Due-on-Sale Clause

What is a Due-on-Sale Clause?

A due-on-sale clause, also known as an alienation clause, is a provision in a mortgage or deed of trust that grants the lender the right to demand immediate repayment of the entire outstanding loan balance if the property is sold or transferred without the lender's prior written consent. This clause is designed to protect lenders by preventing borrowers from transferring their low-interest rate mortgages to new buyers when market rates are higher, or from transferring the property to someone who may not be creditworthy.

The enforceability of due-on-sale clauses was solidified by the Garn-St. Germain Depository Institutions Act of 1982. Before this act, some states had restrictions on their enforcement, but the federal law largely preempted state laws, making these clauses broadly enforceable across the United States. This means that if a property with an existing mortgage containing this clause is transferred, the lender can, at their discretion, call the entire loan balance due and payable.

How a Due-on-Sale Clause Works

When a property owner with a mortgage containing a due-on-sale clause sells or transfers the property, the clause is potentially triggered. The transfer can take many forms, not just a traditional sale. It could involve a gift, a transfer into a trust, a land contract, or even certain long-term lease agreements with an option to purchase. Upon such a transfer, the lender has the option to exercise the clause, demanding full repayment.

Lenders typically monitor property records for changes in ownership. If a transfer is detected, the lender may send a notice to the original borrower and the new owner, informing them that the loan is being called due. If the full balance is not paid within a specified period (e.g., 30-60 days), the lender can initiate foreclosure proceedings, treating the non-payment as a default on the loan terms. While lenders have the right to enforce the clause, they do not always choose to do so, especially if the new owner continues to make timely payments and interest rates are stable or declining.

Key Exceptions to the Due-on-Sale Clause

The Garn-St. Germain Act provides specific, limited exceptions where a due-on-sale clause cannot be enforced, even if a transfer of ownership occurs. These exceptions are crucial for real estate investors and homeowners to understand:

• Transfers to a Spouse or Child: A transfer of the property to a spouse, child, or other relative by devise, descent, or operation of law upon the death of the borrower.Transfers in Divorce or Legal Separation: A transfer resulting from a divorce decree, legal separation agreement, or incidental property settlement agreement where a spouse becomes the sole owner.Transfers into an Inter Vivos Trust: A transfer into an inter vivos trust (a living trust) where the borrower remains a beneficiary and the occupancy of the property is not changed. This is a common estate planning tool.Creation of a Junior Lien: The creation of a lien or encumbrance subordinate to the lender's security instrument, such as a second mortgage or home equity line of credit.Joint Tenancy: The creation of a joint tenancy interest, where the borrower remains a joint tenant.

It's important to note that these exceptions are specific and do not cover all types of transfers. Any transfer outside these defined exceptions could potentially trigger the clause.

Implications for Real Estate Investors

For real estate investors, the due-on-sale clause is a critical consideration, especially when exploring creative financing strategies that involve taking over an existing mortgage. Strategies like "subject-to" deals, wraparound mortgages, land contracts, and lease-options can be impacted.

In a "subject-to" deal, an investor acquires a property by taking over the seller's existing mortgage without formally assuming the loan. The deed is transferred to the investor, but the original mortgage remains in the seller's name. This directly triggers the due-on-sale clause, putting the investor at risk of the lender calling the loan due. While many such deals proceed without issue, especially in stable interest rate environments, the risk of loan acceleration always exists.

Strategies to Navigate Due-on-Sale Clauses

Navigating due-on-sale clauses requires a clear understanding of the risks and a cautious approach. While some investors successfully execute deals that technically trigger the clause, it's crucial to be aware of the potential consequences.

Step-by-Step Process for Considering "Subject-To" Deals (with Caution)

1. Understand the Risks: Fully comprehend that the lender has the right to call the loan due at any time. This means you could be forced to refinance or sell the property quickly, potentially at a loss, if the lender enforces the clause.
2. Assess the Property and Loan: Conduct thorough due diligence on the property's condition, market value, and the existing loan terms. Verify the loan balance, interest rate, payment history, and whether the loan is assumable (most are not).
3. Negotiate with the Seller: Ensure the seller understands the implications of the "subject-to" transaction, particularly that the mortgage remains in their name and their credit is still tied to it. Establish clear agreements on who makes payments and how communication with the lender will be handled (typically, the investor makes payments directly to the lender).
4. Structure the Agreement: Work with a real estate attorney experienced in creative financing to draft a comprehensive purchase agreement and deed. This agreement should clearly outline responsibilities, indemnification clauses for the seller, and what happens if the loan is called due.
5. Manage the Property and Payments: Once the property is acquired, diligently make all mortgage payments on time. Lenders are less likely to enforce the clause if payments are consistent and the loan is performing well.
6. Maintain Communication (with Seller): Keep the seller informed about payment status and any issues. Remember, the lender will still communicate with the original borrower, so maintaining a good relationship with the seller is vital.

