Second Mortgage as Home-Selling Tool

QUESTION: We must sell our house, and this slow real estate market is killing us. We have agreed with the buyer that we will take back a second deed of trust for five years. Can you advise us how we can best protect our money?

ANSWER: More and more, sellers are turning to creative financing to make a deal in today’s real estate market. One of the methods is for the seller to take back a second deed of trust.

A second-trust (mortgage) can be a very effective tool to assist you in marketing your house. Whether your buyer is assuming your existing loan or obtaining a new loan, your willingness to take back financing for a period of time may make the difference in the cash needed by the buyer to meet your selling needs.

If the interest rate that you offer is significantly attractive, this may tip the balance in favor of your making the sale.

It is important, however, that the second trust be properly prepared. Each state has different rules, and you must check with your attorney about such matters as usury laws, recording details and other requirements that state law may impose on a second trust.

For example, the note signed by your borrower might have to state that “it is not negotiable.” This means that you may not be able to sell (discount) the note to a third party, but will have to wait until the full time expires to get paid in full.

To protect yourself, you will have to investigate the credit worthiness of your buyer. Find out what income your buyer makes and obtain the buyer’s permission to do a credit search with a local credit bureau.

If the credit bureau reports a history of slow or delinquent payments to such places as local department stores or oil companies, you may want to think about extending further credit to an already overextended purchaser.

You also want to make sure that there will be more than adequate security in the property in the event of a foreclosure.

For example, if you are selling your house for $200,000 and your buyer obtains an 80% loan for $160,000, you are taking a serious risk if you lend the borrower the difference between his loan and the purchase price, namely $40,000.

If your buyer defaults on the first trust loan, and that lender forecloses, you may very well end up being wiped out because there is little or no equity left in the property. Thus, there should be some restriction on the amount of the first trust that is being loaned, before your second-trust financing.

Obviously, the ideal situation is to sell the property and take back a first trust. For those of us who own our house free and clear of any mortgage, or if we have but a small mortgage that can be paid off out of the sales proceeds, you are always better off taking back a first trust rather than a second.

Indeed, in today’s market conditions, a first trust is probably a better investment than putting the money directly into a bank.

Oversimplified, when you lend money, your buyer will have to sign two pieces of paper. One is a promissory note, whereby the buyer states that he or she has borrowed a certain sum of money, and agrees to repay that money,, with interest, in monthly or quarterly payments.

You have to figure out whether you want the payments amortized equally over a period of years, or whether the buyer will be permitted to pay interest only, until the entire balance of the note becomes due.

This promissory note must reflect provisions for default, so that you will be able to call the note in the event the purchaser misses a payment or two. You have to take a tough stance in connection with your buyer.

If a payment is missed, and you are lenient, you may end up having to foreclose because your buyer will be too far behind in payments to ever catch up.

Additionally, to secure the note, the buyer will sign a deed of trust. This deed of trust (the mortgage paper) when recorded among the land records in the jurisdiction where your house is located, puts a cloud on the title to the property, so that if your buyer is unable to make the payments on the note, you will have an opportunity to foreclose on the property.

You are putting the world on notice that you have an interest in the real estate.

You have to select trustees whom you respect and trust. You have the right to select any person of your choosing, and it can be a relative, friend, business acquaintance or your attorney.

It is advisable to have at least two trustees, and you also must have absolute discretion to substitute trustees. When your buyer signs the deed of trust, in effect the buyer is deeding the property in trust to your trustees.

They hold title to the property, and will either foreclose on the property in the event of a default, or will release the trust when the promissory note is paid in full.

The deed of trust is a very important legal document. It must be prepared carefully, and it must reflect the true legal description of the property.

The original note, signed by the borrower, must be given to you at closing. Do not rely on the title attorney or title or escrow company to keep that note in the files. It is a very valuable piece of paper, which you should keep in a safe place.

The deed of trust will be recorded in the office of land records where your property is located. Make sure that your name and address are written clearly on the original deed of trust so that the record’s office will be able to mail it back to you after recordation.

There are many important provisions that should go into your second deed of trust if you decide to go this route:

--A “cross-default provision.” You want language in your deed of trust that, in the event the borrower is in default on the terms of their first trust, this will automatically trigger a default on your note also.

--The promissory note and deed of trust should contain a very tightly drawn due-on-sale clause. You may be prepared to lend this particular buyer money to purchase your house, but you do not necessarily want that loan to be assumed by a third purchaser down the road. The general rule of law is that in the absence of a specific non-assumption clause in your note and deed of trust, that note and deed of trust are freely assumable.

--A provision should be included in the note and deed of trust requiring the borrower to maintain adequate homeowners insurance coverage, naming you (the lender) as beneficiary in the event of a fire or other destruction of the property. Additionally, the buyer should present evidence to you at least once a year that the real estate taxes and insurance policies have been paid.

Finally, make sure that someone visits the property periodically. If the property is run-down, its value may be diminishing, thereby impairing your security. If significant repairs are evidence, you may want to insist that your borrower take care of these matters promptly. Most standard deeds of trust specifically require that the borrower maintain the property in decent condition.

Second deeds of trust are very valuable tools for a seller, especially in slow market conditions. But a poorly drafted legal instrument is of no use to anyone.