With the current difficulty in obtaining new mortgage loans, especially for those buyers that may have experienced credit-challenges due to the economy, a common scenario that we are seeing more of is that of property owners with existing mortgages ‘seller-financing’ these homes to other owner-occupant buyers.
Property owners may offer seller-financing for several reasons, the most common being that the owner himself is financially-burdened with a property or is facing foreclosure and is unable to sell it, for any number of reasons, on the open market. By offering seller-financing terms, the idea is to have someone else (the new buyer) assume the debt in a ‘roundabout’ way to avoid the impending financial implications.
While the idea of an owner seller-financing a property is appealing to many sellers in order to move a property, little or no thought is given to insuring a property purchased in this manner – and this is where the legal problems begin.
Commonly known as a ‘wrap-around’ mortgage, this article isn’t intended to address the potential issues relating to due-on-sale clauses or trigger-documents, but rather we will discuss only the insurance-related aspects to this type of scenario.
The Seller’s Goal
To begin with, the common goal of the seller in this type of situation is to get out from under the financial burden of a property by offering seller-financing as an incentive for a new buyer to complete a contract and close on the property. The owner ‘sells’ the property to the new buyer (thereby becoming the buyer’s mortgagee), usually by the means of a ‘wrap-around’ mortgage, and the new buyer then makes monthly payments to the seller. The seller, in turn, then takes this money and makes the existing payment to the underlying or original mortgagees (usually a standard financial institution or bank). In most cases, these payments are handled and processed by a third-party note management company.
The Buyer’s Goal
The goal of the buyer, who more often than not has credit challenges or can’t come up with a large enough down payment to secure a traditional mortgage loan, is to be able to purchase a new home and eventually refinance the loan to a lower interest rate after his or her credit has been improved or after a history of occupancy and payments have been established.
The Typical Sales Scenario
The typical scenario in a normal seller-financing situation follows a fairly familiar format:
- the original seller has an existing mortgage with his or her original lender, such as Wells Fargo, Bank of America, or any other bank or lending institution,
- the owner will sell the property to a new buyer by use of a regular promissory note and wrap-around mortgage (which ‘wraps’ around the existing loan and includes the cost of the new loan to the new buyer),
- the seller then becomes the buyer’s mortgagee for this new transaction (the seller’s original loan is still in place between the seller and his or her bank),
- new buyer makes monthly payments to his or her mortgagee (the seller), and the seller in turn takes this money and pays his or her underlying loan installment.
The Legal Problems
The problem with insuring a seller-financed property can be significant source of concern for both the buyer and seller for a number of reasons:
- the new buyer, and only the new buyer, must obtain a new homeowner’s policy in his or her name, listing the seller (and possibly the original lending institution) as a mortgagee, in order to protect his or her personal property, provide liability coverage, and to protect the financial interest that he or she has in the property. The premium for this policy may or may not be escrowed by the seller depending upon the financing arrangements.
- ONLY the policy owner (aka ‘named insured’) may file a claim, modify or terminate a policy, or receive claim-related payments. This means that only the new buyer can file a claim or receive payments if necessary,
- the seller of the property must legally cancel his or her prior homeowner’s policy since he or she is no longer the titled legal owner and is no longer ‘owner occupying’ the property. Homeowner’s policies are ONLY for properties used as a primary or secondary residence and maintaining this coverage in place can be considered insurance fraud in the vent of a loss since it is a ‘material misrepresentation’ on the insurance contract .
- the primary issue or problem is that the original underlying mortgagee (ie: Wells Fargo) is the first-position mortgagee and the original promissory loan and mortgage that are in place are a legal contractual agreement between the lender and the original borrower (in this case the seller), regardless of what transaction may have occurred after this fact. The original mortgagee still assumes that the original borrower is on title and both occupying and maintaining the property.
Scenario # 1 – The Original Mortgagee
Each year on the anniversary date of the original homeowner’s policy that was supplied when the property was first purchased, the original mortgagee (Wells Fargo) is going to require an updated policy declarations page and proof of payment (if not escrowed). The mortgagee requires that this declaration’s page MUST be issued in the name of the original borrower that is on the promissory note and mortgage still in place with the mortgagee. When a property is seller-financed, the new homeowner’s policy is in the name of the new buyer, NOT the original buyer. This means that a policy declaration’s page with the original borrower listed as the ‘named insured’ is not available.
- it is illegal for your agent to knowingly fabricate a false declarations page on your behalf or to knowingly issue or maintain a homeowner’s policy on a property that he or she knows is no longer owner-occupied. The agent’s license could very well be revoked by the state department of insurance and he or she could face substantial financial penalties for committing insurance fraud .
- if the original mortgagee sees a declaration’s page issued in the name of a party other than the original borrower, they may well use their legal option of calling the loan due payable in full by use of the ‘due on sale’ clause included in the promissory note and/or mortgage document. This means that the original mortgagee forecloses on the original borrower (ie: seller) and the NEW buyer(s), who are an innocent party in this issue, are then forcibly removed from the premises and they in turn lose all money and financial stake they have in the property,
- the new buyer(s) may then file a civil lawsuit against the seller.
Scenario # 2 – In The Event of a Claim (New Buyer)
- in the event of a claim, all claims checks and payments are made out jointly to the policy holder (named insured) as well as to the mortgagee. This is a security measure designed to help prevent insurance and claim fraud and the mortgagee must endorse check over the insured in order for it to de deposited ,
- if the new buyer filed a claim, such as a roof claim due to hail damage, and he or she had listed the seller and original mortgagee on his or her policy, the claims check will be made out to the policy owner and both mortgagees, which means both mortgagees must endorse the check,
- the original lending institution or mortgagee was unaware that a private sale had taken place, they are now notified and the ‘due on sale’ clause is triggered and the issue described above may occur.
Scenario # 3 – In The Event of a Claim (Original Owner)
In the event that there was a property claim (fire or hail for example) and the original owner / seller chose to somehow maintain his or her original homeowner’s policy in place in order to ‘outsmart’ the system and avoid notifying the mortgagee of the recent sale, the following events may well occur:
- the claim is filed by the seller under his or her homeowner’s policy,
- the carrier’s claims adjuster reviews the claim, investigates property records, and determines that the property is not occupied by the insured and that the policy is in place fraudulently,
- the claim is denied, the policy cancelled ‘flat’, and the original mortgagee notified of the policy cancellation and possible fraud,
- the ‘due on sale’ clause is triggered and the legal issues already described get set in motion.
In summary, there is no ‘exact’ way to insure property financed with a wrap-around mortgage, regardless of how clever or well-documented a transaction may be. The major reason is that an insurance policy is a non-assignable, straight-forward, and legally-binding aleatory contract made between the named-insured party and the insurance company and it is intended to indemnify (‘make whole financially’) the insured party in the event of a loss and it is not designed to be manipulated or modified based upon the insured party’s business transactions.