree to place a second trust deed on their property. Five years ago, they purchased the property "subject to" a first lien that an institutional lender had made to the prior property owners. The recorded trust deed document lists the prior owner as the borrower, not the current owner. They have benefited from significant equity build-up because the property has substantially increased in value."
The savvy lender, knowledgeable about the potential risks and legal implications of such transactions, responds....
The lender's response to this situation is crucial. We noticed a 'due-on-sale' and 'due-on-further encumbrance' clause in the first trust deed that could be problematic. The first trust deed lender has the right to call the loan due and payable upon transfer to the present owner if they discover a violation of the loan documents. In this case, the lender was not notified of the transfer, which they see as Intentional deception to avoid the due-on-sale clause.
Intentionally deceiving a federally related lender has dire negative consequences. As interest rates rise, the first lien lender may become motivated to accelerate the loan to free up capital to lend to another party at a higher rate. The first lender may declare the loan due and payable, triggering a default that could result in potential foreclosure and loss of the property.
The Garn-St. The Germain Depository Institutions Act of 1982, which took effect on October 15, 1982, provides exemptions that limit the circumstances under which a lender can call a loan due and payable. This act offers a sense of security for certain property owners, but not all, ensuring they are not unduly penalized in such transactions. For example, it allows for certain transfers without triggering the due-on-sale clause, thereby protecting the property owner's rights. This act protects property owners in certain situations, preventing lenders from immediately calling the loan due and payable.
The specific provision is located in 12 U.S. Code 1701J-3. Therefore, if a first trust deed contains a due-on-transfer clause, the lender may or may not be prohibited from exercising the due-on-transfer provisions, depending on the type of collateral property and the applicable exceptions.
Exceptions to the Due on Sale Clause and Due on Further Encumbrance:
Transfer to a spouse or children of the borrower.
Transfer to a relative resulting from the borrower's death.
Transfer because of the death of a joint tenant or tenant by the entirety.
Transferring to a trust where the borrower is the beneficiary does not relate to the transfer of occupancy rights.
https://www.law.cornell.edu/uscode/text/12/1701j-3
https://www.fdic.gov/regulations/laws/rules/8000-8300.html
https://www.alblawfirm.com/case-studies/due-on-sale-clause/
In this example, brokers and lenders representing private-party investors will assess the risk of proceeding with a second loan. Many brokers, lenders, and their private party investors will not agree to make this loan (junior lien) because the first trust deed lender has the right to call the loan due. Others will assume the calculated risks with knowledge of the transaction. The prohibition from calling the loan due and payable on transfer may or may not apply. This complex legal issue requires a lawyer to determine the outcome.
Other than relying on specific exemptions, the due-on-encumbrance provision in any security instrument applies. Purchases, taking the property subject to a lien, are no longer viable with an inquiry into the specific loan documents, the deed of trust, and the loan agreement.
As part of the lender's due diligence, ordering and reviewing copies of the promissory note, deed of trust, and loan agreement is required. The "due on sale" and "due on encumbrance" provisions will appear in the loan agreement, if one exists. Additionally, the lender should order a beneficiary statement from the first trust deed lender or obtain 3 to 6 months of payment statements supplied by the borrower.
Many written clauses in the promissory note, deed of trust, and loan agreements may increase risks. The promissory note is the promise to pay. The recorded deed of trust is a legal instrument used to create a security interest in real property. A loan agreement, typically in the context of complex commercial loans, represents a legally binding contract that meticulously delineates the terms and conditions governing a loan transaction. In addition to these terms and conditions, the agreement includes representations and warranties made by the borrower to the lender concerning the impending loan transaction.
With a trust deed, the legal title is transferred to a third-party trustee. The trustee holds the title on behalf of the lender or beneficiaries. The trustee's role is to ensure that the terms of the trust deed are fulfilled and to act in the best interest of the lender and beneficiaries. In other words, the trustee is a neutral party with limited rights.
One problematic clause in the deed of trust is an "alienation clause," also called a "due-on-encumbrance clause." This clause allows the lender to demand immediate repayment if the property is used as collateral for another loan. Another problematic clause would be a negative-amortization adjustable-rate mortgage, where the principal balance increases with each payment, potentially leading to a situation where the property is worth less than the outstanding loan balance. Being alert and cautious when dealing with these clauses is crucial, as they can erode the protective equity and create unwanted risks for the second trust deed investor.
Another concern for a new lender is when the deed of trust clauses permit additional advances or modifications of other deferred payments. Deferred payments would increase the principal balance and erode the protective equity. Protective equity is the difference between the fair market value of the property and the outstanding balance on the loan(s). When the principal balance increases, the protective equity decreases, increasing the financial risks for the second trust deed investor.
The lender will review other problematic clauses in the loan documents relating to the risks of a second lien. Diligent underwriters will read the promissory note, deed of trust, and loan agreement and obtain recent payment and beneficiary statements to address these issues.
As an agent of the private party beneficiaries (the private parties), the lender may request a lawyer's review of this transaction and the prior purchase transaction to ensure compliance and make informed decisions. This legal review is not just a formality but a crucial step in understanding and adhering to these legal requirements, which are essential to avoid potential issues and ensure a secure transaction.