Purchasing Property Subject to a First Lien Without Notifying the Lender
By Dan Harkey
Real Life Example #4 of 25
Here's a scenario: a borrower acquires a single-family property without a first lien formal bank loan assumption. The property title now belongs to the new owner, but a first lien remains in the previous owner's name with the original lender. This transaction, known as 'taking the title subject to' without lender approval, means the new owner has taken over the property and its financial obligations without the lender's consent. This action carries significant risks, as we'll explore further, and it's crucial for all parties involved to be fully aware of these potential pitfalls.
The mortgage broker said….
“My clients want to borrow some cash and will agree to place a second trust deed on their property.? Five years ago, they purchased the property “subject to” a first lien an institutional lender?made to the?prior?property owners.? The loan reflects the borrowing party as the prior property owner, not the current owner.? There has been significant equity build-up because the property has substantially increased in value.”
The lender responds….
The lender's response to this situation is crucial. They point out that a 'due-on-sale' or 'due-on-further encumbrance' clause in the first trust deed could be problematic.? On properties other than 1 to 4 units, the first trust deed lender has the right to call the loan due and payable upon transfer to the present owner if they discover a violation of the loan documents. In this case, the lender was not notified of the transfer, which they see as Intentional deception to avoid the due-on-sale clause. This could lead to severe consequences.
Intentionally deceiving a federal-related lender has dire negative consequences.? As interest rises, the first lien lender may become motivated to free up the capital to lend to another party at a higher rate.? The first lender may call the loan due and payable and trigger a default. This could lead to severe consequences, including legal action and financial penalties.?But not for single family one to four.
The Garn-St Germain?Depository Institutions Act of 1982.? The law became effective on October 15, 1982, provided exemptions in which the lender cannot exercise the “due-on-transfer and due-on-encumbrance” provisions if the collateral property is a single-family or a one-to-four, including co-ops, residential dwelling owner-occupied.
The specific provision?is in 12 U.S. Code?1701J-3.? Therefore, if a first trust deed contains a due-on-transfer clause, the lender?may or may not be?prohibited from exercising the due-on provisions, depending upon the type of collateral property and the exceptions.
Exceptions to the Due on Sale Clause and Due on Further Encumbrance:
·????? Transfer to a spouse or children of the borrower.
·????? Transfer to a relative resulting from the death of the borrower.
·????? Transfer because of the death of a joint tenant or tenant by the entirety.
·????? Transferring to a trust where the borrower is the beneficiary does not relate to the transfer of occupancy rights.
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In this example, brokers/lenders representing private-party investors will assess the risk of moving forward with a second loan.? Many brokers/lenders and their private party investors will agree to make this loan (junior lien) because the first trust deed lender is prohibited from calling the loan due.? The prohibition from calling the loan due and payable on transfer may or may not apply—technical stuff that requires a lawyer to determine the outcome.
Lenders can still call the loan due on any property “other than” residential single-family and one-to-four units.
Part of the lender’s due diligence is ordering and reviewing a copy of the promissory note, deed of trust, and loan agreement. For other than 1 to 4 units, the “due on sale” and “due on encumbrance” will appear in the loan agreement if one exists. Additionally, the lender should order a beneficiary statement from the first trust deed lender or obtain 3 to 6 months of payment statements supplied by the borrower.
Multiple written clauses in the note, deed of trust, and loan agreements may increase the risks.? The promissory note is the promise to pay.? The deed of trust is a legal instrument used to create a security interest in real property.? A loan agreement, typically in the context of complex commercial loans, represents a legally binding contract that meticulously delineates the terms and conditions governing a loan transaction. In addition to these terms and conditions, the agreement includes representations and warranties made by the borrower to the lender concerning the impending loan transaction.
With a trust deed, the legal title is transferred to a third-party trustee.? The trustee holds the title on behalf of the lender/beneficiaries. The trustee's role is to ensure that the terms of the trust deed are upheld and to act in the best interest of the lender/beneficiaries.
One problematic clause in the deed of trust is an “alienation clause,” also called a “due-on-encumbrance clause.”? Another problematic clause would be a negative-amortization adjustable-rate mortgage, where the principal balance increases with each payment. Being alert and cautious when dealing with these clauses is crucial, as they can erode the protective equity and create unwanted risks for the second trust deed investor.
Another area for concern by a lender is when clauses in the deed of trust allow for additional advances or modification of other deferred payments. Further refinements and deferred payments would increase the principal balance, eroding the protective equity. Protective equity is the difference between the market value of the property and the outstanding balance on the loan. When the principal balance increases, the protective equity decreases, increasing the financial risks for the second trust deed investor. This should be a red flag for any investor, prompting them to proceed cautiously.
The lender will review other problematic clauses in the loan documents relating to the risks of a second lien.? Diligent underwriters will read the promissory note, deed of trust, and loan agreement and obtain recent payment and beneficiary statements to address these issues.
As an agent of the private party beneficiaries (private parties), the lender may request a lawyer’s review of this transaction and the prior purchase transaction to ensure compliance and correct decisions. This legal review is not just a formality but a crucial step in understanding and adhering to these legal requirements, which is essential to avoid potential issues and ensure a secure transaction. Emphasizing the importance of this step can make the audience feel more secure in their investment decisions.
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Thank You
Dan Harkey
Educator and Private Money Lending Consultant
949 533 8315??? [email protected]
Visit www.danharkey.com
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