This is the first episode of our new seven part series dramatizing lender interference under the due-on clause in a trust deed during periods of rising interest rates.

The next episode covers the most common event triggering the mortgage holder’s due-on clause.

Rising rates bring lender interference

During times of upward sales volume, increasing mortgage originations at lower interest rates, and rising absorption rates for space available to rent, the marketplace functions at full throttle. This is known economically as a virtuous cycle.

Responsibility for this frenzy lies with the gatekeepers to real estate ownership — brokers, builders and lenders. To keep those responsible for the activity from excesses which harm the rest of society, the government implements regulations – guardrails – to reduce adverse conduct by these gatekeepers in our real estate and mortgage markets.

During times of rising prosperity, buyers put up with the onerous threshold of entry procedures maintained by the gatekeepers. In their rush to close deals, all the numerous steps to ownership seem justified by the buyers.

However, when both short-term interest rates and mortgage rates rise, lending likewise tightens. At this point, buyers become unwilling to further cope with the regime of higher rates, deceasing mortgage funding, seller price expectations, failure of property condition disclosures, and excessive documentation demands. This recurring paradigm shift triggers a vicious cycle which begins quickly but takes years to unwind after mortgage rates hit bottom.

Lenders are motivated by profit. They do not call loans due or seek a rate modification on a sale of real estate when market interest rates fall below the yield on their portfolio of existing mortgages. Lenders simply permit assumptions of high-rate loans rather than calling them due to lend the funds at lower market rates.

As shown by history, the cycle of values will again turn vicious for owners and lenders when mortgage rates rise.

Enter the seller-crippling due-on-sale restrictions remaining from the Reagan-era federal 1982 mortgage deregulation.

Burden on the use and mobility of title available for ownership

The single greatest burden on the use and mobility of commercially available title for ownership of property rights is created by the existence of the due-on clause buried within all trust deeds held by mortgage lenders and carryback sellers.

During long-term cyclical episodes of declining fixed rate mortgage (FRM) interest rates such as 1983 to 2012, the due-on clause is not an issue. The clause lays dormant as unused for lack of its ability to increase mortgage lender and servicer profits beyond the earnings bargained for at the time of origination.

The decades of the ‘80s, ‘90s and ‘00s are examples of a prosperous time when buyers could easily qualify for new mortgage financing at ever decreasing interest rates to cash out sellers who in turn paid off their existing higher-rate mortgage as they sold at ever increasing prices.

However, booms always turns to bust – cycles are always completed.

In a vicious recession cycle, buyers return to purchase property after prices fall. Also, the most efficient sale arrangement for financing the purchase price is for the buyer to take over the seller’s mortgage — but only when it has an interest rate lower than the rates currently demanded by mortgage lenders.

But there is a catch — a due-on catch.  That catch is a home-run hit for existing mortgage holders and servicers.

The day the FRM becomes a VRM (VaRoom!)

Mortgage holders in periods of rising FRM rates refuse to consent to any type of mortgage takeover or assumption by buyers. The reason: they prefer a payoff as the payoff funds allows them to re-lend the money at the higher current FRM rate. When the payoff is within three years of origination, the lender also demands a prepayment penalty as additional income triggered by forced sales typical in a recession.

Thus, the FRM – once believed by the owner to be reliably unalterable – becomes a VRM (VaRoom! mortgage).

Editor’s note – “VRM” is not to be confused with “variable rate mortgage” previously used to describe adjustable rate mortgages (ARMs). Rather, think of the sound of a race car as it aggressively revs its engine – VaRoom!

By exercising the due-on clause, lenders are able to pump the gas and keep profits fat at all times in the economic cycle or interest rate cycle.

Though the due-on clause did not present a danger to sellers during the quarter century leading up to the Millennium Boom, it now becomes the lender’s noose tightening around the seller’s title during periods like we are now experiencing with interest rates on a long-term rising trend. The combination of generally rising interest rates (following the 2009-2015 zero lower bound interest rates) and the existence of due-on clauses as an adhesion in all recorded mortgages tends to tie the seller to their property, a debt-imposed prison.

