Whenever a seller carries back a promissory note secured by a deed of trust to the property the parties need to fully understand that in addition to their roles as seller and buyer they will have an ongoing relationship as lender and borrower. When the seller extends credit to the buyer in California the parties must complete and sign a Seller Financing Addendum and Disclosure form (“SFA”). The form is designed to make sure that both parties understand the terms of the financing including particularly issues relating to due on sale clauses if applicable and any requirements for a balloon payment. The form was recently updated to inform the parties of certain requirements of the Dodd Frank Act which can apply where the seller is an investor who for example is “flipping” the property. The laws requiring these disclosures (California Civil Codes sections 2956-2967) arose out of a concern that so-called “creative financing” involving seller financing which became popular at a time of very high interest rates led to abuse when buyers would enter into transactions which seemed attractive at the time but led to foreclosures when they were unable to refinance at the time the balloon payments became due. Seller financing is treated as a purchase money loan for the purposes of California anti deficiency laws.
When the Seller carries back a 2nd Trust Deed behind an institutional lender’s 1st Trust Deed loan a problem can arise when the Seller wants the 2nd paid off in less than 5 years. Under Fannie Mae guidelines a 2nd Trust Deed loan has to be for a term of at least 5 years. One method of dealing with this issue, for example when the Seller wants to get paid within 2 years, is to have the interest increase dramatically after the 2nd year thereby motivating an earlier pay off.
One form of seller financing is an All-Inclusive Deed of Trust (“AITD”). AITD’s also known as a “wrap around” mortgage is a structure whereby the seller’s existing loan or loans remain in place and a new deed of trust is executed by the buyer securing a promissory note that includes the amount of the existing loan or loans. To the degree that the AITD exceeds the amount of the existing loan it acts just like a second (or third)) deed of trust being carried back by the seller. AITD’s are employed primarily for the purpose of either: (a) providing financing to a buyer who due to credit or other problems could not qualify for a loan from a lending institution; or (b) to avoid a formal assumption of the existing loan which may either not be approved by the lender or could involve fees and/or an increase in the interest rate. Both AITD financing and simply purchasing the property subject to existing loans involve the risk of having the loan accelerated by the lender pursuant to the due in sale clause which is included in most loan documents. A due on sale clause gives the lender the right to declare the entire unpaid balance of the loan due and payable when the original borrower transfers title to another party.
It is important that sellers and buyers engaging in either an AITD or “subject to” transaction sign a written statement which includes important disclosures regarding the risks and possible consequences of these types of seller financing. The San Diego Association of Realtors has a disclosure form which covers these matters.