Know your rights: here’s how to identify mortgage lock-in clauses, and determine when they’re unenforceable. This article is an excerpt from first tuesday’s upcoming book, Real Estate Finance, Seventh Edition.
Note: the lock-in clauses discussed here are distinct from rate locks.
Restraints on rights of alienation
A builder obtains a long-term permanent mortgage from a lender. The mortgage is called a takeout loan since it funds the payoff of a construction or bridge loan. The builder’s mortgage finances a business purpose — the continued ownership of nonresidential or residential income producing real estate. The takeout loan is evidenced by a note and is secured by a trust deed on the property, collectively called a mortgage, or more specifically, a business mortgage in this case.
The note contains a lock-in clause prohibiting prepayment of the debt for the initial seven years after origination. The note also contains a prepayment penalty which applies to any principal paid off during or after the seven-year lock-in period other than through regular amortization by scheduled payments.
During the seven-year lock-in period, interest rates drop significantly. Wanting to take advantage of the lower market rates to refinance the property, the builder requests a payoff demand from the lender and a reconveyance of the mortgage lien.
However, the lender refuses to allow a payoff and reconveyance. The lender claims the builder is locked in for the first seven years of the mortgage. This contract bars prepayment and reconveyance at any time during the lock-in period.
The builder claims the lock-in clause and the prepayment penalty are in conflict with one another. Thus, the builder believes they are able to pay off the mortgage, as long as they pay the prepayment penalty called for on a default during the lock-in period.
Is the builder prohibited from prepaying the mortgage evidenced by a note containing a lock-in clause?
Yes, by the application of contract law theories. Here, the builder agreed to be locked into the mortgage for the seven year period agreed to in the note. The provision prohibiting prepayment and the duration of the prohibition was part of the mortgage documents. Thus, the builder was fully aware of the provision barring prepayment when they entered in the mortgage transaction, and are bound by its terms. [Trident Center v. Connecticut General Life Insurance Company (9th Cir. 1988) 847 F2d 564]
Enter real estate law for the greater good
However, a real estate matter of public concern exists in the above Trident Center fact situation which was not addressed. The lock-in provision contained in the mortgage documents completely restricts an owner’s ability to freely reconvey and reencumber their interest in a parcel of real estate.
When applying real estate law, a lock-in clause becomes viewed as a restraint on alienation. It prohibits prepayment of debt and reconveyance of the mortgage lien from title. This is an absolute interference with the right to clear the builder’s title and transfer a security interest in real estate to another lender. Here, use of an ownership right commercially marketed is barred.
When a provision which functions as a restraint on alienation is unnecessary to protect the lienholder’s security interest in the property against the risk of loss, it is unreasonable and unenforceable under real estate law. Here, a payoff eliminates any risk of loss of principal and any need for the lender to protect its security interest in the property. [Calif. Civil Code §711]
Also, an owner’s right to a reconveyance can be significantly inhibited by the financial impact of a prepayment penalty. However, the monetary penalty for prepayment is not considered in real estate law to be an unreasonable restraint. Under a prepayment penalty, the owner has the ability to obtain a reconveyance and clear title of the lender’s security interest in the property, albeit at a high cost in terms of money expended.
A prepayment penalty does not bar the reconveyance which clears title of the lender’s security interest. It only makes an owner’s payoff more difficult financially.
The lock-in clause and prepayment penalty distinguished
Unlike a lock-in clause, the monetary prepayment penalty, though an economic constraint, still allows for the voluntary use of the property by the owner. This is true whether the owner intends to further encumber the property or sell it. [Sacramento Savings and Loan Association v. Superior Court (1982) 137 CA3d 142]
Conversely, the lock-in clause absolutely bars the owner from obtaining a reconveyance to clear their title and re-encumber or sell the property. Thus, the lock-in clause is void under real estate law since the lender experiences no risk of loss on a payoff, by either impairment or default. Lenders claim that without the lock-in provision they lose the expectation of the interest to be earned on the note, but this expectation is covered by a prepayment penalty.
