The most important issue in seller financing is the notorious “due-on-sale” clause.
During the late ‘70s, lenders began feeling uncomfortable with assumable mortgages. They realized that assumable mortgages do not allow them to control who they are lending their money to. The original homeowner may have had a stable job and stellar credit, while the new buyer may be just out of bankruptcy.
As a result, lenders began including a due-on-sale clause in their contracts, making assumable mortgages impossible in many cases.
Most due-on-sale clauses look like this:
“Transfer of the Property or a Beneficial Interest in Borrower. If all or any part of the Property or any interest in it is sold or transferred (or if a beneficial interest in Borrower is sold or transferred and Borrower is not a natural person) without Lender’s prior written consent, Lender may, at its option, require immediate payment in full of all sums secured by this Security Instrument. However, this option shall not be exercised by Lender if exercise is prohibited by federal law as of the date of this Security Instrument.
If Lender exercises this option, Lender shall give Borrower notice of acceleration. The notice shall provide a period of not less than 30 days from the date the notice is delivered or mailed within which Borrower must pay all sums secured by this Security Instrument. If Borrower fails to pay these sums prior to the expiration of this period, Lender may invoke any remedies permitted by this Security Instrument without further notice or demand on Borrower.”
Basically, a due-on-sale clause says that the lender may call the entire loan due in 30 days if it finds out about the assumable mortgage (i.e. you will have to come up with cash to pay off the loan or risk foreclosure. Lenders won’t always do this, but the possibility is certainly there. In 1982, a federal law was created to make due-on-sale clauses enforceable no matter what state the loan is in.
Who Does the Due-on-Sale Clause Affect?
The due-on-sale clause is in almost all mortgage agreements created since the 80s.
You can avoid the due-on-sale clause by purchasing a home from a seller who has an old mortgage. Loans from the Federal Housing Administration (FHA) and Veterans Affairs (VA) must be assumable and are not subject to a due-on-sale clause. You may also consider asking the lender for written permission to enter into a seller financing arrangement. However, keep in mind that the lender will likely require you to complete an application and meet the usual requirements. The lender may also ask for an increased interest rate.
If you have a seller-financed private party mortgage (where the seller does not have a mortgage of his own), you can avoid this issue entirely. You may also be able to avoid this issue by taking out a small seller financed carry back loan to bridge the gap between your down payment and a traditional mortgage.
Ignoring the Due-on-Sale Clause
Some real estate gurus advocate ignoring the due-on-sale clause when entering into seller financed deals. They argue that banks rarely act on information about a seller-financed deal and that these deals are not illegal.
Critics contend that the risk is not worth it. It is possible that concealing an ownership from the bank (by having documents mailed to incorrect addresses, etc.) may be mail fraud. If the bank does call the loan due, thirty days is a very short period of time to come up with what could be hundreds of thousands.