Q: In this day and age of Supreme Court cases upholding the "due on sale" clause, and the apparent unwillingness of many mortgage lenders to allow assumptions, the average seller is forced to take back secondary financing. My husband and I are about to sign a fairly attractive contract to sell our house, but we are being asked to take back a large sum of money in the form of a second trust. The monthly income will be adequate for our needs, but we are concerned about the security of this loan. Your comments would be helpful.
A: The National Association of Realtors believes that more than 60 percent of all home sales last year throughout the nation involved some form of "creative financing." Generally, when we use this term, it means that the seller is involved in the financing of the purchase in one form or another.
A second trust is a very common method of financing house purchases. Indeed, long before the current economic crisis in the housing market, the second mortgage (deed of trust) was a very common technique--especially in commercial transactions.
The general rule of law is that a second trust holder has the right to foreclose on property in the event of a default. However, if a second noteholder does foreclose, the person who purchases at the foreclosure sale buys subject to the existing first mortgage. To explain this in simpler terms, let's look at the following example: The purchase price is $100,000. The purchaser places a first deed of trust on the property in the amount of $60,000. The seller receives $10,000 cash at settlement, and takes back a second trust for the balance of the purchase price--in this case $30,000.
If the purchaser falls behind on the payments on the second trust, the second trust holder has the right to declare the note in default and can institute foreclosure proceedings. These proceedings vary between the various jurisdictions in the Washington metropolitan area, and you should consult your own counsel on these details.
When the foreclosure sale takes place, interested investors can bid on the house, and of course they do so with the objective of getting a good deal. You as the second trust noteholder can also bid in on the property, and in many cases you will do so primarily to protect your own investment in the house.
Regardless of who is the successful bidder, that person owns the house but subject to the terms and conditions of the first deed of trust on the property. Before one should consider purchasing at a foreclosure sale, it is advisable to discuss the situation with the first mortgage lender.
It may very well be that the first lender will decide that the loan is not assumable, and thus when the property is sold at the foreclosure sale, the first lender will exercise the "due on sale" clause calling the entire note due. In our example, if you buy back the house at a foreclosure sale, it is possible that you would have to pay off in full the $60,000 mortgage that your buyer originally placed on the property.
It should also be kept in mind that if the first-trust holder forecloses on the property, it is conceivable that your second trust would be totally wiped out. For example, if your buyer was in default on the payments to the first lender, and if they foreclosed and the property sold only for $60,000, your $30,000 deed of trust would have no further validity. You still have the right, of course, to sue the buyer on the promisory note they signed, but unless that person has cash or other assets, such suit might be a fruitless gesture.
I have attempted to paint a very cautious and conservative picture regarding second trusts; they should not be entered into lightly. There are many important provisions that should go into your second deed of trust if you decide or have to go this route.
A "cross default provision." You want language in your deed of trust that, in the event the borrower is in default on the terms of their first trust, this will also automatically trigger a default on your note.
The promisory note and deed of trust should contain a very tightly drawn due-on-sale clause. You may be prepared to lend your buyer money to purchase the house, but you do not necessarily want that loan to be assumed by a third purchaser down the road.
A provision should be included in the note and deed of trust requiring the borrower to maintain adequate homeowner's insurance coverage, naming you (the lender) as beneficiary in the event of a fire or other destruction of the property. Additionally, the borrower should present evidence to you, at least once a year, that the real estate taxes and insurance policies have been paid.
You should name the trustees. We use deeds of trust in this area. This means that the property is deeded in trust to at least two trustees who have the right to sell the property at a foreclosure sale in the event the borrower is in default.
With these provisions included in the promisory note and deed of trust, you will have the minimum protection that you require. You should obtain the original promisory note shortly after settlement, and make sure that the settlement attorney or title company handling the settlement puts your name and mailing address on the deed of trust. After it has been recorded, it should go back in your files.