The impetus of this article is simple – we are asked multiple times a day by well-intentioned investors... More...
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.
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.