The concept of "real estate financing" usually implies that an institution such as a bank or savings and loan association will somehow be involved in the mortgage process. However, it often happens that second trusts and second mortgages are direct arrangements between buyers and sellers, situations in which sellers make loans to purchasers and thus assume a new role, that of a lender.
While commercial lenders are in the business of processing loan papers and making mortgages, individual sellers rarely have an equal level of expertise or training and the steps required to develop such financing may be unknown. Buyers need to be concerned about the formulation of second trusts since late payments--or no payments--may trigger a nasty foreclosure procedure.
The rules governing second trusts are established in the jurisdiction where the property is located. Different jurisdictions have vastly different approaches to second trusts and both buyers and sellers should investigate such financing with care before ratifying a real estate sales agreement. Here are several areas that should be examined when considering the use of a second trust or mortgage, regardless of whether or not the lender is a financial institution or an individual seller.
* Interest. What is the proposed rate of interest? Many states have usury laws that establish maximum rates of interest for various kinds of financing. If the interest rate exceeds the usury level, the lender may suffer severe penalties. In some cases, a distinction is made between the rate that is allowable for residential second trusts and for second trusts that are part of an investment purchase. Therefore, the purpose of the loan may influence the rate being charged.
When money is tight, market conditions may require high-interest levels to justify a second trust. But what happens if the usury limit for second trusts is 20 percent and a fair market return is 22 percent? In such instances, either the loan will not be made or the terms of such financing will be adjusted so that usury rules are not violated. For example, rather than having a $20,000 loan at 22 percent, a buyer and seller may agree to other terms, perhaps a $23,157.90 loan at 19 percent interest.
* Payment. Second trusts are usually designed so that borrowers can make relatively small monthly payments, plus the short term which second trusts generally feature often require a balloon payment at the end of the loan term. How much is the monthly payment? How large is the balloon payment? Where, specifically, will the borrower get the money to repay the balloon payment? By refinancing? Through an inheritance? Savings? If savings, why not structure a self-amortizing loan initially and avoid the whole issue of a balloon payment?
* Format. Standardized real estate contracts commonly call for the precise wording and terms of a loan to be "in the lender's usual form." This means the lender gets to make the rules. If you are a seller/lender then surely you should insist on the same right.
* Servicing. Commercial loan payments can be made at the institution where the loan originated, by mail or electronically from one commercial lender to another. But what about loans that are made by property owners? In many cases, borrowers simply mail monthly payments to second trust holders, a system that may be disrupted if payments are delayed or lost in the mail. To assure that payments are being made--and received--in a timely manner, it may be best to make payments to a local commercial lender who can date and verify the payment and then forward the money to the second trust holder. For more information about establishing such accounts, speak to officers at local savings and loan associations or banks.
* Restrictions. Local rules concerning second trusts may contain a variety of conditions, requirements and restrictions. In the District of Columbia, for example, the right to make a second trust with a balloon note may vary according to whether or not the seller is an owner/occupant or a non-occupant (investor) owner.
* Insurance. Sellers making second trust loans should be concerned with two insurance issues. First, commercial lenders insist on title insurance, of which they are the beneficiary, to at least the value of their loan so they will be protected in the event title to the property is faulty. Second trust lenders often require similar protection so they can be repaid in the event of a title dispute.
Second, commercial lenders routinely require property owners to maintain adequate fire, theft and liability insurance on the property. Second trust holders can have the same requirment, which means that seller/lenders should also get copies of the original policy (at settlement) as well as updates showing that the policy remains in force and that timely premium payments are being made.
* Continuation. If a situation develops where a borrower cannot repay a balloon note, serious questions arise for both the buyer and seller/lender. Should the property be foreclosed? Is there a way the note can be refinanced or extended? One approach to this problem has been developed in Maryland. Borrowers in that state who made balloon notes after July 1, 1982, may unilaterally extend the term of their notes for up to two years, which means that monthly payments would be continued but the balloon payment would be postponed. Does this type of regulation govern balloon notes in your area? If you are a seller, how would deferral of a balloon payment effect your personal finances? Would such a regulation make a second trust unworkable?
* Default of a First Trust. Since first and second mortgage holders are often paid separately, the maker of one note may not know if payments on the other loan have been missed. Many second trusts contain a provision so they are automatically in default if the first mortgage is not properly paid.
* Taxes. The seller/lender will certainly want to know that taxes on the property are being paid in a timely manner. Borrowers may be required to present proof of payment.
* Trustees. If the second note is a "trust" and not a "mortgage," then the owner/lender should have the right to name the trustee or trustees.
* Credit. The willingness of an owner to hold a second trust should be contingent on a review satisfactory to the owner/lender of the borrower's finances and credit. This means that a lender should have the right to see a borrower's credit report and, if the borrower is self-employed, past tax returns as well.
The areas above clearly suggest that second trusts may contain a host of potential problems for the unwary. To avoid needless difficulties, it is essential to consult an attorney who is familiar with such financing in the jurisdiction where the property is located.
Next Week: Looking at Balloon Notes.