04/17/07: Taking Back A Second Trust
By Benny L. Kass
Q: Our home has been on the market for $499,000 for two months, and we are now going to drop the price by $15,000 with the hope of getting a qualified buyer. However, recent homes in our area have only sold for $450,000. We have made many improvements and upgrades and believe that our house would appraise for more than that if the appraiser made an on-site inspection. However, we have been advised that based on these comparable, a mortgage company will only approve a $450,000 loan to prospective buyers.
We are willing to take back a second mortgage for the difference of $35,000. What are the pros and cons of doing this?
A: Creative financing has returned to the real estate market. Sellers are beginning to recognize that it is now a “buyer’s market”, and in order to make a sale must provide attractive benefits to attract and entice buyers into presenting a purchase contract.
Some sellers are offering free plasma television sets; others are providing rental cars with one or two years free rent. And some sellers are considering financial incentives – one of which is a “take-back” second trust.
When you borrow money to buy a house, in order to insure that the lender will ultimately get paid, the buyer/borrower signs a promissory note and a deed of trust.
The promissory note is a legal document which says: “I, the borrower, promise to pay the lender XX dollars, due and payable in Y number of years. I will pay this money in equal monthly installments of ZZ, at an interest rate of AA percent per year.
If the borrower does not pay, the lender can file suit in the appropriate court and get a judgment against that person. Then, the lender has to determine what assets the borrower has, find out where they are, and then attempt to attach those assets based on the Court ordered judgment.
This can be a cumbersome process. And if the borrower has no money, it will be a futile – and expensive – effort. I often tell my clients that “there is no cash register at the back of the courthouse; collecting on a judgment may not be successful.”
Accordingly, to further protect the lender’s investment, the borrower also signs a deed of trust. This is a legal document whereby the homeowner signs a document which technically (and in some states legally) transfers the borrower’s house to a trustee who has been selected by the lender. This document is recorded among the land records where the property is located, so as to put the entire world on notice that title to the house is subject to that deed of trust.
If the buyer makes the monthly payments and is not otherwise in default, when the loan is paid off in full, the deed of trust is released from land records. However, if the buyer is delinquent, the trustee has the authority to sell the house at an auction foreclosure sale. Every state has different rules and procedures about how foreclosures are to take place, and you should consult your local attorney for more details.
In legal terms, a deed of trust is a grant from the home owner to the trustee, giving him/her the “power” to sell the house.
Some states still use mortgages, which in effect provides a lender with the same security as does the trust deed. The basic difference, however, between a deed of trust and a mortgage is that where there is a mortgage, the lender will have to go to court to force a sale. Thus, most lenders prefer to use deeds of trust, since the foreclosure process is easier, less expensive and faster.
You are prepared to offer a potential buyer a second deed of trust in the amount of $35,000. I call this a “second trust” because your buyer will get a first trust from a commercial lender. In simple terms, your trust document will be recorded on the land records after the first trust, and will thus be in second place position.
There are several advantages to this approach:
- you will assist the buyer in going to settlement because he/she will not have to come up with all that additional cash;
- you can set your interest rate lower than the buyer can get on the open market;
- you can defer (not avoid) a portion of any capital gains tax which you might otherwise have to pay if the property sold for all cash. You should discuss the tax benefits with your financial advisors.
However, there is also one important negative factor to consider. If the first trust goes into default, and that lender forecloses on the property, your second trust will be wiped out. The first trust lender must advise you of the pending foreclosure sale, but because that lender is in first place position, your security in the house is not protected. You can still sue the borrower based on the promissory note that was signed, but as discussed above, that may be a useless effort if the borrower has no money.
The bottom line: taking back a second trust is certainly one way of attracting potential buyers, but there are risks. There is absolutely no guarantee that your $35,000 will be completely protected.
If you do not have a mortgage presently on your house, or it there is a small outstanding balance which you can pay off, you may want to consider taking back a first trust in an amount of no more than 90 percent of the purchase price – i.e the buyer must give you at least 10 percent down. That is even a more attractive incentive for potential buyers.
I also want to comment on your concern about the role of the appraiser. You suggest that your house may appraise more with an “on site” inspection of your house. It is my understanding that all professional appraisers must personally go into the house they are appraising, so as to get an accurate picture of the condition of the entire house. Comparable are helpful and important, but they do not – and cannot – take the place of an actual inspection.