As someone who deals with insurance and wrap-around mortgages on a daily basis, I sometimes find it ironic that all parties involved in a seller-financed wrap-around transaction worry a great deal about the new property insurance being sent to the mortgagee in the new buyer’s name and triggering the ‘due on sale’ clause, however, they rarely (if ever) give a moment’s thought to what might happen in the event of an actual claim if funds are made out to the policy owner (new buyer) AND the ‘loss payee’.
As the fourth piece in this series about insuring wraparound mortgages, this article is intended to address the often-ignored issue of property claims and how payment is made by the insurance carrier as well as how it may (potentially) create BIG problems for the buyer and seller in a wraparound mortgage.
Before we go too far, be forewarned that this article (which is a little long) has been a somewhat difficult to write in “layman’s terms” and that it is a little bit detailed and technical because it includes some rather confusing semantics and insurance ‘legalese’. This is not intentional, but there is simply no way to cover this information and describe its relevance without using some degree of insurance-based vocabulary and it is assumed that you, the reader, have some minor familiarity and experience with real estate and mortgage lending. Unfortunately, trying to discuss insurance without using a little ‘insurance-speak’ is like trying to describe water without using the word wet.
To begin with, we must define and explain the actual difference between a “Mortgagee” and a “Loss Payee”, as well as the “mortgagee clause” and “loss payee clause” that are associated with them, as they are often used synonymously (and incorrectly) when speaking about insurance. We will then discuss later in this article how these terms apply to an insurance contract for residential property.
That having been said, here we go…
What’s the Difference Between a Mortgagee, Mortgagee Clause, and Loss Payee?
A “mortgagee“, also known as the “lender”, is defined as the party who holds a mortgage on real property as security or collateral for repayment of a loan. In residential property insurance, the mortgagee is usually automatically included as a ‘loss payee’. This is very different than an automobile policy whereby the lien holder must be specifically added or endorsed as a ‘loss payee’ as their interest as such is not automatic.
A mortgagee clause is simply a clear description how the lender wants their name and address to appear on legal documents. The mortgagee clause is the legal description of the entity that has financial interest in a piece of real property. Some lenders have different mortgagee clauses depending upon the type of loan utilized since the lender may have different offices or locations designed to handle each specific loan type (FHA, VA, Jumbo, 15-year fixed, etc). Getting this information correct is important because it is what stipulates who has the legal right to financial reimbursement in the event of a loss or devaluation of the property.
A “Loss Payee“, on the other hand, is the party to whom insurance proceeds are paid as stipulated in the loss payee clause of an insurance policy which is purchased by the borrower and covers the real property pledged as security to the mortgagee. With regards to property insurance, the lender is usually listed by default as the “first loss payee” and will be paid to the extent of the balance of its loan with the remainder of the money paid back out to the property owner. Lenders may, at their discretion, simply choose to waive payment in the event of an insured loss and allow the payment to go directly to the borrower in order to make necessary repairs (such as a minor water claim). However, they may also accept payment from the insurance company and then disburse funds as repairs are made, such as when replacing a roof or rebuilding a property after a fire, as a method of making certain that the money actually goes back into the property.
A Loss Payee Clause, which is included in most property policies, is an insurance provision authorizing payment in the event of loss to a person or entity other than the named insured (policy owner) having an insurable interest in the covered property – such as the lender. Under a typical loss payable clause, known as a ‘Standard’ loss payee clause (endorsement 438 BFU NS), the lender is covered for a loss even if the named insured is denied coverage due to his or her actions invalidating the claim. More on that topic later. In an ‘Open’ loss payee clause (which are fairly rare), the insurer isn’t under any obligation whatsoever to make payment to the loss payee if payment for a loss can be denied to the insured. In other words, with a ‘standard’ clause, if the named insured (policy owner) committed an intentional act such as arson, the lender is still entitled to recover the loss from the insurer even if the policy owner isn’t. With an ‘open’ clause, the insurer is not obligated to pay claim proceeds to either the named insured or the mortgagee.
Often, an insurance company will make a claim check payable to both the named insured AND the lender (mortgagee) or they will also sometimes send the claim check directly to the lender itself. It varies. Some of the typical language in a loss payee clause requiring this is below:
“Loss or Damage under this policy shall be paid as Interest may Appear to You and the Loss Payee Shown in the Declarations. This Insurance Covering the Interest of the Loss Payee Shall Become Invalid Only Because of Your Fraudulent Acts or Omissions”
“We will pay for any covered property loss of or damage to the Dwelling(s) or Personal Property to the loss payee named as their interests may appear.”
An Easy Example
As an example for clarification that most everyone can relate to, let’s use an automobile. Let’s assume you own a vehicle with a current ’Blue Book’ value of $20,000 but the remaining balance on your loan to your lien holder, such as Toyota Financing, is only $15,000. The vehicle is worth $5,000 more than what is actually owed on it and your insurance policy has Toyota Finance listed as both the lien holder and loss payee. In other words, not only do they hold the title on the vehicle (because they still have your outstanding loan), but they are also listed as a party to which any claim payments are made. If this vehicle were to be involved in an accident and declared a ‘total loss’ by the insurance company, the insurance company would make a claim check for $20,000 payable to both the policy owner (you) as well as Toyota Finance (the loss payee). Toyota Finance would deduct the $15,000 owed to them for the loan and then release the remaining balance of $5,000 to you. On the other hand, if the policy was issued without Toyota Finance formally being listed as a loss payee, the entire $20,000 payment would be made directly to you (policy owner) – and the lien holder (Toyota) , which no longer has any collateral, runs the risk of you simply defaulting on the loan and keeping the money. With no more collateral securing the loan and with the insured having claim funds paid directly, they lose control of their interest.
