QUESTION: We have been trying to sell our house and found a potential buyer that wants us to take back a second deed of trust for a period of seven years. We are concerned about the possible risk.
ANSWER: If you take back a second trust, you are subjecting yourself to some risk.
Many sellers are actually working out arrangements to take back a large first trust, especially since interest rates on a mortgage would be higher than putting all of the sales proceeds in the bank under today’s market conditions.
Obviously, if you need the sales proceeds to buy another property, then you cannot take back a first trust. But if you have a house that is free and clear of all mortgages (or has a low enough mortgage that you can pay it off) you might seriously consider selling your house and taking back a first trust--rather than a second trust.
A first trust puts you in top priority position. If your mortgage (deed of trust) is recorded among the land records, the house cannot be sold without your permission and without getting paid in full. If your buyer goes into bankruptcy, you have a secured position and unless the house significantly drops in value, you should be protected. Obviously, bankruptcy will delay your getting the money, but ultimately under most circumstances you will be relatively secure.
A second deed of trust means that you are in second position to a first trust lender. If the first trust lender forecloses, and there is not enough equity in the house to pay off your second trust, your trust will be wiped out.
While you still have the right to sue the person who bought your house under the promissory note, obviously if they are in financial difficulty, this right to sue will be meaningless. There is no cash register at the back of the courthouse, so that even if you get a judgment against the note maker, the chances of collection will at best be slim.
Obviously, many people want to sell their house, and are willing to take some risk. A second trust can be a very effective tool in marketing your house. If the interest rate that you offer is significantly attractive, it may tip the balance in favor of your making a sale.
It is important, however, that the second trust be properly prepared. Every state has different rules affecting second trust financing, 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.
To protect yourself, you must 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 that credit bureau reports a history of slow or delinquent payments to such places as department stores or oil companies, you may want to reject extending further credit to an already over-extended 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 $250,000, and your buyer obtains an 80% loan in the amount of $200,000, you are taking a serious risk if you lend the borrower the difference between their loan and the purchase price--namely $50,000.
If your buyer defaults on the first trust loan, and that lender forecloses, you may end up losing your second trust because there is little or no equity left in the property. There must be some restriction on the amount of the first trust that will be loaned ahead of your second trust financing.
When you take back financing--whether it is a first or a second deed of trust--you are lending your borrower money. Your buyer will have to sign two pieces of paper.
One is a promissory note in which the buyer states that he or she has borrowed a certain sum of money and agrees to pay that amount, 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 loan becomes due.
This promissory note must contain 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 position in connection with your buyer. If one payment is missed, and you are lenient, you may end up having to foreclose because your buyer will get too far behind in payments to ever catch up.
Additionally, to secure the promissory note, the buyer will sign a deed of trust. This 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. If your buyer is unable to make the payments on the note, you will have the opportunity to foreclose on that property. By recording the deed of trust on the land records, you put the world on notice that you have an interest in that real estate.
You have to select trustees whom you respect and have confidence in. 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 it in the event of a default or will release the trust when the promissory note is paid in full.
You should fully advise the trustees whom you select as to their responsibilities so that they fully understand what their functions will be.
The deed of trust is an important legal document. It must be prepared carefully, and 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 escrow company to keep that note in the files. It is a valuable piece of paper, which should be kept in a safe place.
The deed of trust will be recorded in the office of the land records where your property is located. Make sure that your name and address is written clearly on the original deed of trust so that the recorder’s office will be able to mail it make to you after its recording.
Here are some provisions that must be included in the papers that will be prepared:
--The promissory note and deed of trust should contain a very tightly drawn due-on-sale clause. You may be prepared to lend this buyer money to purchase your house, but you do not necessarily want that loan to be assumed by a third purchaser later on. The general rule is that in the absence of a specific non-assumption clause in your note and deed of trust, the note and deed of trust are freely assumable.
--A “cross-default provision.” Language should be contained in the deed of trust that, in the event the borrower is in default on the terms of the first trust, this will automatically trigger a default on your note also.
If you enter into a second deed of trust, you want to make sure that the first trust lender will advise you, in writing, if the borrower is in default on the first trust payments. IF you are not so advised, a foreclosure can take place and you will never even know about it so that you can protect your interests.
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 needed, 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 can be a valuable tool for a seller--especially in a slow market. But a poorly drafted legal instrument is of no use to anyone, and can cause you to lose your valuable investment.