Further, it kills their motivation the upgrade to another property with superior hedonistic amenities as it requires owners to forfeit their current 3.25% interest rate for today’s 7.25%. Thus, sellers are too often fettered to their home without a financially suitable way out when the principal amount of their mortgage is at or above the resale price for their home with a low mortgage payment.

Editor’s note — Prepayment penalties on consumer mortgages are restricted in their use to fixed- and step-rate qualified mortgages (QMs). [12 Code of Federal Regulations §1026.43(g)]

California agents always feel the effects of the due-on clause whenever either adjustable or fixed mortgage rates increase for a period of time greater than 18 months; one a VRM, the other a VaRoom.

With steady and continuing rate increases, agents will again be shocked by the realization that due-on clauses permit lenders to call a note due (or modify its rate or payment schedule) when an owner seeks permission to sell, lease, or further encumber property financed by the lender – VaRoom! goes the profits, the lender is up and the seller is down in a financially equivalent tradeoff

This severe restraint on all types of real estate transactions was last felt during the 1974-75 recession through the 1980-82 recession period. The virtuous cycle time from 1983 to 2013 is gone, with the vicious cycle now upon us.

Attempts to circumvent the lender’s sales restraint

Consider a parcel of real estate listed for sale in a market of rising mortgage rates. The parcel is encumbered by a mortgage with an interest rate below current market rates, but contains an ever present due-on clause. The seller’s agent locates a buyer for the property.

The purchase agreement negotiated by the seller’s agent calls for closing to be contingent on the buyer entering into an assumption agreement with the existing mortgage holder allowing the buyer to take over the mortgage on the property based on no modification of the terms of the mortgage note. The seller will carry back a note secured by a second trust deed for the balance of the purchase price after the buyer’s substantial down payment.

Editor’s note – For mortgage holders under Regulation Z (Reg Z), when an assumption involves a consumer mortgage, mortgage holder acceptance and a written assumption/modification agreement, it is considered a new consumer mortgage subject to new disclosures, ability-to-repay (ATR) and QM rules. [12 CFR §1026.20(b)]

The buyer is advised the senior mortgage holder may:

  • refuse to allow the mortgage to be assumed, forcing the buyer to arrange new financing when they do not elect to cancel the purchase agreement; or
  • require a modification of the note to increase the interest rate and payments than the current note provides, and demand the exaction of an assumption fee.

Before contacting the mortgage holder to process the 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 mortgage holder. [See RPI Form 163]

The buyer and seller discuss entering into a two-year lease agreement with an option to extend the lease for an additional two years at an increased monthly payment. The buyer will be granted an option to purchase the property from the seller 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 rent payment.

Meanwhile, the seller will continue making payments on the underlying mortgage. When the buyer exercises their purchase option, the mortgage 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 mortgage holder?

No! Any lease agreement which contains an option to purchase triggers due-on enforcement by the mortgage holder on discovery. [12 CFR §591.2(b)]

Interference by mortgage holders is federal housing policy

Generally, mortgage holders are allowed to enforce due-on sale clauses in mortgages on most transfers of any interest in any type of real estate. [12 United States Code §1701j-3; Garn-St. Germain Depository Institutions Act of 1982 (Garn)]

Thus, federal mortgage law deprives Californians of their state law right to convey real estate subject to trust deed liens without the mortgage holder interfering with the transfer of ownership for additional profit.

To interfere with the sale of the secured property solely under our state law, the mortgage holder needed to demonstrate the buyer:

  • lacks creditworthiness; or
  • is wasteful of property in their management.

Essentially, the mortgage holder must prove the buyer is an insolvent arsonist. However, the federal legislative process of preemption bars application of state law to the contrary.

The occurrence of an owner’s activity triggering due-on enforcement automatically allows the mortgage holder to:

  • call the mortgage, demanding the full amount remaining due to be paid immediately, also known as acceleration; or
  • offer to recast the mortgage, requiring a modification of the note’s terms at market as a condition for the mortgage holder’s consent to a transfer, called a waiver by consent.

