Modifying provisions in a note
During the life of a mortgage, the mortgage holder and owner of the mortgaged property may agree to modify, add or rescind one or more of the note’s provisions. Any change in the terms of a note requires:
- mutual agreement between the property owner and the mortgage holder; and
- consideration given in exchange for the modification, with the exception of bankruptcy. [See first tuesday Form 426]
Modifications of a mortgage usually arise out of financial necessity experienced by the owner of the mortgaged property. Conversely, profit taxes a carryback seller incurs on receipt of a payoff of the mortgage often prompt the seller to bargain for a modification to extend the time for payoff.
New rules and new terms for a new category of mortgages
Beginning in January of 2014, changes to Regulation Z of the Truth in Lending Act (TILA) made by the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) took effect. Federal ability-to-repay rules for consumer mortgages became operational.
A consumer mortgage is any debt which is:
- incurred primarily for personal, family or household purposes; and
- secured by one-to-four unit residential real estate. [12 Code of Federal Regulations §1026.2(a)(12)]
For the purposes of this discussion, all other real estate-related debts are referred to simply as business mortgages, since they do not serve a consumer purpose (even when secured by residential real estate).
Lenders and servicers who make and hold consumer mortgages are subject to the requirements of Regulation Z (Reg Z). Among those requirements for consumer mortgage holders are mandatory disclosures of key mortgage details triggered by a mortgage:
- refinance; and
Reg Z also limits certain features and provisions for consumer mortgages, such as prepayment penalties and grace periods, depending on the characteristics of the mortgage and/or mortgage holder.
Editor’s note — For a more detailed look at changes to federal mortgage rules in Regulation Z, see the September 2013 first tuesday primer, Ability to repay, qualified mortgage and qualified residential mortgage—oh my!
Negotiating to modify mortgage terms
In addition to federal consumer mortgage rules contained Reg Z, the modification of a note is controlled by California contract law. Thus, a written contract—in this example a note evidencing a debt—is modified by:
- a written agreement; or
- an oral agreement. [Calif. Civil Code §1698]
However, for an oral modification to be enforceable, both the mortgage holder and the property owner need to execute the oral agreement by taking action on it. To be certain of the modified terms, the two parties need to memorialize the modification in writing.
Written modifications are best initiated by filling out a form to be submitted to the mortgage holder as an offer to modify the note. The form functions as a checklist of issues the agent is to consider when negotiating a modification.
When filled out, the agreement sets forth the terms sought by the person initiating the modification effort. A real estate agent traditionally facilitates negotiations with the mortgage holder on behalf of the owner. [See first tuesday Form 426]
Once the agreement to modify has been negotiated to set the new terms for payment and rates, the agent, broker or escrow officer prepares a Modification of the Promissory Note form. It is the modification form, a sequel to the offer to modify form, which changes the terms of the existing mortgage from those in the original note. [See first tuesday Form 425]
Provisions in the modification form:
- identify the note which is being modified;
- name the parties to the mortgage; and
- identify the trust deed and the mortgaged property involved.
To complete the paperwork called for in the agreement, the signed modification form is attached to the note as an allonge. The terms of the modification then become part of the original note.
Common reasons for a modification
Foreclosure prevention was one of the most common reasons for consumer mortgage modification during the 2000s. However, property owners and mortgage holders agree to a mortgage modification for many reasons.
Common modifications include:
- a due date extension;
- interest rate changes;
- temporary or permanent changes in installment payment amounts or schedule;
- cash advances or accrued interest added to principal; and
- the addition of special provisions.
Editor’s note — Individuals and entities offering consumer mortgage relief to distressed homeowners are subject to the federal Mortgage Assistance Relief Services (MARS) rule requiring special disclosures, advertising rules and fee restrictions.
Very broadly, the rule only applies to mortgage brokers, real estate brokers and agents, attorneys and companies who offer mortgage relief plans, programs or services as part of their business. Mortgage holders who modify mortgages to assist struggling homeowners are not subject to the rule. [16 Code of Federal Regulations Part 322]
Extending the due date
Consider an owner of real estate who executes a business mortgage with a five-year due date.
Later, with the due date of the final/balloon payment approaching, the owner realizes they will be unable make the final payoff. The owner contacts the mortgage holder to negotiate a due date extension for the payoff of the mortgage.
The mortgage holder offers to extend the payoff date if the owner agrees to:
- a higher interest rate and increased monthly payments; and
- a credit check for any change in the owner’s financial status since originally entering into the mortgage. [See first tuesday Form 302]
A change in the interest rates and payment terms
Consider a buyer and carryback seller who become entangled in a dispute following the close of escrow concerning the seller’s representations of the property’s condition. [See first tuesday Form 304]
The carryback seller offers to modify the mortgage, reducing the principal balance and the monthly payments to compensate the buyer for an over-valuation of the property based on the undisclosed property facts. In exchange, the buyer releases the seller from any further claims concerning the condition of the property and the purchase transaction.
