As mortgage interest rates continue their meteoric rise, buyers are struggling to secure traditional financing for home purchases.
California real estate professionals can expect this trend to worsen before it gets better, thanks to the Federal Reserve’s commitment to snuffing out inflation through painful rate hikes.
Becoming an expert in carryback financing is key to thriving in this new environment of rising rates. To prepare agents for the return of mortgage assumptions, this article continues our discussion of usury limits and exceptions in transactions structured as carryback sales — review Part I here.
Loan disguised as a carryback
While the modification of a carryback note on a default does not convert the debt into a loan, a loan transaction disguised as a carryback sale is subject to usury
For example, consider a seller of real estate who negotiates with a buyer to cash out their equity in the property and assume the existing mortgage. However, the buyer does not have the cash reserves needed to cash out the seller’s equity.
The buyer is referred to a lender which is not a licensed real estate broker in California. The buyer contacts the lender directly. The lender agrees to lend the buyer the additional money needed to cash out the seller’s equity.
However, the rate of interest demanded by the lender exceeds the maximum yield allowed by usury laws.
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Rather than lend the money directly to the buyer, the lender requires the sales transaction be restructured as a carryback sale evidenced by a note and trust deed executed by the buyer in favor of the seller. The note is to be payable on terms dictated by the lender. The lender will acquire the note at an agreed price by assignment from the seller concurrent with the close of the sales escrow.
Thus, the buyer will cash out the seller’s equity in a two-step transaction consisting of:
- the buyer’s down payment funds; and
- the lender’s funds structured as payment for the seller’s assignment of the carryback note to the buyer’s lender.
Usury laws avoided?
Will the lender’s plan to structure its advance of funds as a purchase of a carryback note by an assignment from the seller avoid the interest limitations of usury laws?
No! Although the transaction on its face appears to be a credit sale and an assignment of a carryback note to a trust deed investor, the initial purpose for the involvement of the trust deed investor was to loan money to the buyer.
As a loan transaction initiated and negotiated by the buyer to obtain purchase-assist funds from a lender without the involvement of a broker to arrange the loan, the transaction is a loan of money and subject to usury law limitations. [Harris v. Gallant (1960) 183 CA2d 94]
Editor’s note — One way for a private lender to exempt its loans from the limitation on interest rates imposed by usury laws is to retain a licensed real estate broker to arrange the loan or become licensed as a real estate broker itself, since all loans made or arranged by licensed brokers and secured by real estate are exempt from usury limitations. [Calif. Const. Art. XV]
The carryback mortgage sold to a lender
Consider a buyer and seller in reverse roles from the previous example, but with the same goal of cashing out the seller on close of the sales escrow. The seller, not the buyer, initiates negotiations to sell the carryback mortgage to a trust deed investor, who is also a non-exempt lender.
The buyer and seller enter into a purchase agreement calling for the buyer to make a down payment and execute a carryback mortgage in favor of the seller for the remainder of the purchase price. Closing is contingent on the seller assigning the mortgage to a trust deed investor.
From the outset of negotiations, the seller intends to immediately sell the carryback mortgage. To assure the mortgage can be sold, the seller (not the buyer in this example) structures the terms of the carryback note for its sale to a trust deed investor. A trust deed investor approves the buyer’s credit history before the seller waives the contingency for further approval of the buyer’s credit. [See RPI Form 150 §9.6]
The yield the trust deed investor is to receive for the funds they advance to acquire the mortgage exceeds the usury limits.
The sales escrow closes concurrent with the trust deed investor funding the purchase of the carryback mortgage by an assignment from the seller.
Later, the buyer claims the mortgage is usurious and they owe no interest to the trust deed investor since the creation and sale of the carryback mortgage was a sham designed to circumvent usury laws.
However, the carryback mortgage evidenced a debt intended by the buyer and seller to arise out of a valid credit sale. The trust deed investor was not brought in by the buyer to make a loan, but was sought out by the seller to purchase the mortgage the seller intended to carryback and resell.
