Why Seller Financing Should Be a Last Resort

Q: Five years ago this August, we sold our house. We provided owner financing by taking back a first deed of trust for $275,000. The borrower gave us a $25,000 down payment. This was an interest-only five-year balloon loan with a monthly payment of $1,200. We do not plan to renew this loan because we want to buy another property this year.

The buyer has indicated that she thought the balloon would not be due until 2009. Two years ago, she obtained a home-equity loan for $200,000, at a time when the house was appraised at $500,000. Now she is hinting that she might not be able to pay us back the principal.

Why did her bank give her that loan and not do the math about our existing mortgage? Can we, as lenders in a primary position, foreclose on the property? What are the procedures in this situation?

A: Why did her bank give her that loan? Because mortgage lenders, until recently, seemed to think that real estate could only keep appreciating. The bank wanted another loan in its portfolio. And the loan officer no doubt made a healthy profit for himself, too.

I hope that you required your borrower to sign a deed of trust (the mortgage document) that was properly recorded in the jurisdiction where the property is. The deed of trust is the security that all lenders rely on when making a mortgage loan because that document provides the authorization to foreclose.

You can find information about your loan and other loans on the house through the local office of the recorder of deeds. You want to make absolutely sure that your loan is in first place, ahead of the bank's home-equity loan. And you also want to determine whether there are any other impediments to the title, such as tax liens. It would be a good idea for you to retain a lawyer and get a complete title search.

If you are in first position -- and if your borrower is in default on the terms and conditions of your loan documents -- you have the right to foreclose. That will erase the bank's second trust. The bank will still have the right to sue your borrower for the money owed, but that may be a useless gesture if she has no money.

The deed of trust and the promissory note your borrower signed are important. You should read these documents carefully. They spell out when and how the borrower is determined to be in default. Clearly, nonpayment is considered a default. However, it sounds as if your borrower is current with her monthly payments, so at this time you cannot initiate a foreclosure on the grounds of nonpayment.

Some deeds of trust also state that the borrower would be in default if additional financing is obtained from another source without the lender's consent. That would include a home-equity loan. If such language is in your legal documents, then you can declare your borrower in default and proceed to foreclose.

Otherwise, you will have to wait until the August due date.

The procedures regarding foreclosure vary from state to state. In some states, court action or approval is not required. This is known as a nonjudicial foreclosure. In other states, a court has to approve the sale only. In a few jurisdictions, the foreclosure has to be specifically authorized by a court, a procedure called "judicial foreclosure."

Your lawyer can assist you with the process. Most loan documents provide that in the event the lender has to take legal action against the borrower, the borrower must pay reasonable legal fees incurred by the lender. However, if your borrower has no money to pay the loan, she probably does not have money to pay the legal fees, either.