This article clarifies the events which trigger a lender’s due-on clause, and analyzes the adverse economic effects of due-on regulations on the real estate market.
Rising rates bring lender interference
During the good times of upward sales volume, expanding mortgage origination and increasing absorption rates for available rented space, the marketplace functions at full throttle.
Every sales activity feeds on every other sales activity. No one seems to care about the excuses and inherent inefficiences buried in the process.
Responsibility for all this frenzy lies solely with the gatekeepers to entry into real estate ownership, and relocation – the brokers and lenders, all other parties to a real estate transaction are merely affiliated, providing closing services once the broker has located a buyer and the lender qualifies that buyer for a purchase-assist loan. Singularly, these two events by these two guardians of real estate are the nucleus of a sale, and all else follows as support services.
During the good times of rising prosperity for all, buyers will put up with the onerous threshold of entry procedures maintained by these gatekeepers. In the rush to do deals, all the numerous steps to ownership seem to be justified, or are simply overlooked as necessary tedium to get in on the act.
However, when, as always it must, the cause of a recession – short-term interest rates rise to outrun inflation – dampens enthusiasm. The restrictions on entry posted by the brokers and lenders, burdensome in the first place, are actually tightened to discourage the able and ready buyer who become unwilling to put up with both the hassles of entry or relocating and the regime of higher rates and increased credit standards.
Enter due-on-sale restrictions (and efforts to get around brokers).
One of the burens on the mobility of title and the ease with which a buyer and seller can make a deal is the due-on clause buried within the copy of all trust deeds held by conventional lenders. During boom years, the buyer can so easily qualify for a new loans and the seller is relatively unconcerned about the prepayment penalty, that the due-on clause is not an issue.
However, as the boom turns to bust and the buyer wants to take over the seller’s loan, the lender as the gatekeeper is generally saying no to any type of loan takeover or assumption – I want my repayment penalty and I can re-lend the money at higher current rates. Thus, what was not a burden and not an inhibition to deal making during the boom, becomes a noose about the seller’s neck tying him to his property without a way out from under the loan.
Attempts to circumvent the restraint
A parcel of real estate which is listed for sale is security for a loan under a first trust deed lien containing a due-on clause. The listing agent locates a buyer for the property.
The purchase agreement negotiated by the listing agent calls for closing to be contingent on the buyer entering into an assumption agreement with the first trust deed lender. The seller will carry back a note secured by a second trust deed for the balance of the purchase price after the buyer’s down payment.
The buyer is advised the senior lender may:
- refuse to allow the loan to be assumed, forcing the buyer to obtain new financing to acquire the property; or
- require a modification of the loan at a less favorable rate than the note rate on the loan and demand a large assumption fee.
Before contacting the lender to process an assumption, the buyer suggests the sale of the property be structured as a lease-option in an attempt to avoid due-on enforcement by the lender.
The buyer and seller discuss entering into a two-year lease agreement with an option to extend the lease for two years at an increased monthly payment. The buyer will be granted an option to purchase for the life of the lease.
The down payment will be restated as option money. The option money will apply to the purchase price of the property, as will a portion of each monthly payment, called rent.
Meanwhile, the seller will continue making payments on the trust deed loan. When the buyer exercises his purchase option, the loan will be assumed or paid off and the buyer will become the record owner of the property.
Does the lease-option sale avoid due-on enforcement by the lender?
No! Any lease agreement which contains an option to purchase triggers due-on enforcement by the lender on discovery. [12 Code of Federal Regulations §591.2(b)]
Lender interference authorized by federal mortgage law
Generally, all lenders and carryback sellers are allowed to enforce their due-on sale clauses in trust deeds on nearly all transfers of an interest in any type of real estate. [12 United States Code §1701j-3, Garn-St. Germain Depository Institutions Act of 1982 (Garn)]
Thus, the Garn Act deprives Californians (and residents of numerous other states) of their state law right to convey real estate subject to trust deed liens without lender interference with the transfer of ownership, unless the lender could show the buyer lacked creditworthiness, a federal legislative process called pre-emption.
