Understanding the Due on Sale Clause on Your Home Mortgage

The "Due On Sale Clause" is among the most frequently misunderstood and most-feared legal terms in American contractual law. In this article, we are going to take a look at what it is, what it is not, and how to avoid violating it.

What Is The Due On Sale Clause?

On nearly every home mortgage and loan contract written in the United States, the Due On Sale Clause is one of those fine print inclusions that a lot of home buyers overlook.

In essence, the Due On Sale Clause is a legal term that means that if a mortgage holder transfers interest in a real property to a third-party, then the bank or other lender has the "right" to call the loan "due in full", and if the mortgage holder cannot pay the loan in full at that time, the bank has the right to foreclose on the property.

It must be noted however that many banks and lending institutions do not enforce their rights in association to the Due On Sale Clause. Banks and lending institutions are "not required" to enforce the Due On Sale Clause, but they have the "right" to do so at their discretion.

Understanding The Foreclosure Process

This is an area that most consumers simply do not understand. In fact, just ten years ago, even I believed that if a home were foreclosed, the bank would hold the property until they could sell it at its full retail value.

But the truth is that banks and lending institutions generally do not make money when they foreclose a property. Instead, most banks will lose tens of thousands of dollars if they are forced to foreclose on a property.

Here is the reason why.

When a bank forecloses a property, they cannot afford to have non-performing real estate on their books. Banks and lenders also borrow money and have debts to service. So a piece of real estate on their books that is not generating an income is contrary to the lenders business model.

As a result, when banks foreclose on a property, they need to sell that property quickly. Foreclosed properties are sent to a sheriff's sale, usually within 90 days of the completion of the foreclosure process.

Now, here is where we get into the dollars and cents of why your lender is going to lose tens of thousands of dollars when they are forced to foreclose your property. The average property sold at a sheriff's auction will only generate 20- to 40-cents return against the retail value of the property!

So, if you have a 40% equity stake in your home at the time of foreclosure and your bank will only be able to collect 20% to 40% of the homes' retail value at auction, your bank is still going to lose 20% to 40% of the retail value of the property at auction. If your home is worth $100,000, you will lose your 40% equity in the property or $40,000, and your bank will lose 20% to 40% of the retail value of the property or $20,000 to $40,000 when they sell your home at auction.

When you begin to understand why a bank or lender would not want to foreclose your home, then you begin to understand why a bank or lender may choose not to exercise its rights under the Due On Sale Clause.

The History Of The Due On Sale Clause

The Due On Sale Clause began to work its way into mortgage contracts during the 1970's. Homeowners who took loans in the 1950's and 1960's were getting really low interest rates on home loans. But, during the 1970's, interest rates began to spiral upwards.

Home sellers who were willing to entertain "creative financing alternatives" to sell their homes began to sell their homes to other parties through Contract For Deed arrangements. This enabled buyers to avoid going to the bank to get new loans, which would require a much higher interest rate than the rate the current homeowner was paying on the home.

The math was easy to follow. The existing homeowner was paying 2% to 4% interest on his or her mortgage. Buyers getting new loans would be paying 8% to 16% to buy the same house. Assumable mortgages were a clear winner for homebuyers, due to the higher interest rates on new loans, and they were a clear winner for home sellers who would be able to sell their homes more quickly to motivated buyers.

Banks viewed the Due On Sale Clause as a method to force buyers into a higher interest rate. So banks began to include the Due On Sale Clause on all mortgage contracts.

Early on, a few states sided with buyers who felt that the Due On Sale Clause was tantamount to predatory lending practices. So in the late-1970's and early-1980's, state governments began to outlaw the Due On Sale Clause.

However, the federal government sided with the banking and savings and loan industries and passed a law in 1982, The Garn-St. Germain Depository Institutions Act of 1982, that made the Due On Sale Clause legal in all fifty states - with a few exceptions defined by the legislation: (http://www4.law.cornell.edu/uscode/html/uscode12/usc_sec_12_00001701---j003-.html)

The Garn-St. Germain Depository Institutions Act of 1982 Exceptions

As with any document filled with legalese, the language can be somewhat confusing, leaving room for interpretation in the law. As a result, many real estate investors operate on the fringes of this legislation, doing things that some people consider legal and other people consider illegal.