Some judicial decisions, such as those in the above Trident Center case, have attempted to resolve restraints on alienation based solely on general theories of contract law. The historic judicial preference applies more specific rules, not an underlying general rule, to control interference with an owner’s interest in real estate.
Public policy breach
Trident Center rests solely on the contract doctrine that a restraint on alienation provision is valid only if it is willingly entered into between an owner and a lender of relatively equal and sophisticated bargaining power.
However, real estate law, which is the foundation for marketable real estate rights, prohibits unreasonable restraints on alienation. Unreasonable restraints on alienation are prohibited no matter how they are contracted, or how aggressively the lender bargains to achieve an agreement from the borrower or owner consenting to the restraint. The lock-in, as a contractual provision, attempts to trample ancient public policy, which demands property titles remain:
- unfettered; and
- available to the real estate marketplace.
The prohibition of restraints on transfers of real estate interests gives property owners the right to voluntarily use or convey the many ownership rights and interests they hold in their real estate. These rights are subject to lender interference only when it is necessary for the lender to protect itself from an increased risk of loss and interference by third parties holding involuntary liens, such as the Internal Revenue Service (IRS). [Garber v. Fullerton Savings and Loan Association (1981) 122 CA3d 423]
The owner’s right to use their ownership interests is historically ingrained and long-standing. This public policy principle prevails in spite of contractual provisions to the contrary. Court decisions imposing contract law theories to override the pre-existing statutory rights of owners to alienate real estate interferes with owners’ right to freely transfer encumbered property in the real estate marketplace.
Contract law vs. real estate law
Consider a seller who carries back a note secured by a trust deed on the sale of their income-producing property.
A boilerplate provision in the mortgage allows for prepayment of the mortgage, subject to a prepayment penalty.
Further, the mortgage includes an additional typewritten provision which states the buyer is locked in to making monthly installments, and is prohibited from prepaying the mortgage prior to its due date. Also, the clause allowing prepayment remains unstricken from the boilerplate provisions in the mortgage.
Thus, the carryback mortgage includes conflicting provisions:
- two in the printed form which prohibited prepayment and a reconveyance of the property; and
- one added to the printed note form which permitted prepayment and reconveyance without penalty.
The buyer, after making payments on the mortgage, attempts to pay off the mortgage prior to its due date.
The seller claims the addition of the typewritten lock-in clause prohibits prepayment since the buyer agreed to the provision, which has authority over conflicting preprinted provisions.
The buyer claims the lock-in clause is unenforceable since the boilerplate provisions in the mortgage express inconsistent activities, allowing prepayment and reconveyance limited only to the payment of a monetary penalty.
Can the buyer be completely prohibited from prepaying the mortgage, even though the boilerplate provision in the mortgage’s note provides for prepayment?
Yes! Under contract law, the buyer can be prohibited from prepaying the mortgage.
When preprinted boilerplate provisions and additionally entered provisions in a set of documents are in conflict, the added provisions control. Thus, even if a provision allowing prepayment is located in the boilerplate provisions of a mortgage, the additionally entered lock-in clause, which is in conflict, controls under contract law. [Gutzi Associates v. Switzer (1989) 215 CA3d 1636; CC §1651]
Restraints vs. the need to protect
However, continuing our previous example, under the specific real estate law, any lock-in provision prohibiting the release of real estate interests is a restraint on alienation.
The above Gutzi case agreed, but held the restraint was reasonable since the property owner failed to demonstrate the unreasonableness of the interference. The owner did not request a payoff demand from the lender and no interference actually occurred.
The lender is to weigh two factors in restraint of alienation challenges:
- the quantum of restraint on the sale or refinance of real estate necessary for the provisions in a mortgage to be rendered unenforceable under real estate law; and
- the lender’s need to protect its investment from a legitimate risk of loss.
A contracted for lock-in clause becomes an unreasonable restraint on alienation if it causes transferable real estate rights to be unavailable to the marketplace under any present circumstance. [Kendall v. Ernest Pestana, Inc. (1985) 40 C3d 488]
A lock-in clause directly and absolutely bars the owner’s ability to reconvey a lender’s security interest while:
- concurrently encumbering the property by recording a mortgage to another lender with the same priority on title; or
- transferring the property to a cash buyer.