The occurence of an event which triggers due-on enforcement automatically allows the lender to:
- call the loan, demanding the full amount remaining due be paid immediately, also known as acceleration; or
- recast the loan, requiring a modification of the loan’s terms as a condition for the lender’s consent to a transfer, called a waiver.
The Garn Act encourages lenders to allow buyers to assume real estate loans at existing rates, but provides lenders no incentives for doing so. The congressional intent in passing the Garn Act was to pre-empt state law restrictions of due-on enforcement, allowing the lenders to increase their profits. However, the enforcement of the due-on clause by lenders was not intended to occur at the expense of permitting excessive lender interference with real estate transactions, whether they are sales, leases or further encumbrances. [12 USC §1701j-3(b)(3)]
Yet, when the Federal Home Loan Bank Board (now the Office of Thrift Supervision (OTS)) issued due-on regulations to implement Garn, no notice was taken of the congressional request for leniency when exercising due-on rights.
The OTS regulations allow automatic due-on enforcement on any transfer of an interest in real estate, with only a few family-related, single family residence exceptions. No encouragement or guidelines were established for lenders to consent to loan assumptions or to limit interference in commonplace transactions.
Since lenders often disregard the law in their trust deed lending and enforcement practices, it is hard to imagine why they would comply with a mere congressional request. In the absence of any regulatory obligation, lenders use their due-on clauses to maximize their financial advantage over owners by calling or recasting loans on the sale of the secured property. Thus, they increase their portfolio yield in a rising interest rate market by adjusting the rate of interest.
Economic recessions and recoveries
In times of stable or falling interest rates, lenders, when requested, usually permit assumptions of loans at the existing note rate, unless a prepayment penalty clause exists. Lenders have no financial incentive to recast loans, or call and re-lend the funds at a lower rate when interest rates are dropping in the marketplace.
However, in times of steadily rising rates, lenders seize any event triggering the due-on clause as an opportunity to increase the interest yield on their portfolio. Once the due-on clause is triggered, the lender requires the loan be recast at current market rates as a condition for allowing an assumption, lease or further encumbrance of the property by the owner.
Thus, real estate ownership encumbered by due-on trust deeds become increasingly difficult to transfer as interest rates rise, too frequently “imprisoning” an owner in his own home. Lender due-on interference is virtually guaranteed since the interference results in an increase in the lender’s portfolio yield which permits them to remain solvent, if not the owner.
However, the inhibiting effect on buyers during recessions when buyers are required to assume existing financing at higher interest rates has an adverse economic effect on real estate sales, as well as the availability of private junior financing and long-term leasing. Ultimately, as rates and lender interference rise, many buyers, equity lenders and long-term tenants are driven out of the market, which further depresses property values.
Meanwhile, owners are faced with the prospect of watching the value of their property fall below the remaining balance on encumbrances, leaving owners with no equity in the property. It is a vicious cycle which evolves into a dramatic increase in loan foreclosures, the antithesis of the profit motive for automatic lender enforcement of the due-on clause.
Due-on interference was an obscure issue during the 12-year period (1982 through 1994) after Garn became law. During this period, mortgage rates declined from 15% to 7%, the earnings of buyers increased as inflation dropped and mortgage money became more plentiful due to reduced government and corporate borrowing. All that has been reversed since 1999.
Due-on clauses are most commonly known as due-on- sale clauses. However, “due-on clause” is a more accurate term since a sale is not the only event triggering the clause. Still, as the name “due-on-sale” suggests, the primary event triggering the lender’s due-on clause is a sale of property which is subject to the lender’s trust deed lien.