The same is true of a mortgagee who makes a $200,000 loan on a property. If the home were to burn to the ground and the policy owner (borrower) decided to simply keep the funds for him or herself and not repay the loan, the lender would no longer have any real property (except for the land) to foreclose upon and the would lose a great deal of money. For this reason, most insurance policies contain a ‘loss payee’ clause.
The Two Types of “Loss Payable” Clauses (‘Standard’ and ‘Open’)
Seriously? Insurance Makes My Head Hurt...
Before we discuss how the loss payee issue affects the parties in a wraparound mortgage transaction, let’s go back through what the “Lender’s Loss Payee” clause in an insurance policy actually is. In order to do this, we must first flash back in history to May 1, 1942 – one week before the Battle of the Coral Sea began and the same day that Disney released the wartime cartoon “Donald Duck Gets Drafted”. It was on this same date that the “Loss Payable” (438 BFU) ‘Standard’ endorsement was formally approved and included in property insurance policies (yes, it’s that old). Since that time, there have been numerous court cases involving ‘loss payee’ provisions (the most notable being Higgins vs. Scottsdale Insurance Company in 2005) so that some states have adopted alternate loss payable provisions (such as the Washington Insurance Commissioner’s WAC 284-21-990), however, the 438 BFU lender’s loss payable provision is the most prevalent in almost all states and it’s probably the one that is included in virtually every homeowner or dwelling policy purchased in the standard insurance market.
Insurers HATE including this endorsement because it gives such a broad and liberalized amount of coverage to lenders (loss payees), but conversely, mortgagees LOVE it for the very same reason. In fact, most mortgage documents, as a condition of the loan, clearly require that property insurance include this endorsement by clearly stating “The policy must include a standard “mortgage loss payee clause” (Lender’s Loss Payable Endorsement 438 BFU or equivalent) in favor of <Lender’s Name>”
The 438-BFU-NS endorsement, in effect, establishes a separate insuring agreement between the insurance company and the lender (who is also the loss payee) irrespective of any agreement with the named insured and it insures the lender for intentional acts of the insured. For example, if the policy owner were to intentionally set fire to his or her home, he or she would not be entitled to any claims proceeds from the policy because of the illegal and intentional act. In short, this loss payable endorsement grants coverage for the benefit of the mortgagee in the event that the policy is voided by some act of the insured. If the lender were to file the claim to recover from the loss, it would be covered because this 438-BFU-NS endorsement protects the lender’s interest against the intentional acts of the insured. In addition, this loss payable endorsement requires that the insurance company “agrees to give written notice to the Lender of such non-payment of premium after sixty (60) days from, and within one hundred and twenty (120) days after, due date of such premium and it is a condition of the continuance of the rights of the Lender hereunder to be paid the premium due within ten (10) days following receipt of the Company’s demand in writing”
In other words, it continues coverage for the lender even after the insured has failed to pay premiums.
Without the inclusion of this lender’s loss payable clause as a measure of safety and security for the lender, it is unlikely that financial institutions would be able to loan the large amounts of capital necessary to purchase homes and commercial property.
So How Does This Clause Affect Wrap-Around Mortgages and Claims?
Okay, after all of this reading the question finally boils down to what affect does this have on the parties in a wraparound mortgage transaction and what happens when a claim is filed?
And now we get to the ‘meat’ of this article…
There are actually a couple of scenarios that can occur, and there is absolutely no rhyme or reason as to which one will happen. In the event of a claim or loss, the funds will either be (a) made out to the policy owner (named insured) – which is the buyer of the property in a wrap transaction, or (b) the funds will be made out to the named insured AND the loss payee(s) – which consist of the underlying mortgagee and/or the seller (if also listed as a mortgagee). And this is where the potential for problems exists. In most cases it is literally a crap shoot as to which will occur and it is nothing that the policy owner has any control over.
The reason for this uncertainty in how claim settlements will be paid out is simple; generally speaking, most claims adjusters are fairly young, inexperienced, ignorant of the actual loss payable provisions in a policy, and under pressure from management to close claims quickly and for as little as possible in order to keep down ‘loss ratio’ expenses. Claims management is normally a ‘starting point’ for most corporate insurance careers because it is a high-stress, high-pressure field and few people do it for more than a couple of years before either becoming burned out or moving upwards to other areas of responsibility within their company. Due to this fact, few claims professionals truly delve into learning the finer points of the policies that they work with and since many are young, they have very little experience in reading, or even comprehending for that matter, detailed contracts written in ‘legalese’ and more often than not, they have simply been hired as claims adjusters, initially trained through a licensing course, and then sent out into the wilderness to adjust and settle claims. In fact, while preparing for this article, I personally called several claims adjusters as well as their managers at several well-known insurance carriers to discuss the loss payee clause and/or lender’s loss payable provisions contained in their respective policies – and not a single person I spoke with had any idea what this clause was or how it really affected their responsibilities as a company after a loss. I had expected a few people to not know what I was speaking about, but I certainly didn’t expect 100% of them to be so uninformed.
When asked whether they paid claim funds to the lender or the named insured after a loss was settled, virtually all of them stated that ‘it depended upon the amount of the claim’ or ‘we don’t know’. The first is clearly a violation of the 438-BFU-NS endorsement since it makes absolutely no mention whatsoever of any dollar amount threshold to decide which party claim funds are paid to. The second answer is simply unsettling (pun intended).