The Garn-St. Germain Federal Depository Institutions Act of 1982 (Garn) itself encourages mortgage holders to allow buyers to assume real estate mortgages at existing rates, but provides mortgage holders no incentives for doing so. The congressional intent in 1982 when passing Garn was to preempt state law restrictions of due-on enforcement for the sole purpose of allowing mortgage holders to increase their profits on an old mortgage whenever the owner:

  • sells;
  • leases for a term over three years; or
  • further encumbers the secured property.

However, the enforcement of the due-on clause by mortgage holders was not intended to occur at the expense of permitting excessive interference by mortgage holders with real estate transactions. [12 USC §1701j-3(b)(3)]

Yet, when the Federal Home Loan Bank Board (which later became the now defunct 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 following 30 years saw mortgage rates drop. As rates dropped, buyers were no longer willing to take over existing mortgages at higher than current rates. Thus, the granting of leniency was never an issue during the 30 year period of constantly declining rates following Garn. However, leniency will certainly become an issue in the coming years, as occurred in the 1960s and 1970s as interest rose over a 30-year period.

No leniency when exercising due-on rights

The regulations under Garn allow automatic due-on enforcement on any transfer of an interest in real estate, with only a few family-related, owner-occupied single family residence (SFR) exceptions.

No encouragement or guidelines were established in the regulations for consent by a mortgage holder to mortgage assumptions or to limit interference in commonplace transactions. Now, regulatory encouragement will be needed to avoid the inevitable interference as buyers attempt to take over the seller’s low-rate mortgages of the early 2010s and 2020s when the seller will not lower their price.

In the absence of any regulatory guardrails, mortgage holders will use their due-on clauses to maximize their financial advantage over owners by calling or recasting mortgages 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 and payments — VaRoom! — as though the FRM was an ARM all along: a VRM.

Economic recessions and recoveries

Mortgage holders have no financial incentive to recast mortgages, or call and re-lend the funds at a lower rate when interest rates are in a decline, and buyers are unwilling to take them over.

However, in times of steadily rising rates, mortgage funds become more expensive and mortgage holders seize any event triggering the due-on clause to increase the interest yield on their portfolio. They claim it is a matter of lender solvency to be able to rev the engine and adjust FRM rates as a VRM. Lender advertising and disclosures do not give notice to borrowers of the draconian effects of the due on clause in their mortgage documents.

During a period of rising interest rates, mortgage holders enlist title companies to advise them on recorded activity affecting title to properties encumbered by their mortgages. Once a mortgage holder discovers the due-on clause has been triggered, the mortgage holder calls the mortgage or offers to recast its terms at current market rates as a condition for allowing:

  • a loan assumption;
  • a lease with a term over three years; or
  • a further encumbrance of the property by the owner.

Thus, real estate ownership of a seller encumbered by due-on trust deeds becomes increasingly difficult to transfer as mortgage rates rise without dropping the price sufficient to compensate for the increased cost of purchase assist funds available to buyers. These conditions tend to imprison owners in their home as they are unable to sell and relocate without accepting a lower price due to higher rates for new mortgages.

Adverse economic effects on sales

The inhibiting effect the due-on clause has on buyers and sellers during recessions has a similar adverse economic effect on all real estate sales, as well as the availability to obtain private junior financing and long-term leases.

Ultimately, as rates and interference by mortgage holders rise, many buyers, equity lenders and long-term tenants are driven out of the market, further depressing property values.

Meanwhile, owners are faced with the prospect of watching the value of their property fall below the remaining balance on mortgage debt, often leaving recent owners with negative equity in the property. It is a vicious cycle which evolves into a dramatic increase in mortgage foreclosures, the antithesis of the mortgage holder’s profit motive for automatic enforcement of the due-on clause. But, alas, most home mortgages guarantee the mortgage lender will suffer no loss on a foreclosure, and give no relief to the owner in foreclosure whose credit is successfully destroyed by the mortgage lender reporting to credit agencies.

The VaRoom effect.