Land Contracts – Part IV – The Due on Sale Clause – a Black Swan?
by Evan Vanderwey on 18/02/10 at 8:19 am
Black Swans are a fictional bird that everyone talks about but no one ever sees. Unlike Black Swans, Due-on-Sale Clauses exist and have been exercised by banks in the past. It is, however, extremely rare – thus I write this post.
A due-on-sale clause is a paragraph written into a mortgage giving the lending bank the right to accelerate the payoff (foreclose) on a home if the mortgage holder (homeowner) sells the home. Since a land contract is a sale – a transfer of ownership that will hold up in court – the bank would have the right to “call” the loan if the mortgage holder sold in this way. If you have a mortgage, this paragraph is likely in it. This is the plain truth.
First, that is not the same as saying it’s illegal for you to sell your home using a land contract. You are allowed to do it under the law. But it’s wise to gain the permission of your current mortgage lender if you have one before selling your home on a land contract. You can ask for something in writing or for an opinion by calling the customer-service line. You will likely be told that they will not put it in writing but that so long as you make your payments on time, the banks current practice is to leave the deal alone and let you pay.
This makes sense. Banks have enough problems on deals where homeowners are not paying at all, why make trouble on a deal that is performing according to contract, where payments are collected on time?
So, it’s not illegal. And though exercising the due-on-sale clause is the bank’s right, it makes logical sense that they would leave you alone. So why not just go ahead with the land contract?
Well, you do need to be aware of one situation where you might be in hot water. Remember, everyone (even if that “one” is a group of people called a bank) is self interested – just like you are. Let me set this up:
You are paying on your mortgage ‘on time’ and have never missed a payment. Your interest rate is 5.5% on a fixed rate loan. You sold your home to a buyer using a land contract for $150,000 in a market where you might have sold the home for $135,000 on a good day. Your buyer is on time every month with automatic draft payments from his checking account to yours. Everything is going just as planned – you are a few years away from having made a good profit and a great decision.
Fast forward three years. The average market interest rate is now 9%? I don’t think this will happen, but it could. Homes are selling for more money now, your home is worth far more than you owe on it now – it would sell for $160,000 today and you owe $130,000.
If you are the bank, what are you thinking?
Bank: I currently have a mortgage to this person who is contracted to pay me 5.5%. If I had that $130,000 back, I could relend it in the open market at 9%. There is cost in taking over a home by exercising a due-on-sale clause, but it might be worth it.
At the outset, it is not likely that home values will rise a lot if rates are also rising. So those two things would not likely be true at the same time. In long-term situations though, it is possible and it could happen. So, I’m writing about it.
What’s the solution?
Your land contract should include a clause that allows you to cancel the contract with your buyer if your lender accelerates for this reason. Make it fair, give them their down payment back (or part of it ), but make sure you can cancel the land contract if the bank calls your loan. Once the home is sold back, the bank will not be able to take over. They will give you time to do this.
Most of the time, your buyer will have paid you off long ago. If not, then you can still work with the buyer in a lease-to-own situation for the last while before they get a mortgage and finish the transaction with you.
So, even though a due-on-sale clause is real and something you should be aware of, don’t be afraid of them. Chances are, like Black Swans, you’ll never see one.
