Today’s mortgage rate trends point to the reemergence of the once common carryback sale.
A carryback sale is also known as:
- seller financing;
- an installment sale;
- a credit sale; and
- an owner-will-carry (OWC).
A seller who extends installment financing on the sale of their property for deferred payment of part of the sales price is offering a carryback sale.
Why would a seller offer carryback financing? The benefits to a seller include:
- not having to rely on lender financing to close the deal — especially if the agreed-upon price may not meet current appraisal requirements;
- appealing to a larger pool of buyers, including those who may not qualify for traditional mortgage financing;
- the likelihood of receiving an above market sales price, which is much harder to get when the homebuyer is reliant on traditional financing; and
- the ability to defer taxes on taxable profit from the sale, particularly helpful for long-time homeowners whose profits may exceed the principal residence profit exclusion amounts of $250,000 for each homeowner. [26 United States Code 121(b)]
However, there are risks for the seller, too.
The seller takes on the financial risks of a mortgage lender — without a banker’s resources or portfolio diversification to fall back on if the homebuyer defaults. Further, California is a nonrecourse state. Thus, when the homebuyer defaults the seller’s sole source of recovery is to foreclose on the property. The seller cannot collect any of the carryback debt by way of the defaulting buyer’s other assets. The exception to this rule is when the mortgage is subordinated to a construction loan or additionally secured by property other than the property sold. [Calif. Code of Civil Procedure §580b]
The carryback seller can screen for the ideal buyer candidate by reviewing the buyer’s:
- ability to pay and fulfill the obligations of the carryback note;
- relevant information about the prospective buyer’s identity, occupation, employment, income and credit data;
- existing and future loan obligations, including payment history and any pending bankruptcy; and
- credit information as disclosed on a credit application.
On the other side of the transaction, benefits to a homebuyer choosing to take advantage of seller carryback financing include:
- the flexibility to negotiate a down payment amount with the seller;
- competitive and negotiable interest rates;
- more flexible mortgage qualification standards; and
- none of the closing costs associated with traditional financing.
However, with these benefits homebuyers need to expect to pay an above market price for the seller’s home.
Future carryback trends are future interest rate trends
In the old days of rising interest rates, it was quite common to see OWC — owner will carry — on listings, a marketing tool to garner more buyer interest. Going forward, you can expect to see more OWC listings with the rise in interest rates and increased housing construction.
Carryback sales were last common during the era of rising interest rates, which lasted about three decades — from the 1950s through the early 1980s.
This pattern of gradually rising then falling rates tends to last about 30 years on each end of the cycle. We just experienced an end to the last era of falling rates, which began in 1982 and hit a historical low in 2012.
Since 2012, mortgage interest rates have fluctuated on a regular basis, as they tend to do. But the overall trend is pointing up, and will continue up in the coming years.
In 2017, the Federal Reserve (the Fed) has indicated they will continue to bring the Federal Funds rate up from its 0.0%-0.5% target rate, which they began to do in December 2015. The Federal Funds rate has a direct impact on adjustable rate mortgage (ARM) interest rates, since lenders often use it as a sort of benchmark for how costly it is to lend money over the short term.
However, for fixed rate mortgages (FRMs), it is outside market forces that influence the ten-year Treasury note and bond market — like an uncertain global economy and excess dollar availability. These act as a damper on FRM rates, keeping them near their current levels. FRM rates will likely average around 4.0% through the end of 2017.
Zooming out to view the full picture, the next two to three decades will see a gradual rise in interest rates of all kinds, including FRM rates. When this occurs, homebuyers will long for the old days of sub-4% or even sub-5% mortgage rates. The only way they’re going to find these old rates is to take over the seller’s mortgage.
Other market forces that encourage the use of carrybacks include:
- stable home prices; and
- sufficient inventory to meet homebuyer demand.
2017’s housing market does not qualify, since prices continue to rise and inventory is tight due to insufficient residential construction. But an environment rich for carryback sales is on its way, likely in the early years of the 2020s.
Construction continues to increase across California, likely to catch up with burgeoning demand heading into the next decade. On the other hand, California home prices will continue to rise through 2021 or 2022, with a brief dip likely in 2018 as buyers increase savings and mentally adjust to higher interest rates. Prices usually take around 12 months to adjust downward to other market factors, like reduced home sales volume.
