Can You Collateralize (Pledge) Your Loan to Borrow money?

?? ?By Dan Harkey

The short answer is yes, with conditions.

·?????????????? The term “collateralize” means to pledge something of value as security for a loan until repaid. The borrower retains a significant level of control but will usually assign the note and deed of trust to the lender, who retains possession of the collateral until the loan is repaid.

If the borrower defaults and a personal property foreclosure occurs, the lender becomes the absolute owner of the note and deed of trust.

·????? Note hypothecation, a term often used in financial and real estate transactions, is essentially the process of borrowing money using a note you own as security for the loan.

Suppose a party owns a promissory note and deed of trust secured by real estate as a financial asset and collects the principal and interest payments from the property owner. ?They can hypothecate (or pledge) the note to borrow money.

The procedure is to offer to convey a financial asset of value owned by one party, usually a promissory note and deed of trust, attached to a specific real property (as collateral) in exchange for a loan from an unrelated third-party investor.

Hypothecation is like collateralization, but the borrower remains in possession of the collateral during the life of the loan.? The lender holds a security interest, providing reassurance and security, subject to a “Collateral Pledge Agreement” to be discussed later.

Regular private money loans: the lender(s) who agree to make regular private money loans are investors who invest in loans secured by trust deeds or mortgages.? Some states use trust deeds, while others use mortgages. ?Hypothecation: Investors can invest by agreeing to receive an assignment of a promissory note and deed of trust or mortgage as collateral and security for their loan investment.

Seller Carry Back: sometimes, an original property owner/seller, as part of their sale transaction, agrees to carry back or become the lender as a condition of the property sale. ?At the sale’s closing, the seller becomes the lender/beneficiary or owner of a promissory note and deed of trust with a security interest in the property.

·????? Which documents are part of the original property sale transaction between the seller and purchaser?

·????? The original sale transaction documents consist of a written offer, possible counteroffer, acceptance, escrow instructions, written evidence of satisfied contingencies, insurance endorsements for the lender named as lender loss payee, final lender closing instruction, a closing statement, distribution of proceeds, and delivery of security instruments, issuance of a title insurance policy, and an executed recorded seller carrying back promissory note and deed of trust.? The deed of trust as a security instrument is recorded at the county recorder’s office as part of the sale transaction.

·????? Sellers who become seller-carry-back lenders will hold the original loan documents as evidence of the investment and the financial asset. The seller, now beneficiary, will also personally possess the title policy.

·????? A note-hypothecation transaction is separate and distinct from the original sale transactions.

The first loan transaction occurs when the property’s original seller at the closing becomes the (lender) beneficiary of the carry-back promissory note and deed of trust. ?The owners of the promissory note and deed of trust may later decide to borrow money and agree to convey their interest in the documents to the investor party as consideration of a loan.

A third-party investor, often an entity motivated by interest income and annualized yield, agrees to loan the owner the promissory note and deed of trust. The investor will hold a 100% conditional title and interest through a vehicle called “assignment of note and deed of trust” in the promissory note and trust deed as collateral until the loan is repaid, ensuring the security of the investment.

·????? Who are the parties to each separate and distinct transaction?

?·????? Party #A owns a property that is free and clear.? Party #A agrees to sell the property to a purchaser, Party #B, and to become the lender as a seller carry-back transaction.

·????? The new purchaser of the real property, Party #B, will take the title and become the trustor/obligor on the seller’s carry-back money loan—the trustor signs the promissory note and deed of trust.

The deed of trust is recorded and reflects security interest in the loan. ?The promissory note is the written promise to pay the contract. ?Party #B must pay party #A until the loan is repaid.

·????? A sophisticated investor, third-party #C, understands the difference between making a loan on real estate and securing the loan investment by assigning a note and deed of trust.

·????? The same title insurance company as the original sale transaction usually will agree to provide title insurance 104.1 endorsement for the appropriateness of the conveyances of the documentation and the property recording sequence in the hypothecation transaction. This confirmation from the title insurer ensures that all parties are well-informed and knowledgeable about the process.

·????? The validity of the assignment to evidence the transfer of the entire beneficial interest of the named assignee.

·????? No full or partial reconveyance, modification, or subordination of the insured mortgage or deed of trust appears on public record.

·????? The title company does not offer insurance for the speculative nature of the risk investment, nor does it guarantee its success or that the parties will get their money back.

·????? As the original seller, now the lender/beneficiary who owns the carry-back paper, they have three options, each with its own set of implications.

·????? Keep loan assets and enjoy the cash flow until maturity.

·????? Sell the paper on the open market at a discount to free up capital.

·????? The seller/owner of the promissory note becomes the borrower (pledgor), and the new investor becomes the lender/investor-(pledgee).? ?

·????? The third option is for the note holder, who may borrow a portion or percentage of the principal balance from another lender/investor, endorse the note, and assign a deed of trust or mortgage as collateral.

?????????? In practice, the original note holder retains ownership but must give up physical possession to the new lender/ investor or the investor’s loan servicer, subject to the terms and conditions of a pledge agreement.? This process is commonly referred to in the industry as note hypothecation.

·????? Example transactions:

??????????? Suppose a lovely couple has owned a commercial building for 20-plus years.? The building is free and clear, and managing it is a hassle.

??????????? They decide to sell and offer a seller carry-back first loan to take advantage of the tax deferral of an installment sale.

??????????? They negotiate a sale and carry a $1,000,000 loan at 6%, payable at $5,996 monthly, amortized over 30 years, but with a due date of 10 years.