In the case of a wraparound mortgage, let’s assume the following scenario:
- The new buyer files a property claim under her or her homeowner’s policy
- The original underlying mortgagee (ie: Wells Fargo) is still listed as the first mortgagee
- The seller of the property is now listed as the second mortgagee
If the new buyer were to file a claim under his or her new homeowner’s policy and the claim amount was $20,000, depending upon who is handling the claim and how closely that are paying attention to the policy language, it is likely that the settlement check of $20,000 would be made out to the insured as well as both mortgagees – since both are also ‘loss payees’. This means that the buyer would have to get BOTH mortgagees to physically endorse the check before it could be cashed or deposited to pay for repairs. This obviously raises some concerns:
- What if it is two years after closing and the sellers, who were facing foreclosure or short sale when entering into the wraparound, are now far-removed from the transaction or no longer easily located or reached?
- What if the seller, for whatever reason, simply refuses to endorse the check?
- What if the original underlying mortgagee sees that the check is made out to the new buyer and not in the name of their original borrower? Will they call the loan due and payable?
- What if the claims adjuster actually pays attention to the policy language and sends the settlement check directly to the first mortgagee (Wells Fargo) for disbursement to the insured? How will the new buyer (who is not the original loan borrower) get this check from the mortgagee?
Of course all of these are just hypothetical ‘what if’ questions, but they are relevant and all are very possible. Because wrap-around transactions, by their very nature, violate the acceleration (due-on-sale) clause in the underlying mortgage, there is always the possibility of the lender finding out about the property transfer when a claim occurs. Having mentioned all of the above, however, I will say that in all of the wrap-around transactions that I have insured and with the resulting losses that have occurred, there has yet to be an instance of the claim tipping of the lender or the lender demanding the loan be paid in full. It simply has not happened. In fact, most claims are just paid directly to the named insured policy owner (even though this is in direct violation of the loss payee clause).
In the event that a claim settlement is either paid directly to the underlying mortgagee or made out to the insured and the mortgagee, the chances are that the mortgagee won’t really make any issue at all so long as payments are current and the property either has been or is being properly repaired so that the loan is still collateralized.
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If you are involved with seller-financing and you have read any of my articles regarding insurance for these types of transactions, specifically wraparound mortgages, you have probably picked up on a common theme running through all of them – which is that there is a lot of bad advice being given by people with little or no knowledge of insurance and it can cause you BIG problems later on. This includes Realtors, attorneys, and even other insurance agents and brokers. In fact, we ourselves have heard advice that is not only completely wrong but which can almost certainly be construed as intentional insurance fraud – and this was from another insurance ‘professional’ with years of experience.
The reason for this misinformation is because insurance is often treated (at best) as a commodity or viewed (at worst) as a ‘necessary evil’. This apathy and the general lack of importance attached to insurance is what drives the ability for those with no actual insurance knowledge to become ‘overnight experts’ with the ability to direct the insurance-purchasing decision of others. In addition, most licensed insurance agents are simply salespeople that have no first-hand experience with real estate, property investing or contract law and who make very little effort to educate themselves with anything truly insurance-related beyond just the bare minimum knowledge required to sell a basic policy.
In fact, the paragraph below is actually posted on the web site of a legal firm with experience specializing in wraparound mortgages. It is shocking (actually, not really that surprising) that an established legal professional would provide inaccurate advice like this, but this firm is not alone – this is the same type of misguided information parroted to buyers and sellers across the country. As an insurance professional, I don’t even know where to begin tearing apart the text below. It is incorrect in virtually every sentence and, if this advice were to be followed, there is also a very real potential for intentional insurance fraud.
“Sellers in wrap transactions usually want to cancel their casualty insurance policy. Wrong. The wrapped lender, who usually collects an escrow for taxes and insurance, or at the very least is named as an additional insured on the seller’s policy, will be notified of the change. The seller will then get a default letter from the wrapped lender who will “force place” another policy (usually much more expensive) at the seller’s expense. The existing policy should therefore be left in place. Another issue: collecting on the seller’s insurance policy can be problematic after a wrap transaction since title to the property has changed hands. Even if the seller agrees to make a claim on behalf of the buyer, the insurer may refuse to pay it, asserting that the seller no longer has an “insurable interest.” Worse, this could potentially be construed as insurance fraud. Therefore the buyer should procure his own casualty [liability] and contents insurance. It is unfortunate that this results in two policies being in place, but there is no way around it. A wraparound can be a mutually beneficial way to structure a transaction, but it is not a perfect device.”
The paragraph just referenced is an example of ‘Bad Advice # 1″ described below…
BAD ADVICE # 1 – Seller Keeps Existing Homeowner’s Policy in Place and Buyer Purchases a New RENTER’S Policy
There are only three things that pose a problem with this idea; and in order of importance it’s that this advice is (1) Wrong (2) Wrong, and (3) Wrong. Other than those three things it’s perfect. While many of you reading this already know just by common sense that this is an incorrect way to insure a property purchased with a wraparound mortgage, we have heard this exact same advice numerous times from numerous licensed real estate and legal professionals. There are even real estate attorneys working with other insurance brokerages that commonly, as a matter of practice, have the two parties in a wrap mortgage set the insurance up in exactly this manner. This is also the exact same advice given in the paragraph above.
The idea here is that in order to avoid notifying the underlying lender about the property transfer, the seller keeps his or her homeowner’s policy in place (so that the mortgagee is never sent a new policy with a new named insured) and the new buyer (which is now the legal owner) simply purchases an inexpensive RENTER’S policy to provide some liability protection as well as coverage for the buyer’s personal belongings.
To begin with, it is an intentional ‘material misrepresentation’ on the insurance contract with seller’s company. The seller is keeping his or her homeowner’s policy in place, however, these types of policies are only written on ‘owner occupied‘ property. Since the seller no longer occupies the property as either a primary or secondary residence, this violates the carrier’s underwriting and eligibility guidelines for coverage right from the start. Secondly, the seller is no longer the titled owner and even though he or she may still have a promissory note and mortgage with the underlying lender, there is no longer an ‘insurable interest‘ in the property – so the seller now isn’t even qualified to purchase this insurance in the first place.
