You owned a piece of real estate. When you bought it, you didn't have all the cash, so you borrowed money from a lender and, in return, signed a note and mortgage. Later, you decided to sell the property and you found a buyer who paid you a down payment and took over your monthly payment obligation to the lender.
This is a common real estate transaction called an “assumption”. Your new buyer takes title to the property, and “assumes” the payments due on your mortgage. It happens every day.
But, a year later, you discover that the buyer has defaulted on the mortgage payments and suddenly that fact shows up on your credit report, or, even worse, you are named as a defendant in a foreclosure lawsuit!
Surely there's some mistake, you think! It's no mistake. It's the hidden peril of assumptions. Sellers think they are out of the picture, but in fact, they are often still legally responsible for the payments on the mortgage, just like before the property was sold. This seems like an injustice, as sellers have no control of the buyer or the property.
How do you avoid the hazards of assumptions? First, you need to understand the assumption process. There are two basic types of assumptions.
Explaining The Process
The most common type is a SIMPLE ASSUMPTION, in which you remain legally liable for the mortgage even after you sell the property. To understand why this is the case, think of it this way: If you have a mortgage note that you owe to a lender, simply selling your property and having the new buyer take over your mortgage payments does not eliminate the mortgage. That mortgage still exists. You still owe what you originally agreed to repay on that mortgage. There is no new mortgage. You have not been removed from the picture. All that has happened is that the new buyer has agreed to step in and make your payments on the mortgage. The payments are still your responsibility. The fact that you sold the property and accepted a cash down payment has no effect whatsoever on your mortgage obligations to the lender.
The most important fact to keep in mind about simple assumptions is that you are still liable. Many sellers fail to see this plain fact. They presume that the mere sale of the property transfers the mortgage obligation to the buyer. It does not.
There are a few exceptions. In the special case of an FHA mortgage that was created between December 1986 and December 1989, if your new buyer successfully makes the payments on your mortgage for five full years, your liability is automatically removed at the end of this five year period.
If you have filed bankruptcy and discharged the mortgage debt through a court ruling, you are no longer personally liable. However, the lender may continue to hold a mortgage lien on the property.
The laws of some states provide exemptions which protect certain classes of property owners, so that you have no personal liability.
Another exception is the “non-recourse” loan. Some people call this an “anti-deficiency” loan. A non-recourse loan is a loan without personal liability where the lender can only repossess the property. When you borrowed money from your lender, if your mortgage documents specificially contained “non-recourse” language, that means you were never personally liable for the payments. Your sale of the property would not create personal liability where none existed before. Your lender is limited in such cases to repossessing the property.
However, even with these exceptions, the lender may report a delinquency or default which may show up on your credit report, and the public records may reflect a foreclosure against you.
The second type of assumption is often referred to as a “NOVATION” (the substitution of a new legal obligation for an old one). A novation is often called a “formal assumption” or “assumption with release”. This is a situation in which you have obtained a written agreement from your lender removing you from all obligations and placing the responsibility entirely on your new buyer. A novation is essentially a new agreement.
You should avoid simple assumptions and deal only with novation assumptions whenever possible.
Novations are not easy to obtain and they can be expensive. In the first place, your lender has no obligation to grant a novation unless your new buyer meets the lender's specific standards and requirements. Novations cost your lender time and money, and they also bring your lender new risk. Your lender obviously wants the same information and assurances about your new buyer as it had about you. That means a full credit and financial investigation must be completed on your new buyer. Your lender may charge a substantial fee, increase the interest rate on the loan, change the payments, change terms, or any combination, in order to approve the novation.
In many circumstances, a novation may not be available. The lender may simply refuse to grant one for its own reasons, your new buyer may not be able to measure up to the credit or financial requirements, or the cost may be too high.
There are several pitfalls to avoid in assumptions, both simple assumptions and novations. Before you even put your property on the market for sale, check with your lender and make sure your mortgage is assumable. You should obtain a written statement from your lender that the mortgage is assumable and under what terms and conditions.
It would be helpful to first read your mortgage documents. Look carefully to see if there is a “due on sale” clause, meaning that if you sell the property you are required to pay off your mortgage. If the documents say nothing about the loan being assumable and there is no “due on sale” clause, chances are that your mortgage is assumable.
Even if the documents specifically say that the mortgage is not assumable, the lender may consent to the assumption in spite of the documents. It never hurts to ask.