The due-on clause is triggered not only by a transfer using and recording a standard grant deed or quitclaim deed, but by any conveyance of legal or equitable ownership of real estate, whether or not it is recorded. Examples include a land sales contract, lease-option sale, or other alternative carryback devices, such as an all-inclusive trust deed (AITD).
For example, a land sales contract does not involve a conveyance of real estate to the buyer by grant deed. The seller on a contract (for deed) retains the title as security for the carryback debt owed by the buyer rather than use a trust deed lien to evidence his security interest. However, the buyer becomes the equitable owner of the property as soon as the land sales contract is entered into and possession is transferred, triggering the due-on clause in any existing trust deed. [Tucker v. Lassen Savings and Loan Association (1974) 12 C3d 629]
The due-on clause is also triggered by:
- a lease with a term over three years; or
- a lease for any term complied with an option to purchase gratned to the tenant. [12 CFR §591.2(b)]
For example, an owner with a short-term interim construction loan for nonresidential rental property obtains a conditional commitment from a long-term lender for take-out financing to pay off the construction loan. Funding of the take-out loan is conditioned on the property being 80% occupied by tenants with an initial lease term of at least five years.
The owner locates tenants for 80% of the newly constructed property, all with a lease term of five years or more. The lender funds the loan. The loan is secured by a first trust deed on the property which contains a due-on clause. The existing five-year leases do not trigger the due-on clause in the lender’s trust deed. The long-term leases have priority since they were entered into before the loan funded and the trust deed recorded.
However, after obtaining the loan, the owner continues to lease out space in his property for five year terms. Later, after interest rates rise, a representative of the lender (a prior loan officer) visits the property and “discovers” new tenants. On inquiry, the officer learns that some of the tenants entered into leases, or had their leases extended for periods greater than three years, after the loan was recorded.
The lender sends the owner a letter informing him it is calling the loan due since the owner has entered into lease agreements with terms over three years.
The owner claims the lender cannot call the loan since long-term leases were required by the lender as a condition for funding the loan.
Can the lender call the loan due or demand a recast of its terms?
Yes! By requiring leases with terms over three years as a condition for funding the loan, the lender did not waive its right to call or recast the loan under its due-on clause should a lease with a term over three years be entered into after the loan was originated.
However, an assignment or modification of an existing lease does not trigger the due-on clause, unless the lease is modified to extend the term beyond three years, or a purchase option is granted to the tenant.
For example, consider an owner of real estate who enters into a lease with an initial term of 10 years. Later, the owner takes out a loan secured by a trust deed containing a due-on clause. After the trust deed is recorded, the tenant assigns the lease with the owner’s approval, as provided in the lease agreement (which has priority to the lender’s trust deed).
However, the lender’s due-on clause is not triggered by the lease assignment. The trust deed is attached as a lien only on the owner’s fee interest, not the leasehold interest previously conveyed to the tenant. The fee owner whose interest is encumbered by the loan transferred nothing. The assignment of a leasehold by a tenant is not a transfer of any interest in the fee encumbered by the trust deed.
However, consider a landlord who releases the original tenant from all liability under the lease as part of an assumption of the lease by the new tenant and substitution of liability. The release of the original tenant from liability creates a novation of the lease — a new agreement conveying an interest in the secured property to the new tenant by the owner of the fee. [Wells Fargo Bank, N.A. v. Bank of America NT & SA (1995) 32 CA4th 424]
Thus, an assumption of the lease by a new tenant, and a release of the former tenant from liability, constitutes a present transfer of an interest affecting the fee ownership of the real estate since it is a novation. Accordingly, a lease novation triggers the due-on clause — if the lease has a remaining term of over three years or includes an option to purchase.
An owner-occupant of a single family residence (SFR) subject to a first trust deed applies for an equity loan to be secured by a second trust deed on his property. The first trust deed contains a due-on clause.
The loan broker tells the owner he is concerned about due-on enforcement by the senior lender, since the execution of a second trust deed will convey a security interest in the property by encumbering it with a lien. On inquiry, the owner informs the broker he will continue to occupy the property as his residence.