Furthermore, the new buyer, who DOES now have the insurable interest, is left totally and completely uninsured with regards to the property that he or she just purchased. The renter’s policy only covers the buyer’s personal liability (no premises liability for issues occurring on or because of the property) and the only property coverage that exists is for the contents of the home. If a hailstorm occurred, a fire happened, or a pipe burst and caused thousands of dollar’s worth of damage – the buyer (who is the legal property owner) has absolutely no coverage for the structure whatsoever. The only way a claim could be filed would be by the seller with the homeowner’s policy in place that shouldn’t even exist. Not only would the seller be the only one who could legally file a claim or receive payments, but what if the seller is living in another state and has been completely removed from the property since the closing date? Finally, it is technically considered insurance fraud for the seller to file any claim on the property and/or receive any payment monies since he or she no longer has an insurable interest in the property and the seller would be financially benefiting from a property loss that he or she didn’t actually suffer. The policy would also be canceled by the insurance company and the underlying lender notified – which takes all parties right back to where they started in the first place with the insurance situation.
Bad Advice # 2 – Seller Keeps Existing Homeowner’s Policy in Place and Buyer Purchases a New HOMEOWNER’S Policy
This is very similar to the issue just described, however, a couple of things change. Although the seller is still unqualified to maintain a homeowner’s policy since he or she no longer has an insurable interest and isn’t a legal owner any longer, the buyer does now have the proper insurance on his or her home and the buyer can file a claim if needed, however, the parties now have duplicate coverage on the property. This can possibly be an issue in the event of a claim since an insurance report may be run by the insuring company. Since insurance companies send records of policy coverage and past claims to data aggregation companies such as ChoicePoint in Alpharetta, Georgia, there is a possibility that the company can learn about duplicate coverage on the property and either deny or delay the claims process. In addition, the buyer must now have a monthly mortgage payment that covers not only the cost of his or her own insurance but also the cost of the seller’s policy as well. In effect, this means that the buyer’s insurance premiums are double what they actually should be.
Bad Advice # 3 – Buyer Purchases New Homeowner’s Policy and Billing Is Set To Pay From Escrow
The third most common piece of bad insurance-related advice that we hear on a regular basis involves the buyer purchasing a new homeowner’s policy and having the billing set up to be paid by the seller’s escrow account. This causes numerous problems to the point that I have posted an entire article about this issue here: “The Problem with Escrow Accounts“. Rather than repeating the same information on this page, I would suggest you read the article just referenced for more in-depth information.
As experienced investors ourselves, InsuranceForInvestors specializes in insuring wraparound transactions and we know exactly how the insurance aspect of these property transfers should happen. Should you need an accurate proposal for a wrap-financed property, please call us at (800) 299-8994 and we’ll be happy to assist you.
As you may already be aware, there is an enormous amount of information on the internet about wraparound mortgages and the ‘new’ seller-financing alternatives currently being used in today’s market. Too bad most of it’s wrong or incomplete.
Unfortunately, much of the information that exists is written by those, including real estate attorneys, with no first-hand experience or knowledge in insurance, insurance law, and other key areas of knowledge. They unintentionally end up providing only about 75% of the information actually necessary (which may or may not be accurate) that the other 25% pertaining to insurance, escrow accounts, and Trusts (depending upon the transaction) is simply left out altogether as if these things don’t really matter. The fact is that they are left out because most ‘experts’ have no clue whatsoever about these key topics or how to deal with them – so they just omit them and the reader never knows the difference.
First things first, let’s get the obvious questions out of the way.
- Yes, wraparound mortgages are completely legal.
- No, you are not required to notify the underlying lender that a transfer of the property has taken place.
- Yes, the lender has the right (not obligation or requirement) to exercise the acceleration clause’ (aka ‘due-on-sale’ clause), but there is a 99+% chance that they won’t – at least not for several years until interest rates increase.
Now that we have gotten past the ‘Big Three’ questions, let’s get onto the subject of property insurance and escrow accounts… the red-headed stepchildren of the wraparound mortgage industry.
One of the biggest hurdles regarding wraparound mortgages is that of hazard insurance. The documentation and transfer of property is the easy part, it’s the property insurance itself that presents an obstacle. The reason for this is because of the fact that an insurance policy is a very straightforward legal contract between the policy owner (who must have an ‘insurable interest‘) and the insurance company. These contracts are NOT assignable (like a real estate contract is) and insurance is not designed to work in a situation such as a wraparound transaction where the parties are trying to ‘skirt the system’ (for lack of a better term) and keep the underlying lender in the dark about the transfer of property. Trying to be creative and somehow ‘modify’ an insurance contract or make it magically fit the needs of the wrap transaction is like using a screwdriver to paint a wall; it’s not designed to perform that specific task and you’ll end up disappointed with the results. Rather than discussing the many pieces of bad advice and improper (or even illegal) ways to insure these properties, this article is going to focus only on the aspect of the escrow account itself.
This may be elementary, but before we go forward, it’s important to understand just exactly what an escrow account really is.