No recharacterization or alteration of the purchase agreement or the sales escrow instructions was required to complete the seller’s sale of the carryback mortgage by assignment to the trust deed investor.
Thus, the seller may freely assign their carryback mortgage to a trust deed investor. The assignment does not transform the carryback debt into a loan or subject the debt to the annual yield limitations of usury laws. [Boerner v. Colwell Company (1978) 21 C3d 37]
Unconscionable advantage
Although a carryback mortgage and any modification (forbearance) of the terms of an existing carryback note are exempt from usury laws, another judicial limit controls for interest rate charges on carryback debts.
For example, consider a buyer of real estate with a 5% down payment who is only able to obtain financing for 80% of the purchase price. The seller agrees to carry back a second mortgage for the remainder of the purchase price.
However, the seller demands an interest rate of 20% per annum to cover their risk of loss from default and foreclosure. Further, the note amortizes the principal in payments over 30 years, but calls for a full payment in five years.
The buyer agrees to the seller’s terms for the carryback mortgage since the buyer believes they can obtain the funds necessary to pay off the carryback mortgage prior to the five-year due date.
When the due date arrives, the buyer is unable to obtain the funds necessary to pay off the carryback mortgage. The buyer defaults on the final/balloon payment and the seller begin foreclosure proceedings.
Prior to the foreclosure sale, the seller agrees to extend the due date of the mortgage for one year, provided the buyer agrees to increase the interest rate to 200%. The buyer, not wanting to lose their equity in the property after five years of ownership, agrees to the increased interest rate.
Interest payments under the modified carryback mortgage are made for six months, after which the buyer defaults on the mortgage again. As before, the seller begins foreclosure proceedings.
Unconscionable and excessive
Continuing our example, the buyer now claims they are not liable for the interest since the increased interest rate is usurious. Further, the buyer claims the modified interest rate is voidable as it was the result of an unconscionable advantage exercised by the seller when the increased rate was negotiated.
The seller claims the mortgage is not subject to usury laws since it evidences a carryback debt. In regards to the voluntary modification of the annual rate of return, the seller claims the rate is justified based on the risk of loss inherent in a 95% combined loan-to-value (LTV) ratio and rapidly rising mortgage rates.
On the first issue, is the seller correct that the note is not subject to a claim of usury?
Yes! The carryback note evidences a debt owed to the seller which is secured by the property sold, the result of a credit sale. Thus, the carryback mortgage, no matter how it is modified, is not subject to usury limitations on interest rates.
However, the seller is incorrect on the second issue of an unconscionable rate. The interest rate provision of the note as modified is so unconscionably high as to be shocking to a court. Thus, as an unconscionable annual rate of return on the debt, the excessive rate is not enforceable by the carryback seller. [Carboni v. Arrospide (1991) 2 CA4th 76]
Aspects of unconscionability
Unconscionable advantage also occurs in an equity purchase (EP) transaction when the investor exploits an element of oppression or surprise and exacts an unreasonably low and favorable purchase price or terms of payment. These are elements of fraud from threats, undue influence or deceit.
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Unconscionability has two aspects:
- the lack of a meaningful choice of action for the seller-in-foreclosure when negotiating to sell to the EP investor, legally called procedural unconscionability; and
- the purchase price or method of payment is unreasonably favorable to the EP investor, legally called substantive unconscionability.
To deprive the seller-in-foreclosure a meaningful choice between the EP investor’s offer and offers from other buyers, a misrepresentation or other fraudulent activity needs to exist to establish the lack of a meaningful choice or alternative to the EP investor’s offer.
The price paid, like any other provision in a purchase agreement, might be considered unconscionable. When determining the unconscionability of the purchase price, justification for the price at the time of the sale and the terms of payment of that price will be examined.
For instance, an unconscionable method of payment could include carryback paper with a below market applicable federal rate interest rate (AFR), long amortization or a due date on the note that bears no relationship to current payment schedules.
The greater the marketplace oppression or post-closing surprise discovered in the transaction, the less an unreasonably favorable price paid by an EP investor will be tolerated.
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