BROKER RISK MANAGEMENT
WEEKLY PRACTICE TIP
ISSUE: With rising interest rates, I have been hearing about a type of seller-carryback loan, also referred to “wrap loan,” which allows a buyer to buy with little down payment or to take advantage of the seller’s low-interest rates. I understand that this financing includes the buyer buying the property “subject to” the existing financing and the seller receiving a promissory note for the balance of the purchase price. How does this financing work? Is it risky?
RESPONSE: This is an extremely risky transaction for the seller. The buyer purchases the property “subject to” the seller’s existing financing and the seller loans the buyer the difference between the purchase price and any deposits. “Subject to” means that the buyer is not assuming the seller’s existing loan, but rather that the seller’s loan to buyer will be in junior or secondary position behind the existing first loan which is not paid off or assumed, and seller’s lender is not alerted that the sale is taking place.
In other words, after the transaction, the original financing will stay in place, which the buyer agrees to pay. The seller will loan the buyer more money which will be secured by a second or junior deed of trust recorded against the property securing the promissory note to the seller. Generally, the buyer makes each monthly payment to the seller and the seller agrees to pay the underlying existing loan to the seller’s lender.
For example, the seller’s property sells for $1 million and has an existing $400,000 loan at 2.5% interest. The buyer agrees to pay seller $100,000 cash at the close of escrow, and that first loan is not paid off or assumed but remains in place. Instead, the seller takes back a note for $900,000 secured by a note and a second deed of trust at 5% interest. That second note and deed of trust is also known as an All-Inclusive Deed of Trust since it “wraps around” and includes the remaining balance of the first loan.
SCENARIO No. 1:
I received an offer on my $800,000 listing from a buyer who is proposing to purchase the property with only $10,000 cash down and seller to carry a “wrap” loan/deed of trust for $790,000 at close of escrow at 4% with a balloon payment in 2 years. There is an existing loan on the property for $250,000 at 2.5% which will remain secured against the property in first position with seller’s loan in second position. The buyer, an LLC, states that they intend to engage in short-term rentals. The seller is desperate and enticed by increased interest income over the interest rate on the first loan.
The risk is that, if the first lender discovers the recorded deed to the buyer, declares the note due and payable, demands full payment and, if not received, commences foreclosure of the property. If there is a foreclosure on the property, the seller’s second deed of trust is extinguished, and seller is left with an unsecured note against the buyer, which may have no assets.
This is not only risky, but it may also be a scam. The buyer is looking to make money on short-term rentals and, if they cannot pay the seller’s loan, or the first lender forecloses, they just walk away with the cash they made.
SCENARIO No. 2:
Same facts as above, but after the close of escrow, the buyer files for bankruptcy. The senior (seller’s lender) seeks to foreclose on the first. Because of a declining real estate market, there is no equity left to pay off the seller’s note and the buyer has no further obligation to pay the seller due to the bankruptcy.
SCENARIO No. 3:
Same facts as above, but when the costs of improving the property increase due to inflation, the buyer simply stops working on the property and allows the property to go into foreclosure. The seller cannot afford to pay off the senior loan. As a result, the property is sold to the lender at a foreclosure sale and the seller receives nothing. In this instance, the seller sues the real estate agent for failing to properly advise the seller of the risks affiliated with this financing.
PRACTICE TIPS:
- Seller financing and wrap loans are inherently risky. If a seller is interested in seller financing, the seller should be referred to a qualified California real estate attorney to advise on the risks and draft the underlying loan documents, including a deed of trust and promissory note.
- Agents should not prepare or draft the promissory notes or deeds of trust. Agents should refer their clients to qualified California real estate counsel for the drafting of these documents.
- Agents should not recommend that the title or escrow company prepare a promissory note or deed of trust. Escrow/title companies are not in the business of drafting loan documents and generally, the documents they provide are generic standard forms and not sufficient to properly protect the seller.
- With seller financing involving one to four units, a seller financing disclosure is statutorily required. (See CAR SFA Form.) Agents should not prepare that disclosure. The seller, with the assistance of the seller’s attorney, should complete that disclosure. Likewise, agents representing buyers should not prepare that disclosure; a buyer’s agent will become an “arranger of credit” under the statute, if the agent assists with the preparation of this disclosure. That creates additional risk for the buyer’s agent.
This Weekly Practice Tip is an attorney-client privileged document for the exclusive use of clients of Broker Risk Management and their agents. It may not be reproduced or distributed without the express written consent of Broker Risk Management. The advice and recommendations contained herein are not necessarily indicative of standards of care in the industry, but rather are intended to suggest good risk management practices.