The lock-in clause is an unenforceable provision when:
- it imposes a restraint on an owner’s right to reconvey and release liens of record, and;
- the cost of the restraint imposed by the clause is greater than that experienced by the lender due to an early payoff.
Enforceable vs. unenforceable restraints
Prepayment of mortgages is allowed by statutes, regardless of provisions in a mortgage prohibiting early payoff, under each of the following situations:
- the mortgage is secured by one-to-four, owner-occupied residential units [CC §2954.9(a)];
- the mortgage has a variable interest rate and, on notification of a change in the rate, the borrower may prepay it within 90 days [CC §1916.5(a)(5)];
- the debt is a land sales contract which provides for land to be subdivided into lots of four-or-less residential units [CC §2985.6(a)];
- the prepayment penalty clause is not sufficiently specific to allow enforcement [Donahue v. LeVesque (1985) 169 CA3d 620]; or
- the property subject to a mortgage is acquired for public use. [Calif. Code of Civil Procedure §1265.240]
However, if the lender or carryback seller on a mortgage secured by a one-to-four unit residential property is a Regulation Z (Reg Z) consumer mortgage holder, the ability to charge a prepayment penalty is restricted to those consumer mortgages meeting the qualified mortgage (QM) criteria. [12 Code of Federal Regulations §1026.43(g)(2)]
Conversely, a lock-in clause is enforceable in two limited carryback situations when necessary to assure installment sales profit tax treatment. These carryback situations are:
- The buyer of up to four residential units per calendar year can only be locked into the mortgage and barred from prepayment during the calendar year of the carryback sale. After the lock-in period expires, the buyer has the right to pay off the mortgage at any time, subject to the prepayment penalty agreed to and as limited by law.[CC §2954.9(a)(3)]
- The lock-in clause is enforceable on the prepayment of a seller carryback documented as a land sales contract on four-or-fewer residential units. This can be prohibited for up to a 12-month period following the sale. [CC §2985.6(a)]
Carrybacks and the lock-in
A carryback seller’s primary motivation for locking in the buyer is their desire to prevent the seller’s premature payment of profit taxes which would be due on an early payoff of the note.
Carryback sellers reporting profits on installment sales limit their taxable profit in any one year to the pro rata share (contract ratio) of profit in the principal paid on the note. Similar to a traditional mortgage provided by a lender, the installments received each year on a carryback note typically include only a small amount of principal, with a majority of the payment going to interest. Thus, use of a lock-in clause bars early payoff of principal, one method for allowing the seller to take economic advantage of the tax deferral in installment sales reporting. [Internal Revenue Code §453]
Lenders and lock-ins
For lenders, a lock-in clause is a portfolio tool to assure a consistent, long-term yield on a mortgage, regardless of actual market rate fluctuations during the life of the mortgage.
Editor’s note — Lock-in clauses worked to the lender’s advantage during the half cycle of declining interest rates from 1980 to 2012. However, the rising interest rates to be experienced during the coming 30-year half cycle in interest rates will work to the advantage of owners, not lenders. Under a lock-in clause, the fixed-rate mortgage (FRM) rate will remain level even as interest rates increase.
Locking in the borrower to prevent early payoff of mortgages made during periods of high interest rates is the lender’s long-term motive when interest rates will drop. Inevitable cyclical inflation is broken by the Federal Reserve’s (the Fed’s) monetary policy. As mortgage rates decline, the real rate of return to the lender, and thus real earnings, increases on the old FRM.
The reverse will occur over the next few decades of steadily rising interest rates and favor owners.
As inflation abates, the lock-in clause protects the lender’s now excessive real rate of return, an economic distortion delivering a windfall profit to the lender due solely to Fed monetary policy moves. The profit in the lender’s portfolio yield is the spread between the rate of inflation (its cost of funds) and the underlying mortgage rate.
As an exaction to enforce a right to protect a mortgage from loss, interference for the purpose of increasing a lender’s portfolio yield has been denounced in California as beyond the legitimate purpose of a mortgage lien on real estate. [Wellenkamp v. Bank of America (1978) 21 C3d 943]