Some state laws prevent the enforcement of due on sale clauses in certain situations, so even if there is a due on sale clause in the documents, it may not be enforceable.
Furthermore, your mortgage may have been sold on the secondary market. For example, the actual owner of your mortgage could be an insurance company, Federal National Mortgage Association (“Fannie Mae”), Federal Home Loan Mortgage Corporation (“Freddie Mac”), or a private party. The wants and rules of the secondary market could be the governing factor about the assumability of your mortgage, either overriding or strictly enforcing the terms on your documents. For example, if your mortgage has been sold Fannie Mae, the due on sale clause may not be enforced. Fannie Mae may be the actual owner of the mortgage and the party collecting your payments may actually be just a servicing agent. Freddie Mac may traditionally follow a practice of strictly enforcing the due on sale clause. Thus, your “lender” (actually your servicing agent) may not give you the right answers about the assumability of your mortgage. It is important to find out whether, and to whom, your mortgage has been sold.
In any circumstances, it's important to get the lender's (or servicing agent's) statement in writing.
With a simple assumption, your first task is to make sure that clear and affirmative statements are signed by your new buyer accepting legal responsibility for payment of your mortgage. Even though this sounds quite elementary, many sellers fail to obtain these statements and later discover, when problems occur, that they did not complete a legally binding assumption.
The practical effect in this case is a sale “subject to” your mortgage, but without your new buyer incurring personal liability to pay it. Such a “subject to” sale invites trouble. For example, even though your new buyer has an incentive to keep up payments on your mortgage or lose the property and the down payment, there is no worry about personal liability if things go wrong. That makes it easy for your buyer to walk away from the property if there is a change of circumstances – loss of job, bad economy, sudden illness. That leaves you with the total liability.
However, if the new buyer signs clear and affirmative statements accepting legal responsibility for the payments, then your new buyer's personal assets may be at risk. This is a strong incentive for your new buyer to make good on the assumption. Self-protection by your new buyer automatically protects you.
Your second task with a simple assumption is to make sure you get a sizable cash down payment. The more your new buyer has at stake, the less likelihood there is of a default. It's a good idea to check the source of the down payment to make sure that it's not a sudden windfall that gives you a false impression of your buyer's finances and commitment to the purchase. Inquire to see whether the down payment was borrowed, came from a gift, or originated from questionable sources.
The third task is to make sure that you are furnished, and that you carefully evaluate, full credit and financial information on your buyer so you know who you are dealing with and what to expect – the lender often requires this information anyway. If there is a default, it is important that your new buyer has sufficient assets to pay any resulting losses that you might suffer.
A possible fourth task is to obtain a signed agreement from your buyer acknowledging that by taking over your payments, the buyer takes on your obligation. You could obtain a voluntary lien signed by your buyer, and record it against the property as security for your buyer's performance of this agreement. The agreement could include language that your buyer agrees to “indemnify, protect, and defend” you in case of your buyer's default or foreclosure of the property. The agreement should also include language allowing you to recover any attorney fees and costs which you are required to pay as a result of a default by your buyer. As a practical matter, this language may not help you because if your buyer has trouble making the payments, it's unlikely that your claims can be paid.
As a final item, you should obtain a stipulation from the lender and your new buyer to give you continuing access to all information about your loan. Because you are liable for the mortgage, you have a right to this information as a matter of course, but it may prove helpful to have a written document at your disposal. As a practical matter, you may find that despite your rights, you may not actually receive the late notices and continuing information you are entitled to. If the lender sells the loan or the servicing agent changes, your notifications may get lost in the shuffle. In addition, clerks may not be aware of your rights and refuse to honor them, especially if your name no longer appears on the computer.
In many states, you are entitled to record a request to be notified if a foreclosure is started. This does not guarantee that you will receive any additional information or that you will be notified when the default first occurs.
Be sure to consult a qualified real estate attorney to assist you in transacting any assumption. There may be significant tax consequences in any assumption depending on your personal circumstances. These tax consequences should be evaluated with your tax professional.
With these cautions in mind, you can be prepared for the perils of assumptions. Clearly, your best course in an assumption is to obtain a novation.
If a novation proves impossible, take special care to obtain clear and affirmative statements of legal liability from your new buyer, as well as a sizable down payment and a thorough credit and financial investigation. Staying alert to these problems will not eliminate your legal liability, but is a practical way to minimize your risk.