·????? They can enjoy the monthly cash flow payments for the life of the loan, capital gains on any principal reductions or upon the loan’s maturity, and ordinary income taxes on the interest earned over the life of the loan.

·????? If they decide to sell their note and deed to cash out, they will probably take a 40% discount so that the purchaser gets a reasonable yield of 9 to 10%.

?????? The third option is to borrow using an assignment of their loan documents as collateral. ?Assume that they borrowed $500,000 at 9.5% interest only, with monthly interest payments only of $3,958.22 for the life of the loan.

·????? When the loan servicer collects the payment from the property owner, they deduct the payment for the $500,000 loan and send it to the hypothecation investor. The servicer would also deduct a servicing charge of .05% /12=$208.33 and send the overage to the original owners (hypothecation borrowers).

·????? When the loan is repaid, the hypothecation lender/investor would ??????????receive the first $500,000, plus prorated interest, and the remainder of $500,000 would go to the original note owners (the hypothecation borrower will get paid off through the process)

·????? At the closing, the title to the note and deed is returned to the original owners.? Upon payoff, the trustee would issue the reconveyance deed.

·????? The required documentation for note hypothecation is as follows:

·????? Collateral pledge agreement and security agreement to pledge an interest in the note and deed of trust as security for the loan.

·????? Secured promissory note separate from the seller carry-back loan. ?This promissory note is between the parties who own the note and deed and the third-party investor who will take an assignment as part of the hypothecated loan.

·????? Conditional assignment of the promissory note and deed of trust assigning interest to the third-party investor

·????? Offset statement & estoppel certificate to prove the outstanding balances and terms on the underlying loan.

·????? Contact the property insurance broker to ensure that the hypothecation investor is the named insured on the property insurance policy.

·????? Uniform Commercial Code filing, UCC-1, that provides public notice of the personal property lien.

·????? 104.1 Title policy endorsement.

·????? Each of the above documents has a unique purpose.

The note and deed of trust assignment secure the new loan.? The pledge agreement states the terms and conditions of the loan.? The content of the pledge includes loan payments, due dates, advancement of cost and expenses, provisions for default and foreclosure, servicing rights, and the method of re-conveying the paper back to the original note holder, now borrower (assignee) when the loan payoff is satisfied. ?The pledge agreement may have a series of representations and warranties by the pledgor.

Suppose a loan servicer is responsible for collecting payments from the property owner. ?Those proceeds will pay the investor/pledgee and then send any overage to the pledgor. ??????

Suppose the pledgee was to foreclose on the pledgor to perfect ownership of the promissory note and deed of trust. ?In that case, it is a matter of personal property and falls under the laws of the uniform commercial code. ?An important distinction is that customary fundamental personal property foreclosure law prevails if the lender forecloses on the property owner.??????????????????

·????? Servicing agent:

·????? The servicing agreement is a broader note management agreement that includes collecting loan payments from Party #A (the property owner) and distributing the income to the investor Party #C. ??If there is a difference, the remaining proceeds are paid to party #B.

·????? The foreclosure process for personal property transactions is much quicker and easier than real property.

·????? A secured promissory-written agreement and promise to pay the pledgee from the pledgor will be deposited with a foreclosure trustee to begin a personal property foreclosure procedure.

·????? Assignment of note and deed of trust. According to a particular secured promissory note, the assignor becomes obligated to the assignee, which transfers, assigns, pledges, conveys, hypothecates, and delivers all the assignor's rights, powers, and privileges. Once the loan obligation is satisfied, the pledgee will re-convey the title to the original note holder, the pledgor.

·????? The property owner signs an offset statement. This document memorializes the declaration of facts relating to the property owner’s loan obligation, including outstanding principal amount, interest rate, payment schedule, payment history, due date, and any other agreements between the parties. It is an estoppel certificate.

·????? Some lenders file a UCC-1 filing, which constitutes notice to the public that a security interest in a specified personal property asset is the underlying promissory note and deed of trust. ?The creditor will file a UCC-1 form to prove public notice to the public that they have a security interest in the debtor’s personal property. ?Upon satisfaction with the debt, the debtor would file a UCC-3 termination statement with the Secretary of State.

·????? Summary- What are the financial benefits to the principal parties?

·????? In most cases, the seller was initially motivated to carry back paper, earn a cash flow, and enjoy a deferred tax incentive.

·????? The tax deferral incentive is known as an installment sale.? The owner of the carry-back paper will pay capital gains taxes on the principal portions received annually and ordinary passive income taxes on the interest portion.? Capital gains taxes may be deferred or spread out over the life of the loan.? This strategy requires the counsel of a competent enrolled agent or CPA.

·????? Sometimes, a seller will finance the sale to help the buyer, who needs more downpayment, qualify for institutional financing.? A first loan or a subordinated junior second is an option.

·????? As time passes, the seller, the note holder, may discover they need to free up cash for some reason. ?They own a financial asset that can be hypothecated or used as collateral for the loan. ?In many cases, the seller miscalculates the capital gains taxes required and must free up cash to satisfy a thirsty IRS obligation.

·????? ?Interested parties should not attempt any part of an installment sale transaction without seeking counsel with a competent CPA or enrolled agent.

·????? Parties interested in note hypothecations should seek counsel from a competent real estate lawyer and an experienced loan broker.

Thank You

Dan Harkey

Educator & private money finance consultant.

949 533 8315?? [email protected]

Visit www.danharkey.com

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