The broker correctly assures the owner the second trust deed encumbrance will not trigger the senior lender’s due-on clause, as long as the owner continues to occupy the residence. Due-on enforcement based on a further encumbrance of an owner- occupied, one-to-four unit residential property is not permitted. [12 CFR §591.5(b)(1)(i)]
However, on real estate other than an owner- occupied, one-to-four unit residential property, any further encumbrance without first obtaining the existing lender’s waiver of its due-on clause triggers the due-on clause, giving the lender the right to call or recast the loan.
Thus, junior financing without a waiver of the senior lender’s due-on clause becomes a risky enterprise for trust deed investors in times of rising interest rates. Increasing market rates give trust deed lenders a powerful incentive to call loans on the transfer of any interest in the secured real estate — with the exception of owner-occupied, one-to-four unit residential properties.
For example, a private lender accepting a junior trust deed position on a type of property other than an owner-occupied, one-to-four unit residence without first obtaining a due-on waiver from the senior lender risks having the economic value of his position in title:
- reduced by an increase in the interest rate on the first; or
- wiped out by the first’s foreclosure, should the first exercise its due-on rights based on the further encumbrance and not be paid in full. [La Sala v. American Savings & Loan Association. (1971) 5 C3d 864]
Owners are forced to look elsewhere for funds when the existing lender does not grant a due-on waiver. Thus an owner is forced to refinance existing encumbrances in order to generate cash from their equity in the property, typically a more expensive process due to prepayment penalties and increased rates than had they obtained an equity loan.
Now consider a seller who carries back a second trust deed on the sale of property without the consent of the holder of the first trust deed which contains a due-on clause.
The first trust deed lender learns of the sale and calls the loan. To avoid the call, the buyer assumes the first trust deed loan and modifies the note by shortening the due date.
The carryback seller claims his second trust deed now has priority over the first trust deed since the modification of the first trust deed note substantially impairs his security by increasing the potential for default on his trust deed.
Here, the modification of the first trust deed note without the consent of the junior carryback seller does not result in a change in trust deed priorities since the existence of the second trust deed note is in violation of the due-on clause in the first trust deed.
When the secured property is sold and the seller accepts a second trust deed without receiving the lender’s prior written consent, the due-on clause has been breached under federal mortgage law. Thus, no duty is imposed on the first trust deed lender to avoid futher subordinating the interest of the holder of the unconsented-to junior lien by recasting the first trust deed note. [Friery v. Sutter Buttes Savings Bank (1998) 61 CA4th 869]
A parcel of real estate is subject to first and second trust deed liens. An owner defaults on the first trust deed. The junior trust deed holder reinstates the first trust deed and forecloses on the second, acquiring the property at the trustee’s sale.
The senior lender informs the junior lender, who now owns the property, that it is calling its loan due, based on the transfer of the property by trustee’s deed.
Can the senior lender call its loan due based on the completion of foreclosure by the second trust deed lender?
Yes! A senior lender may call a loan due on completion of the foreclosure sale by a junior lender or carryback seller on any type of real estate. A trustee’s deed on foreclosure is considered a voluntary transfer by the owner, since the power of sale authority in the junior trust deed was agreed to by the owner of the real estate.
However, the due-on clause is not only triggered by the voluntarily agreed-to trustee’s sale, but also by any involuntary foreclosure, such as a tax lien sale. [Garber v. Fullerton Savings and Loan Association (1981) 122 CA3d 423]
Federal regulations allow due-on enforcement on any transfer of real estate which secures the lien, whether the transfer be voluntary or involuntary. [12 CFR §591.2(b)]
The risk of a senior lender enforcing its due-on clause on a trustee’s sale by the junior lender has an inhibitory effect on the availability of junior trust deed loans and carryback sales. Many lenders and sellers are unwilling to accept a junior position which exposes them to paying off a senior debt should they be forced to foreclose on the real estate. [Pas v. Hill (1978) 87 CA3d 521]
Due-on-death and exceptions
Transfers of real estate which trigger due-on enforcement include the inevitable transfer resulting from the death of a vested owner even if title was vested in a revocable inter vivos trust. However, as with due-on enforcement triggered by further encumbrances, some exceptions on death apply to owner- occupied, one-to-four unit residential property.