Without going into too much detail, an escrow account, which is usually required by the original mortgage document and which is established in the name of the original borrower, is a separate account established by your lender or loan servicer used to collect and hold funds to pay your annual property taxes, insurance premiums, and/or other charges when they become due. This account is normally established by the lender as soon as the initial closing occurs. The reason is simple; the lender has a first-lien position on the property and they want to maintain control of the loan by making certain that all taxes and fees are paid and that the property, which is collateralizing their loan, is always fully insured against a loss. If an escrow account didn’t exist, there is always the possibility that the borrower could fail to pay his or her property taxes each year – which may result in a County tax lien that supersedes the lender’s original lien position (regardless of the amount of taxes due). Also, if the property suffers a loss and the insurance has been terminated for non-payment, the lender has no collateral any longer and they may very well lose part or all of their money on the loan. Each month when the borrower makes a mortgage payment, part of the amount goes to the Principal and Interest balance of the loan and a small part is ‘siphoned off’ and deposited or credited to this separate escrow account. Each year the lender receives a bill for the insurance and taxes and they, in turn, use the money in this account to pay these bills in full until the following year.
When purchasing a property with a wraparound mortgage, the seller (original borrower) normally has an escrow account already established with the lender with funds in it – and this is where the problem begins.
You see, this escrow account is the name of the original borrower (the seller) and NOT in the name of the new wraparound buyer and all parties are trying to keep the transaction ‘invisible’ so that the underlying lender is not notified about the property transfer.
When the transfer happens, the new buyer must obtain property insurance in his or her name. However, if the initial transaction is not set up correctly (which they seldom are) and no third-party loan servicing agency has been contracted to set up a NEW escrow account in the name of the NEW BUYER, then there is an immediate built-in problem.
Because most attorney’s and agents dealing with seller-financed transactions have no experience and little or knowledge about insurance, bad advice is given and the sale is usually set up so that the new insurance policy is simply sent to the underlying lender to be paid from the original existing escrow account (with the silent hope that the lender doesn’t see the name change and cause a stir). The problem here is that this escrow account is in the name of the original borrower (the seller in this case) and NOT in the name of the recent buyer – who is the ‘named insured’ policy owner on the new insurance. The mortgagee can’t and won’t release funds from John’s escrow account to pay for David’s insurance. Period. They can’t use one party’s money in that party’s account to pay for someone else’s insurance.
Hence the problems of (1) who pays the insurance and (2) what does the lender due now that they have been tipped-off as to the transfer of the property?
The normal result is that the insured has to then contact the insurance company issuing the policy and take responsibility for either paying the premium in full (which few can afford to do) or otherwise set up monthly billing arrangements. The obvious concern here is that the new buyer owner fails to pay for the policy and it cancels for non-payment of premium. This happens about 50% of the time and it results in continuous cancellations, reinstatements, and possible permanent loss of insurance depending on how many times this occurs. Without intending too sound too harsh, many (not all) buyers of seller-financed property have already had past credit and/or financial-responsibility issues and leaving them in full control of paying yet another bill and making certain the property is always insured is normally not a very good idea and it’s an absolute set-up for future long-running issues and constant babysitting of the loan.
The best solution to the potential problems mentioned is to treat the new wraparound exactly like a traditional mortgage loan. The new buyer should pay the first year’s insurance premium in-full at the closing table and then a loan servicing agency should be contracted to set up the management of the wraparound sale from the day it closes. This servicer should establish a brand-new escrow account in the name of the new buyer and fund it with each monthly mortgage payment. The bill for the insurance (as well as property taxes) is sent to the loan servicer each year who in turns pays the entire amount from the buyer’s escrow account.
WHAT ABOUT THE ORIGINAL ESCROW ACCOUNT?
Good question… Herein lies another issue to consider. This escrow account, which presumably has funds in it, is in the name of the seller – who is probably now far-removed from the sale and just glad to have it done and in his or her past. However, it continues to get funded even more each month as this underlying mortgage payment is made by the loan servicing company. With this in mind, one of two things can normally happen.
# 1 – the seller can send the mortgagee/lender proof of the taxes and insurance being paid in full (the new buyer or loan servicer must provide this information to the seller who in turn provides it to the underlying mortgagee – which means the parties must stay in contact with the seller at least on an annual basis). Once this proof of payment has been sent, the seller can now request that the ‘overage’ in the escrow account be returned to him or her and, in theory, forwarded onto the new buyer. The obvious concern being the steps and effort involved as well as the fact the seller can technically keep this money once it has been sent by the underlying lender. The wraparound documents may state that the seller ‘assigns’ this escrow account to the new buyer, but this is really only between those two parties – not the underlying lender. The original lender did not agree to the assignment and their consent can’t be construed simply because the other two parties agreed amongst themselves to the assignment. Furthermore, escrow accounts can’t be ‘assigned’ any more than your checking account can be ‘assigned’ to your next-door neighbor. If the seller chooses to keep this money, the only real recourse is for the buyer to pursue litigation against the seller, which really isn’t an option anyway since it will probably cost more in legal fees than the amount of escrow money actually returned and because of the nature of these sort of issues, it could possibly notify the underlying mortgagee of the transfer and litigation – and now the due-on-sale clause can become a very real issue.
# 2 – In some states, the seller (original borrower) can request that his or her escrow account be canceled and that he or she be solely responsible for paying all taxes and insurance as well as sending in annual proof of payment to the mortgagee. In theory this eliminates the problem altogether. The ‘gotcha’ to this is that this possibility varies by state and there must usually be less than 65% of the balance still owed (a 35% equity position). When dealing with wraparound mortgages, this is normally not possible because of the fact that if the property had that much equity it would have probably been sold on the open market with traditional financing in the first place and if the seller was in a foreclosure or pre-foreclosure position with the lender, the lender is probably not going to take on even more risk and allow the escrow account to be canceled so that the seller (who was previously in default) now has control of tax and insurance payments due directly to the past financial problems and payment history of the loan itself.
