Q)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)A second trust is a very common method of financing house purchases. During the early 1980s, when many borrowers were unwilling or unable to pay 15 to 18 percent interest on mortgage loans, they resorted to some form of "creative financing." Generally when we use this term, it means the seller is involved in the financing in one form of another.
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 note holder does foreclose, the person who purchases at a foreclosure sale buys subject to the existing first trust. 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 of $60,000 on the property. The seller receives $10,000 cash at settlement, and takes back a second trust for the balance of the purchase price, which would be $30,000.
If the purchaser falls behind on payments on the second trust, the second trust holder has the right to declare the note in default and institute foreclosure proceedings. These proceedings vary between jurisdictions in the Washington area, so consult your attorney for details.
When the foreclosure sale takes place, investors can bid on the house, and of course they trying to find a good deal. You, as the second trust note holder, can also bid on the property and in many cases you will do so primarily to protect your own investment in the house.
The successful bidder then owns the house, but subject to the terms and conditions of the first deed of trust on the property. When considering purchasing at a foreclosure sale, it is advisable to discuss the situation with the first mortgage lender.
It may 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 might have to pay off in full the $60,000 first mortgage that your buyer 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 will 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 second deed of trust would have no further validity. You still, of course, have the right to sue the buyers on the promissory note they signed, but unless those persons have cash or other assets, such a suit might be a fruitless gesture.
I have attempted to paint a picture that encourages a very cautious and conservative attitude toward 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 to go ahead with one:
A cross-default provision. You want language in your deed of trust stating that if the borrower defaults on the first trust, he or she also automatically defaults on your note.
There should be a provision in the note and deed of trust requiring the borrower to obtain adequate homeowners' insurance coverage, naming you (the lender) as beneficiary in the event of a fire or other destruction of the property. Additionally, the buyer should present evidence to you, at least once a year, that the real estate taxes and insurance policies have been paid.
The promissory 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 later.
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 promissory note and deed of trust, you will have the minimum protection that you require. You should obtain the original promissory 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.
You should also contact the first trust lender and try to get it to agree to notify you if it institutes foreclosure proceedings. The first trust lender often will be cooperative, but it does not have a legal obligation to notify you. But if you foreclose as the second trust holder, it is your obligation to notify the first trust holder.
To sum up, you should make sure that your interests are protected, and that there is adequate security in the property before you enter into a transaction. If, for example, the first trust lender made a loan of $80,000, you would be unwise to take a second trust of $20,000. This leaves you barely enough room, since there is little or no equity left in the property.
Benny L. Kass is a Washington attorney. 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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.