By Benny L. Kass
Saturday, May 17, 2008

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.

Unfortunately, your options are limited. If there were no second trust (i.e., the home equity loan), your borrower could give the property back to you by way of a "deed in lieu of foreclosure." But that would mean that you would be stuck with the home-equity loan.

There are two paths you should explore. First, sit down with your borrower and try to work out an amicable deal. I know that you want the money to buy that new house, but I don't think that is going to be possible. You may want to extend the term of the loan, say by one or two years, and at the same time increase the interest rate so that, at least, you will be getting a larger monthly mortgage payment. Perhaps in a year or so, the real estate market will bounce back.

You or your lawyer should also talk with the bank that made the home-equity loan. Explain that if you cannot work something out, you will foreclose on the property in August. Because that would wipe out the bank's security in the house, the bank might be willing to work with you and the borrower. For example, the bank could buy the promissory note your borrower gave you. The bank would then be in first-trust position.

The bank may be willing to entertain this suggestion, but it is unlikely to buy the loan at face value -- for instance, it may offer you 75 percent of the value of your $275,000 promissory note. You then have to make a business judgment: Will you make out better if you foreclose on the property?

You have to determine the true value of the house in today's market. If it is still worth about $500,000, then perhaps foreclosure will be your best bet. You will start the bidding at the foreclosure sale at $300,000 (this will pay you the full amount of your loan plus the costs of the foreclosure), and perhaps someone will get a good deal.

But the lower the value of the house, the lower your chances are that someone will buy it. If no one shows up at the auction or if there are no decent bids, you will end up owning the house. I seriously doubt that you want that to happen. You do not want to pay the real estate taxes and the insurance on this property, with no certainty when you will be able to resell. In addition, you would probably have to take legal action to evict your borrower.

Seller financing can be a good selling tool but should be used as a last resort. You have a serious problem, with limited solutions. Unfortunately, you will have to make some compromises because I suspect that you will probably not get back all of your money.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, www.kmklawyers.com.