While the term "assumption" is used generally to describe mortgages that are passed from seller to buyer, more specific definitions are required to resolve the important issue of who is responsible to the lender if loan payments are missed?
To determine the precise obligations of buyer and seller in the event of default, one must see if the property has been purchased "subject to" the mortgage or if the loan has been "assumed."
In cases where property is purchased "subject to" the mortgage, it is understood that the buyer is not responsible for the repayment of the loan. If payments are not made by the buyer, the lender will seek compensation from the original borrower.
While the buyer may have little responsibility to repay the loan, it would take a truly irrational person not to recognize that default means foreclosure, the loss of any equity invested in the property and the total improbability of future mortgage borrowing.
When mortgages are "assumed" and the buyer agrees to be responsible for the entire debt, the lender can pursue both the original borrower and the purchaser in case of default.
Properties purchased with assumed financing or "subject to" the mortgage represent deals between buyers and sellers rather than lenders and borrowers, except when the "consent" of the lender is given. This means that it is possible for freely assumable financing, such as most FHA or VA mortgages, to be passed from seller to buyer even when the purchaser is unknown to the lender or is considered financially unqualified.
Lenders may not be able to prevent the takeover of freely assumable mortgages, but, in turn, they are not required to release original borrowers from the repayment obligation. After all, if sellers could merely pass on the responsibility to repay mortgage debts, it would be simple to harm a lender. Here's what could happen in the worst case.
Smith bought a property 10 years ago for $100,000 that was financed with $20,000 in cash and a freely assumable $80,000 mortgage. Because of flooding, the value of Smith's property has dropped substantially. To reduce his loss, Smith sells his home to a vagrant who agrees to assume the original loan.
The vagrant makes no payments on the mortgage, and the bank soon forecloses. The mortgage balance is $75,000; the foreclosure value is only $40,000. The lender suffers a loss of $35,000 plus foreclosure expenses.
How much liability, in real terms, do original borrowers have when a loan is assumed or payments are continued "subject to"? Since the overwhelming majority of all mortgages is never in default there is only the most limited possibility that a lender will pursue an original borrower for compensation. Even when a loan is defaulted, original borrowers still benefit from several practical protections.
First, the innate value of the property is generally far greater than the balance of assumed financing.
Second, in those sales that feature large down payments and second trusts, the original borrower's liability for a first trust is well defended because all proceeds from a foreclosure sale would first be applied to the repayment of that debt before payments would be made for a second trust or to the purchaser. In "no cash" or "cash-plus" sales however, the seller's protection would be limited, if not nonexistent.
There are some who argue that it is a good strategy to remain liable for a mortgage. If the buyer defaults, it is suggested, it may be possible to get the property back at discount, perhaps by repurchasing from a buyer faced with foreclosure.
Whether or not it will be possible for original borrowers to get a release depends on the policies of the lender. Lenders, however, have little incentive to release original borrowers except in those cases where the terms of the mortgage can be structured more favorably in their behalf. These include the following:
* Higher Interest. A lender may authorize a release for the original borrower if the interest rate on the loan can be raised.
* Buyer Qualification. Lenders have a clear and understandable desire to assure that new borrowers will be creditworthy. Raising interest rates is a useless exercise if a new borrower cannot afford monthly mortgage payments.
* New Papers. In some instances lenders will release original borrowers if they can issue a new mortgage with the same terms as the first loan. A new mortgage, rather than a mere continuation of the old loan, will generate additional fees to the lender.
* Assumption Fees. Assumption fees are charges made by lenders to cover the cost of processing new paperwork. However, some lenders see such charges as profit-centers and exact substantial payments to permit a release.
In addition to getting a release directly from a lender, original borrowers may also need a release from other parties associated with the mortgage such as the Veterans Administration, Federal Housing Administration and private insurers.
VA borrowers can be released from all liability, according to the VA, "by having the purchaser assume all of the veteran's liabilities in connection with the loan and having the VA approve the assumption agreement and specifically release the veteran from all further liabilities to VA."
Being released from liability is a distinct process from any possible restoration of entitlement.
Again to quote VA materials, borrowers may have their entitlements restored when "the loan has been paid in full, or the VA otherwise has been relieved of the obligation under the guaranty and the home has been disposed of" or a VA-qualified buyer has "agreed to assume the outstanding balance of the loan, has consented to substitute his or her entitlement for that of the original veteran-borrower" and meets all other current VA requirements. For more information, contact the nearest VA office (at 275-1400 in the Washington area) and ask for Pamphlet 26-4 and the "ROL/SOE Package."
The release procedure through the FHA varies from the VA format. With FHA loans, lenders submit an application for release (FHA Form 22-10) and a credit report (Form 2900) on the new borrower. If the FHA is satisfied with the creditworthiness of the new borrower, it will inform the lender.
Note that in both cases there is no requirement for the lender to release the original borrower. Also, FHA procedures, unlike those of the VA, envision communication between a lender and the agency rather than the agency and an individual borrower.
For information about private mortgage insurers, which guarantee to pay lenders if a mortgage borrower defaults, consult with the insurer directly or the lender.
If a release is important, original borrowers should be certain that the sales contract outlines the buyer's obligations, providing credit information, completing forms, for example. Alternatively, buyers may view a request for a release as a bargaining chip, one that might be traded for a reduced sales price or other consideration.
Questions to ask include: What are the lender's release policies? Will a release result in additional fees and costs beyond a nominal sum if a loan is assumed or taken over "subject to"? If you are an original borrower, do you feel you require a release?
Next Week: Second-Party Financing.