As you can tell, the original escrow account is almost always the ‘fly in the ointment’ regarding seller-financing, however, the problems posed with insuring wraparound mortgages can be greatly diminished if managed and dealt with properly at the beginning instead of waiting until all legal documents have been signed and executed and then dealing the after-the-fact problems as they occur. InsuranceForInvestors deals extensively with wrap-mortgage situations and we are more than happy to help you minimize your insurance-related headaches.
This may be a short article, but it’s an important one – especially with regards to insuring seller-financed ‘wraparound’ mortgages. Since the insurance industry is founded on the principals of risk, contract law, and civil liability, properly insuring properties purchased in this manner can be a challenge, especially when titled in a trust, and the issue of ‘legal‘ title versus ‘equitable‘ title often arises with regards to who has an ‘insurable interest‘ and who doesn’t.
EQUITABLE TITLE – This type of title refers to the actual enjoyment and use of a property without absolute ownership. It is the interest in the property held by a buyer (vendee) under a purchase contract, contract-for-deed, or an installment-purchase agreement. The buyer (vendee) has the right to demand that legal title be transferred upon payment of the full purchase price after the final installment payment has been made. This interest is transferable by deed, assignment, subcontract, or mortgage. Equitable title is conveyed to the buyer (vendee) as soon as the seller (vendor) actually countersigns and agrees to the offer to purchase. In other words, Jack agrees to purchase a home from David under a contract-for-deed’ arrangement. In layman’s terms, a contract-for-deed means “you (buyer) fulfill your part of the contract (pay the balance in full) and ONLY THEN do I (seller) have the obligation to transfer the deed to you.” Jack takes ‘equitable title’ in the property as soon as David agrees to the contract and signs it. However, the legaltitle (which defines absolute ownership) is not formally transferred from David (seller/vendor) to Jack (buyer/vendee) until he has made his last installment payment under the contract and paid the agreed-upon amount in full, whether he pays the balance in one year or over a period of thirty years. Also, with equitable title, the vendee (purchaser) benefits from any increase in value between the date of the agreement and the final delivery of the deed once the balance is paid in full. If the property increases in value the vendee gets the increased valuation of the property; if the property value declines the vendee in turns suffers that as well.
Equitable does not give the actual legal title to the property like it would if a buyer were using a mortgage. Equitable Title means giving the buyer an “equitable position” in the property. The legal title is conveyed only after the buyer has satisfied the contract.
The reason that equitable title and not legal title is conveyed in contract-for-deed purchases as mentioned above is because there is no deed of trust filed, this only occurs AFTER-THE-FACTonce the purchaser (vendee) fulfills the contract agreement, and legal title can only be transferred by a deed.
LEGAL TITLE – Legal title is the ownership of property that is enforceable in a court of law, or one that is complete and perfect in apparent right of ownership and possession, but that unlike equitable title, carries no ‘beneficial interest’ in the property. In other words, in the example of David and Jack above, David holds the ‘legal’ title to the property and is the ‘legal owner’ while Jack only has ‘equitable title’. However, with his ‘legal’ title, if the property goes up in value, David cannot benefit from this change and retroactively increase his sales price to Jack to make more money. As another example, if valuable minerals were discovered on the property, David could not ‘benefit’ from this change in the property either.
When utilizing traditional mortgage financing involving a bank or institutional lender, there is promissory note, a mortgage, and a deed of trust signed and filed. This deed of trust is what transfers legal title from the seller to the buyer. The seller of the property transfers legal title to the new buyer at closing because the contract price has been paid in full by the bank or lender – and now it’s up to the borrower to repay the lender in installments. The buyer now has both legal and equitable title. In turn, the buyer collateralizes the bank’s loan with the property being purchased and the legal title still remains with the buyer unless there is a foreclosure. If a foreclosure occurs on the property, the deed (and legal title) is transferred to the lender so that the lender then retains legal title.
An insurable interest exists when an insured party derives a financial or other kind of benefit from the continuous existence of the insured object. For example, you derive a benefit from your home not burning to the ground. A party also has an insurable interest in something when loss-of or damage-to that object or item would cause the insured party to suffer a financial or other kind of loss.
As an example of a suffered loss, the house you own is destroyed by a fire. Because of this, it’s value has been greatly diminished and whether or not you choose to have the home rebuilt or simply sell it at a reduced price, the fact remains that you have suffered a financial loss resulting from this fire. The loss is either (1) the loss of value in the property or (2) the cost to rebuild the property. You have an ‘insurable interest’.
However, if it’s your neighbor’s home that burns down, you may feel sorry for them, but you yourself did not suffer the loss and you do not directly benefit from their being able to live in their own home, so you obviously do not have an insurable interest in this property.
A basic requirement of all insurance is that the party purchasing a policy must have an insurable interest in the subject of the insurance. You obviously have an insurable interest in any property you own or any property that is in your possession and with regards to typical property and casualty insurance, this insurable interest must exist both at the time the policy is purchased as well as the actual time a loss occurs.
Every week I work with buyers and sellers of residential property who are utilizing seller-financing (specifically wraparound mortgages) and trying to obtain the appropriate hazard insurance while at the same time going out of their way not to tip off the underlying lender that a sale has taken place. Everyone involved is terrified of somehow notifying the underlying lender and triggering the ‘acceleration clause’ (referred to as the ‘due on sale’ clause) found in the underlying mortgage contract. In every case that I have worked with thus far (which are hundreds) this fear is generally uncalled for and it originates more from ignorance about the potential use and implementation of this clause rather than the reality itself.
To begin with, the ‘due on sale’ clause is, and has for decades been, a common provision in a mortgage or a deed of trust which allows the lender or mortgagee to demand immediate payment in full of the remaining balance of the loan if the mortgage holder transfers the property. Simply put, a due-on-sale clause is a standard provision in a mortgage or deed of trust that states that the lender has the right to demand that the entire balance of the loan, at the lender’s sole discretion, may be called due upon any transfer of the property used to secure the promissory note.
