Subject To Financing -- an Endangered Species

Subject To Financing - an Endangered Species By Gary Mialocq, Ph.D. One of the most popular means of investing in real estate over the past several years has been "subject to" financing - meaning you take over the payments on the existing loan(s) subject to the existing terms and conditions. The seller remains on the loan and you to take title to the property. Many years ago, both FHA and VA would allow you to assume their loans without a down payment and without qualifying. No longer. There is one major pitfall about this type of financing and that is that it violates the Due on Sale Clause (DOSC) and the lender has the right to call the loan once the seller transfers title to the Buyer. Many investors laugh and say that they've never heard of the DOSC being invoked. The Due on Sale Clause The due-on-sale ("acceleration clause") is a provision in a mortgage document which gives the lender the right to demand payment of the remaining balance of the loan when the property is sold or transferred. It is a contractual right, not a law. A violation of the DOSC is NOT illegal. It is a violation of the contract provision and compromises the lender's wishes which can result in termination of the mortgage and foreclosure on their security at the lender's discretion. In the event of such action, it would be sanctioned and fully supported by law (FDIRA 1982/12USC1701-j-3) except under certain circumstances which I will detail in a subsequent article. There are many gurus who expound on the benefits of this type of financing and pooh-pooh the danger of this happening. One so-called guru says that it is his belief that if the loan is kept current then no 'flag' is thrown to trigger this clause. He says that it is not illegal to take over or become responsible for someone else's loan, but admits it is a DOSC violation and says it is a risk inherent with 'Subject To' investing, but certainly one that doesn't concern him. Well, it should, and it should concern the many student who are blindly following this type of bravado. Just because you have never heard of anyone exercising a DOSC does not mean it won't happen or does not happen. It has happened recently in Colorado and in San Diego, and as interest rates rise, we are apt to see far more DOSC violations. Do not overlook this item in the loan or regard it as something of no concern. Rest assured that when the market rate on notes jumps up, there will be a lot of activity in this area. Plan to be smart enough not to get caught when this occurs. The DOSC does have fangs and the well known and respected, Bruce Norris (hard money lender), has encountered DOSC issues on more than a few occasions. Let's take a sample "subject to" situation. You've got a great "subject to" deal and everyone is pleased, the seller, you and your optionee. There's good equity and the property's in a hot, appreciating market. Interest rates are rising, but you've got 3 years left before the ARM adjusts (5/1 ARM), a great deal for you since you've got a 2 year exit strategy planned. The lender decides it would be better served by loaning that money at a higher interest rate... and, there's equity and appreciation. The Lender decides it is not such a bad deal to call the loan, get control of the property, and write a new loan at the new high rate of interest so he invokes the DOSC and calls the loan. What do you do? Your guru told you not to worry. He's not worried. And, what about the seller? It is him, not you who has to cough up the payoff within 90 days. Your real problem is with your tenant/optionee who will be unceremoniously thrown out of a house he thought he was purchasing. Can you say L-A-W-S-U-I-T? Your unprotected assets are at risk. Legislation There are now over 1 million realtors in America, more than at any time in history, yet an increasing amount of homeowners are selling their properties For Sale By Owner (FSBO). This means that more realtors have less of a piece of the pie to share and they are not happy. They are also a strong political force and are affecting recent proposed legislation aimed at the small investor. North Carolina House Bill 725 is a prime example. The AG's office in that state claims to have "hundreds of complaints" from people who were hurt by investors who bought properties "subject to" existing mortgage loans, then defaulted. This bill has targeted the investor who buys a property subject to an existing loan, then resells the property either by lease/option or land contract. The bill requires disclosures to all parties involved. It requires the seller to get written permission from his lender before transferring a property subject to an existing deed of trust. What are the chances of that happening? This will hurt the seller who is facing foreclosure and seeking to sell for whatever he can. If the investor can no longer cure the seller's back payments and/or negotiate a short sale with the lender, the seller will be forced to walk away from the property and the bank will foreclose. This bill will hurt both the small investor and homeowner, but it exempts real estate agents from the law, which means a licensed agent can buy a property subject to an existing deed of trust without lender permission and without having to give the same disclosures as a non-licensed investor. This doesn't leave much doubt in my mind that realtors are trying to stake out their share of the market on investing or at the very least want to require an agent's assistance. This bill will very likely pass. Other anti small investor bills are being considered in Texas where they have already virtually outlawed the lease-option, Maryland, North Carolina, Utah, etc. There is a way to use the "subject to' method that is entirely legal and exempt from the DOSC - the land trust, and that will be the subject of another article. Copyright @ 2006 Gary Mialocq, Ph.D. All Rights Reserved.