Thus, seller carrybacks will see a full comeback at the start of the next decade. Carrybacks will be the saving grace for real estate professionals who may otherwise suffer from fewer sales and lower prices produced by the unique market factors brought on by rising rates, excess inventory and stable prices.
However, there is an obstacle to the coming wave of carryback sales: the lender’s due-on clause.
The due-on clause curbs future sales
California agents and brokers licensed in the past decades may not be familiar with the due-on clause found in all trust deeds, as it hasn’t been relevant with declining interest rates and massive sums of money for mortgage investment. The due-on clause is a trust deed provision used by lenders to call the mortgage immediately due and payable. The owner’s transfer of any interest in the real estate (with the exception of intra-family transfers) triggers the lender’s right to use the due-on clause.
In a rising interest rate cycle, lenders prefer to exercise their due-on right rather than lose the opportunity to re-lend at a higher interest rate whenever the opportunity arises. When a transfer event occurs that triggers due-on enforcement, the mortgage holder may:
- call the mortgage, demanding the full amount remaining due to be paid immediately, also known as acceleration; or
- recast the mortgage, requiring a modification of the note’s terms (i.e. a higher interest rate) as a condition for the mortgage holder’s consent to a transfer, called a waiver by consent.
All of this is made possible by the Garn-St. Germain Federal Depository Act of 1982, which preempts state-level limitations on a mortgage holder’s enforcement of the due-on clause.
The state law that Garn-St. Germain supersedes limits lenders from interfering with the sale of the property to instances where the lender can demonstrate the buyer:
- lacks creditworthiness; or
- is wasteful of property.
However, since the federal law supersedes California state law, lenders may automatically call the mortgage due on any transfer of an interest in real estate, with only a few family-related exceptions.
While lenders don’t commonly employ the due-on clause, the threat of the clause stifles future carryback sales.
Change the law: repeal the due-on
Repealing Garn-St. Germain would open up the sales pool, since sellers would be able to offer carryback sales without fear of the lender calling the loan due.
During periods of rising interest rates — as in the coming years — lenders seize on any event triggering the due-on clause to increase the interest yield on their portfolio. When the due-on clause is triggered, the mortgage holder requires the mortgage to be recast at current (higher) market rates as a condition for allowing:
- a mortgage assumption;
- a lease with a term over three years; or
- a further encumbrance of the property by the owner.
Thus, mortgages become increasingly difficult to be taken over by buyers as interest rates rise. This imprisons homeowners unable to sell and relocate without accepting a lower price for cash-out sales, ultimately stifling home sales volume. Recall that when interest rates rise, the value of real estate declines, all other market conditions remaining constant.
The current solution is for the agent arranging the carryback to query the mortgage holder — the lender of the existing mortgage — to see if it is willing to allow a carryback without calling the note. The lender’s response will be to:
- allow the carryback transaction if the buyer agrees to a recast of terms, such as a higher interest rate; or
- deny the request.
The longer-term solution is to repeal Garn-St. Germain altogether and avoid the exaction by the lender which stifles the ability to sell.
The only beneficiaries of Garn-St. Germain are the lenders, who use the threat of the due-on clause to exact additional profits from homebuyers. Repealing Garn-St. Germain would return the right to alienate property (sell, lease or further encumber) to the property owners. State law only allows lenders to interfere when buyers are not creditworthy or would put their security at risk (the insolvent arsonist buyer).
Is a repeal of Garn-St. Germain likely?
Not under the current administration. But as more interest is expressed in seller carrybacks during the future decades of rising interest rates, future state legislation that would go around the federal law is possible.
California can legislatively bar the use of trustee’s and judicial foreclosure proceedings as a remedy for due-on enforcement. This would limit the lender’s recourse to judicial foreclosure proceedings in federal courts, which are time-consuming and costly for the lender to simply get the property back when demanding extra profits on an assumption.
Change starts with real estate professionals like you. Canvass mortgage lenders for their voluntary limitations to due-on enforcement and safeguard your future sales volume.
Want to learn more about carryback financing? Check out Realtipedia volume: Creating Carryback Financing, Fifth Edition.
Disclosure — Fred Crane, first tuesday’s Legal Editor, was the attorney of record on the two landmark due-on enforcement cases: [Wellenkamp v. Bank of America (1978) 21 C3d 943] and [Fidelity Federal Savings & Loan Assoc. v. de la Cuesta (1982) 458 US 141].