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.