Subject-To Financing: Taking Over Existing Mortgages

Buying a property "subject to" its mortgage means the seller deeds the property to you while the existing loan stays in the seller's name. You make the monthly payments, but the lender never approves you, you are not personally liable to it, and the seller remains legally responsible for the debt. The main risk is that the sale lets the lender demand the full balance under the loan's due-on-sale clause, and the federal exceptions to that clause do not cover a sale to an investor.

For the bank loans this strategy tries to avoid, see tips for getting approved for an investment property mortgage.

How a subject-to purchase works

1. Verify the loan. Get the seller's latest mortgage statement, a payoff statement, and the escrow account balance. Confirm the interest rate, the monthly payment, and any missed payments or fees you would have to cure.
2. Sign a purchase contract stating that you take title subject to the existing loan, with the lender, loan number, balance, payment, and rate listed, and stating whether you will pay the seller anything for their equity.
3. Get written authorization. The seller signs a third-party authorization so the servicer will talk to you about the account.
4. Close through a title company or attorney. The deed is recorded in your name, and you buy an owner's title policy. The existing mortgage stays on title as a lien.
5. Take over payments and insurance. Pay the servicer directly each month from your account, and put insurance in place before closing (see below).

Your cost is the seller's equity payment, if any, plus any past-due amount you cure and your closing costs. Because the loan stays on the property, you still owe the full balance if you sell or refinance later.

The due-on-sale clause and why the federal exceptions do not apply

A due-on-sale clause lets the lender declare the whole balance due if the property, or any interest in it, is transferred without the lender's written approval. The federal Garn-St Germain Act makes these clauses enforceable and lists the only transfers a lender cannot act on, for homes with fewer than five units:

• A second mortgage or other lien that does not transfer the right to live there.
• A transfer at the death of a joint owner, or to a relative after the borrower's death.
• A transfer to the borrower's spouse or children, or to a spouse in a divorce.
• A transfer into a living trust in which the borrower remains a beneficiary.
• A lease of 3 years or less with no option to purchase.

Federal regulations limit these protections to loans on a home the borrower lives in or will live in. A sale to an investor is not on the list. Putting the property into a land trust and assigning the beneficial interest (the right to the trust's property and income) to you does not change that, because the clause covers the transfer of any interest in the property, and the seller no longer remains the beneficiary.

If the lender calls the loan, you have to pay it off, usually by refinancing at current rates, or the lender can foreclose. The lender decides whether and when to act. Before you buy, confirm you could qualify for a refinance or have the cash to pay the balance.

Insurance and escrow problems

The seller's policy was written for the seller as the owner, usually as a homeowner living there. Once you own it and rent it out, you need a policy that covers you as owner and the use of the property, with the lender still listed as mortgagee as the loan requires. Ask the insurance agent in writing how the policy will be written and who is the named insured, and keep the policy from lapsing at the switch.

If the servicer believes the required insurance has lapsed, federal servicing rules let it buy force-placed insurance and charge it to the loan. It must first send a notice at least 45 days before charging and a reminder at least 15 days before charging. Those notices go to the borrower, who is the seller, so require the seller to forward every letter from the servicer to you within a set number of days, and send the servicer proof of the new policy as soon as it is issued.

Taxes and insurance paid through the loan's escrow account can change the monthly payment each year. The servicer's escrow statements also go to the seller. Budget for increases and check the payment amount every month.

The seller's continuing liability

The seller stays on the loan until it is paid off. Late payments can appear on the seller's credit report, and a foreclosure is the seller's foreclosure. The seller can also be held liable for any amount the sale does not cover, depending on state law.

The loan also affects the seller's next mortgage. Under Fannie Mae's rules, a lender can leave a mortgage payment out of a borrower's debts only when the person making the payments is also obligated on the mortgage and has paid on time for 12 months. A subject-to buyer is not obligated on the loan, so the payment stays in the seller's debt-to-income ratio. If the seller has a VA loan, the VA entitlement used for it (the amount of VA guaranty a veteran can use for a home loan) generally stays tied up until the loan is paid in full, unless a qualifying veteran assumes it and substitutes their own entitlement.

Sellers should have their own attorney write protections into the contract, such as a deadline for you to refinance or pay off the loan and monthly proof of payment. The attorney may also ask you to sign a note and deed of trust back to the seller, which gives the seller a lien and the right to foreclose under state law if you stop paying.

State laws on buying from homeowners in foreclosure

When the seller is behind on payments, some states regulate how you can buy the home. California's Home Equity Sales Contracts Act covers buying a 1 to 4 unit home the owner lives in after a notice of default has been recorded. The seller can cancel until midnight of the fifth business day after signing, or until 8 a.m. on the day of the foreclosure sale if that comes first. Until the cancellation period ends, you cannot have the seller sign the deed, record any document the seller signed, or pay the seller, and you cannot make misleading statements about the home's value or the seller's rights at any point.

Before you sign with a seller who has received a default or foreclosure notice, have a local attorney check whether your state has an equity-purchaser or foreclosure-rescue law and what contract form it requires.

How subject-to differs from an assumption

Subject-to keeps the seller's rate and term as written. An assumption takes longer and involves fees, but it removes the due-on-sale risk, and it ends the seller's liability if the lender grants a release. See loan assumptions for how to apply. If the seller owns the property free and clear, seller financing avoids the lender problem entirely, and creative financing strategies compares the other options.