Other Creative Financing Approaches

• Lease-Options: In a lease-option, the investor leases the property with an option to purchase it later. The due-on-sale clause is generally not triggered by the lease agreement itself, as legal title does not transfer. However, it would be triggered if the option to purchase is exercised and the deed is transferred.Land Contracts (Contract for Deed): Under a land contract, the seller retains legal title until the buyer completes all payments. While legal title doesn't immediately transfer, many land contracts are structured to give the buyer equitable title, which some lenders may view as a triggering event. This is a gray area and depends on the specific contract and lender's interpretation.Wraparound Mortgages: A wraparound mortgage involves a new loan that "wraps around" an existing mortgage. The seller remains responsible for the original mortgage, and the buyer makes payments to the seller on the new, larger loan. While legal title typically transfers to the buyer, the original mortgage is not assumed, making it a potential trigger for the due-on-sale clause.

Real-World Examples and Scenarios

Example 1: Standard Property Sale

Scenario: Sarah owns a home with a $300,000 mortgage at a 3.5% interest rate. She decides to sell her home for $450,000. A buyer, Mark, obtains a new mortgage to purchase the property.

Outcome: Upon closing, the proceeds from Mark's new loan are used to pay off Sarah's existing $300,000 mortgage. The due-on-sale clause is technically triggered, but because the loan is immediately paid in full, there are no adverse consequences. This is the most common scenario for property sales.

Example 2: "Subject-To" Purchase by an Investor

Scenario: John, a homeowner, is facing foreclosure on his property with an outstanding mortgage balance of $220,000 at 4.0% interest. An investor, Alex, offers to buy the property "subject-to" the existing mortgage. Alex takes over the payments, and John deeds the property to Alex. John receives $5,000 cash for his equity.

Outcome: The deed transfer triggers the due-on-sale clause. The lender, upon discovering the transfer (e.g., through property record monitoring or insurance changes), has the right to call the $220,000 loan due immediately. If Alex cannot pay off or refinance the loan, the lender could initiate foreclosure. However, if Alex consistently makes payments and the lender doesn't actively monitor or choose to enforce, the transaction might proceed without issue. This is a high-risk strategy.

Example 3: Transfer to a Living Trust

Scenario: Maria owns a rental property with a $180,000 mortgage. For estate planning purposes, she transfers the property's deed into her revocable living trust, where she is the sole beneficiary and trustee. The property continues to be rented out, and the mortgage payments are made as usual.

Outcome: This transfer falls under an exception to the Garn-St. Germain Act. As long as Maria remains a beneficiary of the trust and the occupancy of the property does not change (i.e., it remains a rental property, not converted to a primary residence if it wasn't before, or vice versa), the lender cannot enforce the due-on-sale clause. The mortgage remains in place.

Example 4: Property Transfer in a Divorce

Scenario: David and Emily own a home together with a $400,000 mortgage. As part of their divorce settlement, Emily is awarded the home, and David deeds his interest in the property to Emily.

Outcome: This transfer is explicitly protected by the Garn-St. Germain Act. The lender cannot enforce the due-on-sale clause, and the mortgage will remain in place under Emily's responsibility (though David may still be liable on the original promissory note unless formally released by the lender, which is rare without refinancing).

Example 5: Lease-Option Agreement

Scenario: An investor, Sarah, wants to acquire a property but doesn't have the down payment for a traditional loan. She enters into a lease-option agreement with the homeowner, Tom. Sarah leases the property for three years with an option to purchase it at a predetermined price. During the lease term, Sarah makes rent payments to Tom, and Tom continues to pay his mortgage.

Outcome: The lease-option agreement itself does not typically trigger the due-on-sale clause because legal title to the property does not transfer. Tom remains the legal owner and borrower. The clause would only be triggered if Sarah exercises her option to purchase the property and the deed is transferred into her name, at which point she would need to secure her own financing or pay cash.

Legal and Ethical Considerations

When considering transactions that might trigger a due-on-sale clause, it is paramount to consult with a qualified real estate attorney. Legal advice ensures that all agreements are properly structured, risks are understood, and all parties are protected. Attempting to circumvent the clause without proper legal counsel can lead to significant financial and legal repercussions, including foreclosure.

Ethical considerations also play a role. While "subject-to" deals are legal, transparency with the seller is crucial. The seller must fully understand that their name remains on the mortgage and that their credit score could be negatively impacted if the investor fails to make payments or if the loan is called due. Full disclosure and clear communication are essential for maintaining trust and avoiding future disputes.

Current Market Conditions and Lender Behavior

Lender enforcement of due-on-sale clauses is often influenced by the prevailing interest rate environment. In periods of rising interest rates, lenders are more likely to enforce these clauses because it allows them to replace older, lower-yielding loans with new loans at higher, more profitable rates. Conversely, when interest rates are stable or falling, lenders may be less inclined to enforce the clause, especially if the loan is performing well, as calling the loan might mean losing a performing asset without a clear benefit.

However, it's critical to remember that the lender always retains the right to enforce the clause, regardless of market conditions. Investors should never assume a lender will not enforce it. The risk, while sometimes low, is never zero. Due diligence should include assessing the lender's historical behavior, though this information is often not publicly available. The safest approach is to assume the clause could be enforced at any time.