For example, the transfer of a one-to-four unit residential property to a relative on the death of the owner- occupant does not trigger the due-on clause, on the condition the relative becomes an occupant of the property. [12 CFR §591.5(b)(1)(v)(A)]
Also, where two or more people hold title to one-to- four unit residential property as joint tenants, the death of one joint tenant does not trigger due-on enforcement as long as at least one of the joint tenants, whether it was the deceased or a surviving joint tenant, occupied the property at the time the loan was originated. Occupancy is not required for a surviving joint tenant who qualifies for the joint tenancy exception. [12 CFR §591.5(b)(1)(iii)]
In all other transfers, the death of a vested owner, joint tenant or other co-owner will trigger the lender’s due-on clause. Thus, due-on enforcement is triggered on death by:
- a transfer of the deceased’s residence to a non-relative, by will or by trust, following the death of the owner;
- the death of a joint tenant owning a one-to-four unit residential property which was not originally occupied by any of the surviving joint tenants;
- the death of a co-owner of any type of property other than one-to-four residential units; and
- the transfer of any property, other than the deceased’s residence, to a relative or anyone else on the death of the owner.
Divorce and inter-family transfers
A married couple occupies a residence which is vested in the name of the husband and owned as his separate property. The residence is subject to a trust deed containing a due-on clause.
The couple separates and the residence is transferred to the wife as part of the property settlement to dissolve the marriage. The wife continues to occupy the residence.
Does the transfer of the residence to the wife on divorce trigger due-on enforcement by the lender?
No! Federal due-on regulations bar due-on enforcement on transfer of one-to-four unit residential property to a spouse after a divorce, so long as the spouse occupies the property. [12 CFR §591.5(b)(1)(v)(C)]
However, if the acquiring spouse chooses to lease the residential property to tenants for any lenght of time rather than occupy it, the lender can call or recast its loan.
Also, the due-on clause is not triggered by an owner’s transfer of his one-to-four unit residential property to a spouse or child who occupies the property. [12 CFR §591.5(b)(1)(v)(B)]
This inter-family transfer exception for four-or-less residential property applies only to transfers from an owner to a spouse or child. For instance, any transfer from a child to a parent to provide housing for the parent triggers due-on enforcement.
Finally, consider an owner-occupant of one-to-four unit residential property who transfers the property into an inter vivos trust, naming himself as beneficiary. The owner continues to occupy the property after transferring title into the trust, commonly known as a living trust.
The owner notifies the lender he will be transferring title into the trust vesting. The owner agrees to give the lender notice of any later transfer of his beneficial interest in the trust or change in occupancy of the property as requested by the lender.
Would this transfer into a living trust trigger the due-on clause in a trust deed encumbering the owner’s residence?
No! The owner met the federal regulatory conditions for avoiding due-on enforcement based on a transfer of owner-occupied, one-to-four unit residential property into an inter vivos trust. [12 CFR §591.5(b)(1)(vi)]
To meet regulations, the owner must provide means acceptable to the lender by which the lender will be given notice of any later transfer of the beneficial interest in the trust or change in occupancy. If the owner conveys the property into the inter vivos trust without the lender’s approval of the notice provision, the lender may call the loan due.
The notification provision requires the owner to first obtain the lender’s consent before transferring the property into a trust vesting.
Also, if the owner does not continue to occupy the property, or later transfers the beneficial interest in the trust, the lender can call or recast the loan.