The buyer accepts the seller’s offer to modify the mortgage and agrees to release the seller and waive the buyer’s rights to any future claims. [See first tuesday Form 181]
Now consider an owner whose income-producing property is located on an earthquake fault. The existing business mortgage encumbering the property is a recourse debt.
The owner is concerned about their future liability exposure in the event an earthquake renders the property valueless. If disaster reduces the property’s value below the amount owed on the mortgage and the mortgage holder forecloses judicially, the owner is personally liable for the difference, called a deficiency. The owner wishes to eliminate this risk of loss.
The mortgage calls for the owner to carry earthquake insurance which shifts the risk of loss from the owner to the insurance carrier. However, the premium for the insurance policy has become too expensive.
The owner seeks a mortgage modification with the mortgage holder, increasing the interest rate in exchange for:
- the elimination of the earthquake insurance provision; and
- a release of the owner from liability in the event circumstances beyond the owner’s control impair the security, called an exculpatory clause.
Adding a special provision
Now consider a seller who carries back a mortgage containing a five-year due date. By its terms, the mortgage will soon be due.
However, the seller does not want the mortgage paid off at this time since depreciation recapture and capital gains taxes will be due on the profit from the final payoff. Also, the current market interest rate is much lower than the interest rate on the carryback note.
The seller wants to negotiate an extension of the due date and include a prepayment penalty provision in the note, sufficient to cover any profit taxes if the mortgage is paid off early. The seller will lower the interest rate — possibly below market rates — in exchange for the buyer agreeing to the extension and prepayment penalty provision.
Editor’s note — If the carryback mortgage in this scenario is a consumer mortgage, Reg Z rules govern the mortgage holder’s ability to charge prepayment penalties.
Insuring trust deed priority
Most real estate-related debts are secured by a lien on title to the real estate. Such liens typically take the form of a recorded trust deed which describes the mortgaged property and is insured by a title company.
Title insurance is needed to assure a mortgage holder of the continued priority of their trust deed lien relative to the other interests on title to the real estate. Thus, any agreement to modify the mortgage needs to be conditioned on re-insuring the trust deed by obtaining:
- an additional title insurance policy; or
- an endorsement to the mortgage holder’s existing policy.
A title insurance policy is obtained or endorsed for the modification of a mortgage to assure the mortgage holder that any junior trust deed liens (such as a second mortgage) will still be considered junior to the modification. The person seeking the modification generally pays the premium charged for the title insurance policy.
In turn, the title insurance company will require any junior mortgage holder to sign a specific subordination agreement before re-insuring the trust deed securing the modified mortgage, even if a future subordination agreement exists permitting the owner to later modify the senior mortgage.
Junior lienholder is subordinated
If the modification of a senior mortgage puts a junior mortgage holder at a significantly greater risk of loss than already exists, the modified terms will not have priority. To avoid loss of priority on a significant modification, a junior mortgage holder needs to agree to the greater risk of loss, called subordination.
Consider the holder of a first mortgage and property owner who modify the owner’s mortgage. The modification agreement:
- shortens the due date;
- raises the interest rate; and
- increases the amount of principal balance.
Later, the holder of a second mortgage secured by the property claims the first mortgage lost its priority since the modification significantly reduced the value of the second mortgage holder’s security interest in the property.
The first mortgage holder claims only the modification agreement does not have priority to the second mortgage, since only the modifications have the potential to impair the secured position of the second trust deed.
Here, the modifications to the first mortgage do not have priority over the second mortgage, but the original terms of the first mortgage note do retain their priority. Thus, the second mortgage remains unimpaired by the modifications made to the first trust deed note and retains its original financial and legal position. The terms of modification are essentially a third trust deed lien. [Lennar Northeast Partners v. Buice (1996) 49 CA4th 1576]
Seller’s breach of the due-on clause
Now consider a seller who carries back a second mortgage on the sale of their property. The property sold is subject to a first mortgage which contains a due-on clause. The holder of the first mortgage is not advised of the sale.
Later, the first mortgage holder learns of the sale and calls the mortgage due and immediately payable. To avoid the call, the buyer assumes the mortgage and modifies the note to shorten its due date.
On discovering the modifications, the carryback seller claims their second mortgage now has priority over the first since the first mortgage modification increases the risk of default, substantially impairing the seller’s security interest.
In this example, the modification of the first mortgage without the junior carryback seller’s consent does not result in a change in trust deed priorities. The mortgaged property was sold (and the seller accepted a second mortgage) without the first mortgage holder’s written consent. Thus, the seller breached the due-on clause in the first mortgage holder’s trust deed. Due to the breach, the first mortgage holder has no duty to avoid impairment of the owner’s second trust deed lien. [Friery v. Sutter Buttes Savings Bank (1998) 61 CA4th 869]
However, the modification of an existing junior mortgage does not trigger the due-on clause in senior trust deed liens on title to a property. Only the act of creating a new security interest — such as recording a mortgage — triggers the due-on clause.
