Q: We own a small house in Northeast Washington. We plan to retire shortly and our house has been on the market. Recently, a nice young couple gave us a contract under which they would assume our first mortgage and we would take back a $15,000 second mortgage at a 12 percent rate.
The arrangement on this second mortgage was for the purchasers to make monthly payments of $154. The entire balance of the note would be due in three years. Several people are telling us, however, that this kind of second mortgage is not legal in the District.
A: Unfortunately, when the D.C. City Council recently amended the usury laws, they inadvertently threw out one of the most important financing tools for the average homeowner. Having read and reread the usury law for the District, it is my opinion that second trust balloon notes on houses are usurious -- at any rate.
Let's look at this whole picture carefully. A balloon note is a transaction where the monthly payments are low (usually based on an amortization of 20 to 30 years,) but the entire balance becomes due -- in other words, balloons up -- within a shorter period of time. The usual period for this kind of payback ranges between three and five years. t
In your example, to amortize a $15,000 note at 12 percent over three years would require monthly mortgage payments of $498. Needless to say, this is rather steep for anyone's budget. Accordingly, you were attempting to work out an arrangement where the $15,000 would be paid out on the basis of a 30-year spread -- at $154 a month -- but within three years the balance would be due.
Since one rarely reduces principal by much during the first few years, at the end of the three-year period a little less than the full $15,000 would be owed.
Your buyer was hoping inflation would escalate the value of your house. Presumably, at the end of the third year, your buyer would refinance, pulling out the $15,000 from the equity in the property and paying you off in full. I suspect that your buyer was also hoping that the interest rates would be lower in three years and thus the refinance might also have the effect of lowering the monthly payments.
Unfortunately, several years ago the balloon note created serious problems for many unsuspecting homeowners. Shady and fradulent home improvement contractors, touting aluminum siding or driveway repairs, had homeowners sign promissory notes calling for extremely low monthly payments. But at the end of one or two years, the entire note ballooned up.
Since the unsuspecting homeowners had secured the promissory balloon notes with second deeds of trust on their properties, those homeowners who were unable to meet the balloon payments had their homes taken away.
To protect against this problem in the District, the City Council several years ago prohibited second trust balloon notes if the simple interest rate exceeded 8 percent. According to the language of the law, the loan needed to "contain a schedule of payments under which each payment shall be equal to, or substantially equal to, the other payments and the intervals between payments shall be substantially equal."
Thus, since the proposed second trust in our transaction provides for monthly payments that are not equal to the final payment (the one that balloons), your note is considered a balloon note. Under the orginial law enacted by the council several years ago, you could have at least taken back that form of second trust at an interest rate of 8 percent.
Unfortunately, when the council revised its usury laws last October, it restructured the entire legislation. Currectly, there is no doubt that any balloon note on residential property in the District -- other than that secured by a first deed of trust -- falls within the usury law, and I cannot recommend that the seller take back such a loan. The penalty in the city for violating the usury law is forfeiture of all the interest.
There are exceptions, however, to this usury law. If the balloon note is secured by a first deed of trust, it is acceptable. If you are prepared to take back that same second trust, with only one payment at the end of three years -- the full $15,000 plus the interest that accured -- this is not a balloon note and is legal. This way, while you would lose the ability to get monthly payments, you still can assist your buyer and your note is secured.
Additionally, if the borrower is a not-for-profit corporation or a religious organization -- or is intending to use the loan for carrying on a business, professsional, commercial or investment activity -- the balloon provisions of the usury law do not apply.