Waiver by negotiation and by conduct
Under federal regulations, lenders have the power to dictate the fate of financing in most real estate transactions, since most real estate is encumbered by adhesion trust deeds containing due- on clauses.
However, an owner wishing to enter into a transaction to sell, lease or further encumber his real estate without lender interference must first negotiate a limitation or waiver of the lender’s due-on rights.
Waiver agreements are basically trade-offs. The lender will demand some consideration in return for waiving or agreeing to limit the exercise of its due-on rights in the future, such as increased points on origination, additional security, principal reduction, increased interest and larger payments, a shorter due date or an assumption fee.
For example, a buyer applies for a loan to purchase a residence which he intends to occupy for only a few years. The buyer is concerned due-on enforcement will later make it more difficult for him to resell the property since it will limit the seller’s ability to finance the sale of his equity.
Thus, the buyer and the lender negotiate the conditions on which a later qualified buyer will be able to assume the loan without a call by the lender. In exchange for the lender’s limitation of its future due-on rights, the buyer agrees to pay increased points or interest.
Any time a lender recasts a loan as a condition for consenting to a buyer’s assumption, it is essentially forcing a modification agreement on the buyer. In exchange for agreeing not to call the loan due on a transfer of the property to the buyer, the lender receives consideration, such as increased interest and payments (the modification of the loan) and an assumption fee.
The lender’s waiver of its due-on rights under an assumption agreement applies only to the present transfer to the buyer. Unless additionally agreed to, any later transfer of an interest in the property will trigger the due-on clause, allowing the lender to call or recast the loan again.
In addition to a waiver (assumption) agreement, waiver of the lender’s due-on rights may occur by conduct — the lender loses its due-on rights by failing to promptly enforce them.
For example, a buyer purchases real estate subject to a loan secured by a trust deed containing a due-on clause. The lender is informed of the transfer and immediately calls the loan. However, the lender then accepts payments from the buyer for over a year. Finally, the lender seeks to enforce its prior call by refusing further payments and foreclosing.
However, the lender, by its conduct, waived the right to enforce its due-on clause. The lender accepted payments from the buyer for over a year after calling the loan on learning of the transfer of the real estate. [Rubin v. Los Angeles Federal Savings and Loan Association (1984) 159 CA3d 292]
Broker liability for due-on avoidance
When the seller intends to transfer ownership of the property to the buyer, the senior lender’s due-on clause is triggered regardless of the form used to document the sales transaction.
Of course, the lender can only call the loan when it actually discovers a change of ownership has taken place. If the buyer’s option is not recorded, and the lease agreement is for a term under three years, the lender might not discover any transfer of an interest in the real estate has taken place, which triggered its due-on clause.
If the lender later discovers a change of ownership has taken place, its only remedy against the buyer and seller is to call the loan due, or recast the loan as a condition for waiving its right to call and allowing an assumption by the buyer. Under the note and trust deed, the lender cannot recover the retroactive interest differential (RID) for the period before it discovered the transfer and called the loan. The only recourse against the buyer or seller is to call the loan and be paid in full or foreclose. [Hummell v. Republic Federal Savings & Loan (1982) 133 CA3d 49]
However, an adviser, such as a broker or attorney, assisting the buyer or seller to mask the change of ownership from the lender with the primary purpose of avoiding the lender’s due-on enforcement, can be held liable for wrongfully interfering with the lender’s right to call or recast the loan, an offense called tortious interference with prospective economic advantage.
The adviser’s liability arises based on the extent to which his actions were specifically intended to conceal the transfer and prevent a call by the lender, and on the foreseeability the lender would incur losses due to the concealment. [J’Aire Corporation v. Gregory (1979) 24 C3d 799]
The lender’s losses caused by the adviser’s wrongful interference are calculated based on the interest differential between the note rate and the market rate on the date of sale, retroactively applied from the date of discovery by the lender to the date of the transfer.