The same rules apply to the modification of an existing lease, with the exception of extensions beyond three years.
Modification to change priority
In some instances, a mortgage modification may be made to accommodate the deliberate change of lien priority.
Consider a seller who carries back a mortgage on the sale of a parcel of vacant land. Later, the buyer asks the carryback seller to subordinate their mortgage to a construction loan.
Subordinating their interest to a construction loan inherently increases the seller’s risk of loss. As a result, the nonrecourse carryback mortgage is automatically converted to recourse debt.
In exchange for the seller’s subordination to the construction loan, the buyer agrees to:
- modify the carryback mortgage to increase the interest rate and monthly payments;
- record a Request for Notice of Delinquency (NODq); and
- serve a copy of the NODq on the construction lender. [See first tuesday Form 412]
Editor’s note — Interest rate modifications on carryback notes are not subject to usury laws. [DCM Partners v. Smith (1991) 228 CA3d 729; CCP §580b]
If a modification or replacement note restructures a carryback debt and the debt remains secured solely by the property sold, the debt remains outside the usury law interest rate limits. Also, the debt retains its original nonrecourse, anti-deficiency character since the modified or replacement note evidences a continuation of the original carryback debt. [Ghirardo v. Antonioli (1994) 8 C4th 791; CCP §580b]
Mortgage modifications are also made when the mortgage is assumed by a subsequent owner. Here, the buyer arranges with a seller and the mortgage holder to take over the mortgage. Often on an assumption, a mortgage holder will seek a modification and added portfolio yield based on current factors such as:
- changes in market interest rates;
- the new owner’s creditworthiness; or
- consideration for permitting the assumption.
Consider a buyer who is willing to cash out the seller’s equity and assume the existing business mortgage which encumbers the property, called a cash-to-loan (CTL) transaction. The seller, however, is unwilling to remain liable for the recourse mortgage, even though the buyer agrees to assume it.
The seller’s agent negotiates an arrangement agreeable to the mortgage holder, buyer and seller. The buyer assumes the existing mortgage and the mortgage holder releases the seller from further liability, a series of activities called a novation.
The novation agreement is accompanied by a separate agreement to modify the mortgage. The modification is the consideration the mortgage holder demands for releasing the seller from liability for the mortgage. The modification agreement calls for:
- an increased interest rate and monthly payments; and
- an assumption fee paid to the mortgage holder.
Remember, special rules apply to assumptions of a consumer mortgage. An assumption triggers new consumer mortgage disclosures and adherence to the ability-to-repay (ATR) rules when:
- the mortgage is assumed by a buyer who will occupy the property as their principal residence;
- the mortgage holder expressly agrees to accept the buyer as the primary obligor; and
- the assumption agreement is in writing.
Thus, the assumption of an existing consumer mortgage on a property owner’s principal residence is considered a new mortgage transaction whether or not its terms are modified. [12 CFR 1026,20(b); Supplement I — Official Interpretation to 1026.20(b)]
On a mortgage modification, the note itself is not to be cancelled or rewritten, especially if it is secured by a trust deed. If the note is replace by a newly written note, the dates of the note and trust deed will differ, even though the debt evidenced by the new note remains the same with only a change in repayment terms.
Mismatched dates will cause difficulty on foreclosure or reconveyance of the trust deed since the recorded trust deed refers to the secured debt as that evidenced by a note “of same date.”
Additionally, on a consumer mortgage, cancelling and replacing an existing note with a new note is deemed a refinance, even if the new terms are substantially similar to the original terms. A refinance requires a Reg Z mortgage holder to provide new disclosures and apply ATR rules. [12 CFR §1026.17(a)(1)]
A few exceptions to Reg Z exist for modifications to existing consumer mortgages. If a consumer mortgage modification meets the criteria of a refinance, it is exempt from new disclosures and ATR rules if it is:
- a renewal of a single-payment obligation with no change in the original terms;
- a reduction in the annual percentage rate (APR) with a corresponding change in the payment schedule;
- an agreement involving a court proceeding, such as a bankruptcy or settlement;
- a pre-foreclosure workout agreement (unless the interest rate or principal balance is increased); or
- a renewal of optional insurance, as long as required disclosures were provided at the original purchase of the optional insurance. [12 CFR §1026.20(a)(1-5)]
However, the modifications above are only exempt from Reg Z disclosure requirements if undertaken by the mortgage holder who originated the mortgage. A refinancing by an assignee of the mortgage triggers new disclosures and application of the ATR rules, even if the refinancing falls into one of the exempt categories above. [12 CFR §1026.20, Supplement I]