Mortgage assumptions have suddenly become more attractive for homebuyers now that the Federal Reserve has signaled its intent to continue interest rate hikes to cool the economy.

As carryback sales grow in viability and popularity, real estate professionals need to keep in mind how usury limits apply to home sales structured as carrybacks.

Modified, assigned and unconscionable rates

The interest rate yield received by a lender on a real estate loan, unless exempt, is limited by California’s usury law to the greater of:

  • 10% per year; or
  • the rate comprised of the discount rate at the Federal Reserve Bank of San Francisco (FRBSF) and a margin figure of 5%.

A non-exempt real estate loan is usurious if the note evidencing the loan provides for an interest rate exceeding the ceiling interest rate yield on the day the loan is agreed to by the lender.

However, usury laws apply only to a loan origination or forbearance of lender rights on the default of a money loan. Thus, credit sales are not subject to the interest limitations of usury laws.

Further, loans exempt from usury limitations on annual yields include real estate loans made or arranged by a licensed real estate broker.

Related article:

Word-of-the-Week: Usury


Usury limits on interest rate yields

Consider an investor who enters into an agreement for the purchase of income-producing real estate. The purchase agreement calls for a down payment with the balance of the price to be evidenced by a carryback mortgage in favor of the seller.

The carryback note prepared by escrow based on the terms set by the purchase agreement call for the buyer to make monthly payments of interest only on a straight note. The principal is due one year after the close of escrow. The interest rate negotiated for the carryback note is 20%.

The buyer defaults on the carryback mortgage after making payments for several months. The seller begins foreclosure on the real estate under the trust deed.

The buyer claims the seller cannot foreclose since the interest charged on the note is in excess of the rate allowed by usury laws, rendering the interest provisions in the note void. Thus, the buyer claims no payments are due until the principal is due, and all payments made are to apply only to principal.

Can the note carried back by the seller ever, at any rate of interest, be usurious?

No! A carryback debt is the result of a credit sale by the seller. Carryback debt is not a loan of money or forbearance of the right to foreclose on default of a money loan. Thus, a carryback mortgage is not subject to usury limitations on interest rate yields. [Verbeck v. Clymer (1927) 202 C 557]

Carryback notes modified at usurious rates

Consider a property sold to a buyer on terms which includes a carryback mortgage in favor of the seller for a portion of the sales price. The carryback note includes a due date for a final/balloon payment.

When the due date for a final/balloon payment arrives, the buyer, unable to obtain funds to pay off the carryback mortgage, defaults.

The buyer and seller agree to extend the note’s due date for the final payment of principal. In exchange, the buyer agrees to an increase in the note’s interest rate, raising the rate above the usury threshold. Thus, the seller’s yield on the debt after the modification exceeds the rate ceiling set by usury laws.

After making all payments due on the modified carryback note (including the final/balloon payment), the buyer demands the seller return all the interest paid after the modification, claiming the seller’s modification of the note was a forbearance controlled by usury limitations.

Is the buyer entitled to recover the interest paid after the modification in the rate of interest due on the carryback debt?

No! Again, the transaction in which the debt was created was a credit sale. As a credit sale, the debt is not a loan and thus not subject to usury laws. Although the terms of the note evidencing the carryback mortgage were modified and a forbearance (such as a cancellation of foreclosure) occurred, the status of a carryback debt is not transformed by a forbearance into a loan. [DCM Partners v. Smith (1991) 228 CA3d 729]

Restructuring carryback debt

Consider a buyer of real estate who acquires property and takes over the seller’s existing mortgage evidenced by a note carried back by a prior owner of the property.

Later, the buyer defaults on the carryback mortgage. The mortgage holder initiates foreclosure.

A pre-foreclosure workout agreement is negotiated between the buyer and the mortgage holder. Under the terms of the agreement, the original carryback note is cancelled and the trust deed lien is reconveyed.

In exchange for cancelling the note, the buyer signs and delivers a new note and trust deed in favor of the holder of the cancelled carryback note and reconveyed trust deed. The new note is secured by the same property as described in the new trust deed.

The new note is for a greater amount than the principal amount which remained on the carryback debt since the holder of the note was given a bonus for restructuring the terms for payment of the debt, a sum added to the unpaid principal. Also, the interest rate on the new note is increased.

The higher yield on the new note resulting from the modified note rate and bonus paid to the mortgage holder exceeds the maximum annual average yield allowed over the life of the debt by usury laws.

After paying off the new note, the buyer demands the return of all the interest paid on the new note, claiming it was the result of a forbearance which brought the carryback debt under the protection of usury laws.

Is the mortgage holder entitled to retain the interest bargained for and paid on the note?

Yes! The new note evidenced a restructuring of the original credit sale debt, and the debt remained secured by the property originally sold. As a rollover of the debt created in a credit sale into a new mortgage on the property sold, the debt retained its original characteristics as a carryback debt.

Restructuring the carryback debt with a new note and trust deed did not convert the debt into a loan. Thus, the debt remained exempt from usury laws. [Ghirardo v. Antonioli (1994) 8 C4th 791]

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