What is the Due-On-Sale Clause and How We Overcome It
What is a Due-On-Sale Clause?
A due on sale clause is a provision in most mortgage contracts that gives the lender the right to demand the full payment of the loan balance if the borrower sells or transfers the property without the lender's consent. This means that the borrower cannot sell or transfer the property to another person or entity without paying off the existing loan or getting the lender's approval. If the borrower violates the clause, the lender can invoke it and accelerate the loan, meaning that the borrower has to pay the entire loan amount immediately or face foreclosure.
What Does a Due-On-Sale Clause Do?
The purpose of the due on sale clause is to protect the lender's interest and profit. The lender wants to make sure that the borrower pays the loan according to the original terms and conditions, and that the lender can recover the loan amount if the borrower defaults. The lender also wants to prevent the borrower from transferring the property to someone who might not be able to pay the loan, or who might get a better deal than the lender. The due on sale clause gives the lender the power to control the property and the loan, and to prevent the borrower from changing the terms or the parties involved.
A Bit of History
The due on sale clause has a long and controversial history. It was first introduced in the 1970s, when the interest rates were high and volatile. The lenders wanted to protect themselves from losing money on their loans, as the borrowers could sell or transfer their properties to someone else who could get a lower interest rate or a longer loan term. The lenders also wanted to take advantage of the rising interest rates and make more money by lending to new borrowers at higher rates. The due on sale clause allowed the lenders to do that, by forcing the borrowers to pay off their loans or get their consent before selling or transferring their properties.
However, the borrowers and the investors did not like the due on sale clause, as it limited their options and flexibility. They wanted to be able to sell or transfer their properties without paying off their loans or getting the lender's approval, especially if they could get a better deal or a higher return. They also wanted to use creative real estate strategies, such as subject-to deals, lease options, land trusts, or seller financing, where the ownership of the property changes hands without paying off the existing loan. These strategies allowed the borrowers and the investors to save money on closing costs, avoid qualifying for new loans, leverage their capital for multiple properties, and generate passive income and appreciation.
The borrowers and the investors challenged the validity and enforceability of the due on sale clause in court, arguing that it was unfair, unreasonable, or unconstitutional. They claimed that the clause violated their rights to contract, to property, and to privacy. They also claimed that the clause was not applicable or enforceable in certain situations, such as when the property was transferred to a trust, a corporation, or a relative, or when the property was sold subject to an existing mortgage. The courts had different opinions and rulings on these cases, creating a lot of confusion and inconsistency.
In 1982, the federal government passed the Garn-St Germain Depository Institutions Act, which clarified and standardized the due on sale clause. The act stated that the lenders could enforce the due on sale clause in most situations, except for some specific and limited exceptions, such as when the property was transferred to a spouse or a child, or when the property was transferred to a trust where the borrower remained the beneficiary. The act also stated that the lenders could not enforce the due on sale clause on certain loans, such as FHA and VA loans, which were assumable by qualified borrowers. The act effectively ended the legal disputes and established the due on sale clause as a common and important provision in most mortgage contracts.
What Can Trigger the Due-On-Sale Clause?
The due on sale clause can be triggered by various events or actions that involve selling or transferring the property without the lender's consent. Here are 5 of the most common triggers:
The lender finds out
Improper insurance
The investor misses a payment
Incorrect paperwork
Angry seller
10 Exceptions to the Due-On Sale Clause
When the property is transferred to a relative upon the death of the borrower
When the property is transferred between spouses due to divorce or legal separation
When the property is transferred to a trust where the borrower remains the beneficiary and occupant
When the property is transferred to a spouse or child who will occupy the property
When the property is subject to a federal, state, or local government program that encourages homeownership
When the loan is assumable by a qualified borrower under certain federal programs, such as FHA, VA, or USDA loans
When the loan is modified, refinanced, or consolidated with the lender’s consent
When the property is subject to a lien or encumbrance that does not affect the occupancy rights
When the property is leased for three years or less without an option to purchase
When the property is transferred by operation of law, such as by inheritance, bankruptcy, or foreclosure
How We Avoid the Due-On-Sale Clause
Generally the due on sale clause occurs when the bank notices there has been a change in ownership. This is very common with foreclosures. If you are working with a foreclosure or need to catch up payments, you wait 10-15 days after the loans been reinstated to close escrow to help reduce the likelihood of the bank noticing a change in ownership.
How We Overcome the Due-On-Sale Clause
We overcome the due-on-sale clause in 2 primary ways. However, if the bank is small, we always try to go through them first and see how they have handled these being called in the past to build relationships with them for the future.
Best Option: You can deed the property back to the original owner, and then buy it again on a lease option, which is a contract that gives you the right to rent the property for a certain period of time, with the option to purchase it at a predetermined price and time. The option price is set to be the remaining mortgage balance at the time you exercise your option, which means you only have to pay the difference between the option price and the loan balance.
Last resort: You can deed the property back to the original owner, and then buy it again on an agreement for sale. You are still the owner, but you don’t transfer the deed and are not in breach of the contract. The agreement of sale can be structured as a land contract, where the seller retains the legal title to the property until the buyer pays off the full purchase price, or as a land trust, where the property is transferred to a trust and the seller and the buyer become the beneficiaries of the trust.
Buy Due-On-Sale Clause Insurance. There are companies out there that offer due on sale insurance and will handle the situation for you in case it comes up.
Bonus: Wrap-around mortgages are another potential, though not as common of a solve. If you wrap a mortgage around an existing mortgage, it is less likely the lender will find out, but the due on sale can still be called.
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If this is all overwhelming to you, or you have a deal and don’t have time to learn all the ins and outs of these concepts - do not worry! Reach out to us and we would love to make sure your deal closes on time and all of the T’s are crossed and I’s are dotted!