In the 27 years since this legislation was passed, the federal government has not taken steps to clarify any of the ambiguity in the legislation. As a result, it is entirely possible to find lawyers who argue for each side of the specific interpretation of the legislation.

Although some elements of this legislation remain ambiguous, some elements of the legislation are crystal clear. (As always, you should consult with an attorney before signing any contract.)

One point that is crystal clear is that any loan written on a manufactured home (mobile home) cannot include a Due On Sale Clause. All loans made on a manufactured home may be assumed by a third-party. Vanderbilt Mortgage, one of the largest lenders on manufactured homes, makes the process super easy. They will send you a credit application for your buyer, and if the person passes credit check, that person can take over your home loan immediately under whatever terms you set.

Another exception includes the ability to sign a lease of up to three years, so long as that lease does not include an Option To Buy.

Allowances for an exception to the Due On Sale Clause have been included to reflect the possibilities of the death of a borrower or a couple getting a divorce.

One more important exception to the Due On Sale Clause has to do with Inter Vivos Trusts. Also called a Living Trust, the Inter Vivos Trust is a legal instrument that permits the transfer of the ownership of the property from the individual to a legal trust, managed by a trustee and held by the homeowner as beneficiary. This was important to note, because many real estate investors use this as a tool to protect the interests of the buyer and seller in the real estate transaction.

If you want to know all of the specifics of this legislation, please refer to the Cornell Law URL included above.

The Due On Sale Protects The Lenders' Interests

Although banks and lending institutions have the "right" to enforce the Due On Sale Clause, most lending institutions will not exercise that right.

Some of the ambiguity that accompanies the legislation regarding the Due On Sale Clause is whether a borrower is required to notify his or her lender of a transfer of interest in a property. While it is fraud and a crime to mislead your lender, some argue that if you don't tell your lender, then you will have circumvented the legal ramifications of violating the Due On Sale Clause. After all, if you don't lie to your lender, then you have not committed any fraud.

The people who take this approach also believe that if the lender never figures it out, then nothing is lost if the buyer continues to make all of his or her payments on time every month.

Personally, I prefer that you play straight with your lender. As someone who buys homes that have a mortgage, it is in my best interest also, if the lender is aware of our intent to do a transaction. I would hate to buy your house under contract, pay on that house for one payment or dozens, and then have your lender discover that you did not tell them that I was buying your house. If your lender calls the Due On Sale Clause after I have worked out a purchase deal with you, then that would be a pain in my you-know-what.

Some lenders will not hesitate to call the Due On Sale Clause, although most are happy so long as they continue to receive on-time payments for the life of the loan.

That is why I suggest always to call your lender with a "If I wanted to" scenario. Don't tell your lender "you did it". Tell your lender before you sign the paperwork "you would like to do it".

Test the waters with your lender before you venture into the deal. Chances are that your lender will agree, so long as the buyer knows that if the payments come late, that the bank may exercise its right to Due On Sale.

One More Note

Someone asked what a Demand Clause was and if it is similar to the Due On Sale Clause. It is similar, but very different. The Demand Clause allows the lender to demand full payment at any time for any reason. With the Due On Sale Clause, then full payment can only be required if the interest in the property changes hands.

In Conclusion

Tens of thousands of deals are done every year, where the mortgage holder sets up a Contract For Deed deal with a buyer, and the lending institution permits the transfer to happen unimpeded - even though the lending institution has the right to stop the transaction at any time under the terms of the Due On Sale Clause.

If you want to sell your home during this housing crisis and credit crunch, your first best bet is to call your lender and have a discussion about "If I wanted to sell my house through a Contract For Deed" scenario.

If your lender says that they would call the note, then you know that this option is not for you. However, if they indicate that they would be happy to let you go through with such a deal on certain terms, then you will know that you have another option for getting out of that house that you do not want anymore.

Author's Note: This article originally published here:
http://www.libertyhomesellers.com/blog/2009/02/due-on-sale-clause/