Although the lender has the contractual right, it isn’t a law and they do not have a hard and fast obligation to call the note due in the event of a sale. Again, this is a contractual right of the lender, not a legal requirement. This means that if a transfer takes place, the lender may (or may not), at its sole discretion, decide to “call the loan due.”
Notice that in the paragraph above it was stated that the lender the due on sale clause is triggered by a ‘transfer’ of the property – nothing at all has been said regarding the word ‘sale’. Technically, a ‘transfer’ is any transaction which transfers any ownership or title to the property, whether it is equitable or legal title. This can take numerous forms and can even consist of a common lease-option (which is an executory contract whereby a transfer of ‘equitable title’ occurs) even though the lessee hasn’t even exercised his or her option to actually purchase the property yet.
The common, and often mistaken belief, is that transferring any property already secured by a mortgage with a due-on-sale clause is somehow illegal. This is untrue due to the fact that triggering this clause is a matter of civil, not criminal, liability. By definition, in order for something to actually be considered “illegal”, it must first be in violation of a criminal law, code, or statute and there is currently no state or federal law which makes it a crime to violate a “due on sale” clause. In other words – these transactions are legal.
As it has already been stated, if a lender does find out about the transfer, it may at its option, call the loan due and payable and if the borrower is unable to pay the loan, then the lender always has the option of initiating foreclosure proceedings.
So, when considering a seller-financed purchase or sale, such as those utilizing a wraparound mortgage, the question to ask is whether or not both parties are willing to enter into a transaction subject to a mortgage containing a “due on sale” clause and risk getting caught. This is often a ‘risk versus reward’ situation that normally makes sense to do. More often than not, the seller has been denied short-sale options, he or she is unable to sale the property to a buyer that can obtain traditional financing, and the mortgage is in arrears and facing possible foreclosure if the sale does not occur soon so that payments are caught up and the loan brought current. So what’s the risk for the seller? Usually nothing. More often than not he or she is already facing foreclosure and the wraparound mortgage is the only means to prevent that from happening. If the loan does get called due, then the situation isn’t really any worse for the seller than it was before the sale. On the flip side, the buyer may have had past credit-related issues, he or she may not have enough money for a 10% or 20% down payment, or the buyer may not otherwise qualify for a traditional mortgage loan due to employment, income, or other issues. Without this seller-financing option, the possibility of home-ownership for the new buyer is slim to none. The gamble is usually pretty safe for both parties.
With regards to wrap mortgages, the due-on-sale clause is an obvious issue of concern for any property owner that wishes to transfer (sell) the property and have the new buyer take over the existing loan rather than paying it off as part of the sale as in a normal transaction involving third-party financing. The downside is that, as already stated, if the lender finds out about the transfer and then decides to call the loan due and the balance is not paid off, the lender could of course choose to foreclose on the property – which means that the seller now has a foreclosure on his or her record and the new buyer is also subsequently evicted in the process, which also means the entire loss of all down payments and other monies paid. This could, of course, lead to other frivolous litigation between the parties. However, the likelihood of this actually happening is pretty low and it really depends on how the real estate market is doing at the time. The reality is that as long as the buyer continues to make the loan payments when they are due, it is unlikely that the lender will actually call the loan due and payable. Given the extremely low interest rates that are expected to exist for the next few years and the current backlog of non-performing assets that banks already have on their books, calling a current and performing loan due isn’t very likely at all.
However, in the past things were different. In the late 1970s and 1980s interest rates were very high, sometimes up to 16% or more, so banks were very keen to enforce these clauses in order to foreclose on properties with lower rates of interest so that they could turn around and resell these homes or lend out the money at a much higher rate. However, as stated above, with current interest rates likely to remain low for at least a few more years, a record-high number of foreclosures, and a two-year backlog of new foreclosure processing already awaiting processing by many banks, the probability of this clause being enforced is very, very remote.
Also, something that many buyers and sellers don’t realize is that nobody associated with the transaction is under any contractual obligation whatsoever to notify the underlying lender that any transfer has taken place. Not the original borrower, not the Realtor, not the attorney, not the transaction coordinator, not the title company, and not the buyer. There is no inclusion in the mortgage loan requiring notification to the lender at all – and what they don’t know doesn’t hurt them. Generally speaking, so long as payments are caught up and maintained current so that the lender has a performing asset on their books it’s a non-issue.
Furthermore, from a legal standpoint, choosing not to disclose the sale or transfer to the lender is not considered either fraud or an ethical violation by the Realtor although all parties involved in the transaction should obviously be made aware of the existence of an underlying due-on-sale clause. In addition, many state-promulgated real estate contracts, addendums, and other forms contain provisions specifically referencing ‘subject to’ transactions. It is also not an ethical issue for attorneys since there have been several rulings concluding that assisting buyers and sellers to conceal a transfer from the underlying encumbrances is not considered a fraudulent act.
The most likely opportunity for the lender to become aware of the transfer of the property is when the buyer is purchasing new hazard insurance.
