Mortgage ContractWith the tightening credit standards and increased down payment requirements in today’s mortgage industry, many sellers have become willing to provide financing for prospective buyers via a contract for deed.

In a contract for deed, which is also known as a “land contract”, the seller acts as the bank for the buyer.

All the terms of the “loan”, including interest rate, monthly payments, amortization schedule, length and down payment requirements are negotiable, just as all of the terms of the purchase of the duplex itself are.

While a contract for deed certainly avails a seller of more prospective buyers, it’s crucial that prior to offering it, he know whether or not his mortgage has what’s known as a “due-on-sale clause”, which may also be called an acceleration clause.

When contained in a promissory note, this clause stipulates that the original lender, or bank, may require the entire balance of a loan be paid in full upon the sale or transfer of any interest in the property used to secure the note. (Please know there are some exceptions between spouses, with estates, etc.)

These clauses came into existance in the 1970’s when double-digit interest rates made new loans unattractive. Buyers found if  they assumed a seller’s existing loan, they could usually obtain financing at a greatly reduced interest rate.  To stop this practice (and offer loans at higher interest rates), banks began using the due-on-sale clause.

The truth is, most of today’s mortgages have this language. In fact, in a Fannie Mae or Freddie Mac single family mortgage, for example, it’s usually found in paragraph 17, where it’s called the “Transfer of the Property or a Beneficial Interest in Borrower”.

Uh-oh, right?

Not necessarily.

First, it’s important to know it isn’t illegal to violate the due-on-sale clause and transfer a property without paying off the loan in full. The language simply gives the bank the right to accelerate the loan if they discover the owner transferred his interest.

After a bank exercises this right, if the loan isn’t paid in full, they may commence foreclosure proceedings.

It’s simply important that both buyer and seller be fully aware of the potential risks involved.

Is there a remedy? Well, there are differing opinions on this. However, most who claim that there is focus on the idea that it is only triggered if the bank discovers the transfer.

Typically, lenders learn about it one of three ways:

1. When the name on a deed is changed (lending institutions generally only check deeds when they are suspicious of something between them and the original borrower).

2. When the name on the checks paying the mortgage changes. Again, this is rare as usually office clerical workers wo process countless payments daily tend to the file.

3. A transfer of hazard insurance. Normally, when the title of the duplex or four-plex is transferred, the beneficiary of the hazard insurance is as well. When this happens, the bank, who is also listed as a beneficiary, receives notice from the insurance company. As a result, this is the way most banks become aware of a contract for deed, resulting in them excercising the due-on-sale clause.

While I am not an attorney (and it’s worth consulting one on this), some buyers and sellers have circumvented the acceleration clause through the creation of a land trust.

A land trust is an agreement were one party simply agrees to hold ownership of a piece of real estate for the benefit of someone else.  So, in this case, the seller sets up a trust in which he is the Beneficiary. He makes the Buyer a Trustee of this trust.  He then transfers the title of the property to the Trustee, assigns his interest in the trust to the Buyer, whereby the Buyer then becomes the beneficiary.

Normally, assigning this interest would trigger the due-on-sale clause. However, as there is no public record of it, the likelihood of a lender discovering it is remote.

What about payments? The original seller can continue to make payments to the bank. Or,  he may send a letter to them advising them he has transferred title into a revocable, living trust for purposes of estate planning and that a named trustee will make all future payments on behalf of the trust.

Of course, there are a number of legal technicalities involved in the process. It would be wise to contact a qualified real estate attorney if you intend to pursue a land trust as a means of selling your property.