05/13/08: First Trust Position Trumps a Second
By Benny L. Kass
Q: Five years ago this August, we sold our house through owner financing and took back a first deed of trust in the amount of $275,000. The borrower gave us a $25,000 down-payment. This was an interest-only, five year balloon loan, with a monthly payment of $1,200. We do not plan on renewing this loan because we are planning to buy another property this year.
The buyer/borrower has indicated that she thought the balloon will not be due until 2009. Two years ago, she obtained a home equity loan of $200,000, when the house was appraised at $500,000. Now she is hinting that she might not be able to pay the principal at all.
How did her bank give her that loan and not do the math about our existing mortgage?
Can we, as lenders, in primary position, foreclose on the property ourselves?
What are the procedures involved in situations like these?
A: Welcome to the wonderful world of banking. How did her bank give her that loan? Because bankers – like all other mortgage lenders in the hey-day of the early 2000's –believed that real estate would only keep appreciating at a rapid pace, and the bank wanted another loan in its portfolio. And the loan office no doubt made a healthy profit for himself and/or his bank.
Hopefully, your buyer signed a deed of trust (the mortgage document) which was properly recorded in the jurisdiction where the property is located. You can go to the office of the local Recorder of Deeds to get this information. You want to make absolutely sure that your loan is in first place and is ahead of the bank’s home equity loan. And you also want to know if there are any other impediments to title, such as tax liens. It would be a good idea for you to retain a local attorney and get a complete title search.
If you are in first position – and if your borrower is in default on the terms and conditions of your loan documents – you have the right to foreclose on the property and that will erase the bank’s second trust. The bank will still have the right to sue your borrower for the moneys owed, but that may be an academic gesture if she has no money. The deed of trust is the security that all lenders rely on when making a mortgage loan, because that document provides the authorization to foreclose.
The deed of trust and the promissory note that your borrower signed is important, and you should read these documents carefully. They spell out when and how the borrower is determined to be in default. Clearly, non-payment is considered a default, but since it appears that your borrower is current with her monthly payments, this does not give you the right at this time to initiate a foreclosure.
Some deeds of trust also state that the borrower is in default if additional financing is obtained without the lender’s consent from another source – such as a Home Equity loan. If this language is in your legal documents, then you can declare your borrower in default and proceed to foreclose upon the property.
Otherwise, at the present time, you will have to wait until the August due date.
The procedures and the laws regarding foreclosure vary from state to state. In some states, court action or approval is not required. This is known as a “non-judicial” foreclosure. In other states, the Court only has to approve the sale, while in a few jurisdictions, the foreclosure has to be specifically authorized by a Court of Law (called a “judicial foreclosure”).
Your lawyer can assist you with this process. Most loan documents provide that in the event the lender has to take legal action against the borrower, the borrower must pay the reasonable legal fees incurred by the lender. Once again, however, this is an academic statement, since if your borrower has no money to pay the loan, she probably does not have any money to pay the legal fees either.
Unfortunately, your options are limited. If there was no second trust (i.e. the home equity loan) your borrower could give the property back to you by way of a “deed in lieu of foreclosure”. But in your case, that would mean that you would be stuck with the home equity loan. Unfortunately, your options are limited. If there was no second trust (i.e. the home equity loan) your borrower could give the property back to you by way of a “deed in lieu of foreclosure”. But in your case, that would mean that you would be stuck with the home equity loan.
Here are two possible solutions.
First, sit down with your borrower and try to work out an amicable deal. I know that you need the money in order to buy that new house, but I don’t think that is going to be possible. You may want to extend the term of the loan, say by one or two years, and at the same time increase the interest rate so that at least you will be getting a larger monthly mortgage payment. Perhaps, in a year or so, the real estate market will bounce back.
You – or your attorney – should also talk with the bank that made the home equity loan. Explain that if you cannot work something out with the bank, you will be forced to foreclose on the property in August. Since that will wipe out the bank’s security in the house, the bank may be willing to work with you (and their borrower). For example, the bank can buy the promissory note your borrower gave you, so that the bank will then be in first trust position.
The bank may be willing to entertain this suggestion, but may only offer you 75 percent of the value of your $275,000 promissory note. You then have to make a business judgment: will you get more if you foreclose on the property?
You have to determine the true value of the house in today’s market. If it is still worth around $500,000, then perhaps foreclosure will be your best bet. You will start the bidding at the foreclosure sale at $300,000 (this will pay you the full amount of your loan plus the costs of the foreclosure including legal fees), and hopefully someone will be able to get a good deal if they are the successful bidder.
But the lower the value of the house, the lower are your chances that someone will buy the house. If no one shows up at the auction sale – or if there are no decent bids – you will end up owning the house, which I seriously doubt that you want to happen. You do not want to pay the real estate taxes and the insurance on this property, with no certainty as to when you will be able to resell it. And more importantly, you will probably have to take legal action to evict your borrower.
A seller take back loan can be a good selling tool, but should only be used as a last resort. You have a serious problem, with limited solutions. Consult your financial advisors and try to work this out as best you can. Unfortunately, you will have to make some serious compromises, since I suspect that you will probably not get back all of your money.