The concern here is that the lender will receive an evidence of insurance form from the company listing the new buyer as the named insured rather than the original borrower and this will alert the lender and trigger the due-on-sale clause. While possible, this is seldom as much of an issue as it is made out to be and more often than not it is much ado about nothing. You see, the insurance departments for banks and lenders are far removed from lending operations and most people working in these departments are hourly data-entry personnel. As long as they see that insurance is in force for whatever property that they happen to be working on at the time everything is fine. Also, if the seller (ie: the original borrower) is listed as an additional interest or additional insured (which are two different things) and whoever is working on the file at least sees the seller’s name somewhere on the form or policy, no questions are asked. Don’t be fooled, the personnel working in these insurance departments actually know little or nothing about insurance itself, they are clerks who are simply responsible for making certain that updated proof of coverage is obtained each year for the loans in their work que. There is also another way to obtain insurance for the buyer in a wraparound mortgage transaction that virtually eliminates the lender ever being tipped of to the transfer of the property, but it is more complicated and some buyers and sellers choose not to pursue doing this due to the fact that the transaction has already been closed and the insurance is being purchased as an ‘afterthought’ or the insurance was set up incorrectly in the first place and it is too late. To learn more about this strategy, refer to my article “How to Insure a Wrap Mortgage Without Notifying the Lender“.
In summary, there is always the possibility of the loan being called immediately due and payable by the lender, but the chances of that happening are very, very slim and in my personal experience and opinion, it is no reason to worry excessively or forgo the sale.
As an investor or owner of rental property, the most common type of insurance that you will purchase is known as a ‘dwelling’ policy. These policies are similar to a homeowner’s policy in many ways, but instead of a primary residence, they are used to insure non-owner occupied property (click here to read about the various types or versions of dwelling policies). However, these policies vary greatly from one insurance company to another with regards to what they actually cover (and more importantly, what they don’t cover) and very few agents know very much about them at all. In fact, if you do happen to already have a dwelling policy insuring one of your rental properties, there is a better than average probability that it is a very basic policy form and that you are poorly insured.
So the question is: “Why do so few agents know anything about the dwelling policies they sell?” and “Why don’t insurance companies provide very good coverage with these types of policies?”
The answer is simple: Neither the insurance companies nor the agents themselves want to be in the business of insuring rental property. This is not the ‘target market’ for either party.
The truth is that all personal insurance companies such as Farmers, State Farm, Nationwide and other well-advertised insurers will happily accept your premium dollars for such things as normal homeowner and automobile insurance – and they all compete with one another based solely on price (the ‘whose cheaper’ business model) – but when it comes to rental property, they simply don’t want the risk and they only offer dwelling policies as an ‘and that too’ type of product because they have to. They don’t advertise their dwelling policies, they don’t train their agents in insuring rental property (and few agents have the initiative to learn themselves), they often provide as few coverages and as many policy exclusions as they possibly can, and they price these policies to be more expensive than traditional homeowner insurance. This is normally the type of business that they prefer to shy away from.
Simply put, these companies do not want to be in the business of inuring rental property. Period. Because of this, they offer little and charge much.
In fact, some insurance companies actually pay much smaller commissions to agents for selling a dwelling policy than they do for a comparable homeowner’s policy – sometimes as much a 66% less. Because of this demotivating factor, agents have even less desire to sell or service these policies. As far as these companies are concerned, the obvious idea is to make as much money as possible while taking on as little risk as possible. Generally speaking, non-owner occupied properties present a higher risk for loss than an owner-occupied residence due to maintenance condition, pride of ownership (which tenant’s by definition don’t have), property age, property value, and the fact that more often than not they are located in less-desirable areas. Rental properties also have a high rate of vacancy due to tenant turnover which results in claims due to damage from vandalism and copper theft.
In addition, most personal-lines insurance agents and brokers work within a very small box with a limited scope of knowledge and experience. Rather than being insurance professionals, they are more often than not just salespeople with limited insurance knowledge and quotas to fulfill. Their primary objective is to sell home and auto insurance (again based primarily on ‘whose cheaper’) and they care little about insuring rental units – often because the company that the agent represents usually has a poor or limited dwelling policy product for the reasons already mentioned and they themselves have no first-hand experience or concept of being a landlord – which means that they don’t normally understand the realities of managing cash flow or the liabilities associated with high deductibles and physical losses, invasion of privacy, discriminatory housing, premises liability, and other such things. All of these things combined mean that you (the investor-consumer) often pay high premiums for poor coverage.
Like other types of insurance, dwelling policies vary a great deal from company to company and price alone should never be the determining factor. A few examples of how these polices differ depending upon the insurer are below:
- Some companies provide liability insurance with their dwelling policies while others do not. If liability coverage is not included in the policy (which is common), you must ‘extend’ the liability provided in your homeowner’s policy over the rental unit(s). This is not automatic. If you do not contact your agent and have your homeowner policy changed (or ‘endorsed’) to provide liability coverage over the rental unit – then you are not protected against any liability claims.
- Other companies do provide liability coverage in their dwelling policies, but they only include ‘Premises’ liability and NOT ‘Personal’ liability. This can be a big deal. ‘Premises’ liability provides coverage or injuries or issues arising from usage of or because of the physical property itself, but it does not protect you against ‘Personal Injury’ claims such as discriminatory or unfair housing, invasion of privacy, slander, defamation, and/or wrongful eviction.
- Most companies, because they do not want to be in the business of insuring non-owner occupied property, only sell the most basic ‘DP-1’ policy form. Again, this is because this particular policy version offers the least coverage (which lessens the insurer’s risk with regards to claims). The policy may have endorsements added and have a fancy name such as “DP-1 Plus” or similar, but they normally still don’t cover such things as vandalism and water damage.
- Few companies will issue dwelling policies in the name of an LLC while other will. Most companies consider any policy issued in the name of anyone other than the individual owner to be ‘commercial’ insurance.
- Finally, some companies require as much as a minimum 2% deductible for all dwelling policies while others will allow 1% or less.
As you can see, there can be a very big difference from one company to the next regarding the type of dwelling coverage provided as well as the experience and motivation of the agent. Dwelling policies, while certainly not uncommon, are often mis-sold and incorrectly issued and it is up to you – the investor/consumer, to make certain that you are properly insured against loss and litigation on your own rental property.