One topic that does not get much coverage is how to protect the seller in a subject-to transaction. There are several ways.
1 – A wrap. A wrap mortgage (also known as a “wrap-around” mortgage) is a type of lien that gets recorded in the land records as security for the seller. It’s a junior lien, meaning it is subordinate to the existing financing that has been left in place but it is called a wrap because it wraps around or includes the current note. The wrap often consists of the balance of the original loan plus an amount to cover the new purchase price for the property if that difference (which equals the seller’s equity) is not paid at settlement. Wraps can be either at the exact same interest rate as the existing financing or at higher rate. In the latter scenario the seller would make monthly money on the spread. In this context, see my message below regarding note servicing companies.
2 – A subordinate lien with balloon payment. If the sub-to purchaser does not have the cash to pay for the seller’s equity at settlement, the seller may instead decide to take its equity in the form of a second trust with a balloon. For example, let’s say the seller has $50,000 in equity at the time of the subject-to purchase. To get the deal done the seller may agree to finance that $50,000 at a reasonable interest rate but with a balloon payment due in 1-3-5 years. This arrangement enables a purchaser to get into a property with less out of pocket and enough time to renovate or improve the property. The plan would then be to either sell or refinance to get the seller paid when the balloon becomes due. The difference between this and a wrap is the wrap would typically be payable over the full term of the underlying mortgage… i.e., there would be no balloon payment. This method gets the seller paid out earlier.
Whether a wrap or stand-alone subordinate lien are used to secure the seller, a note servicing company should be engaged. This is very important. Note servicing companies handle the collection of funds, make loan and other payments, and take care of reporting. The use of a third party also allows the seller to monitor things at a distance and make sure the underlying mortgage is being timely paid.
3 – A performance deed. A performance deed (also known as a “pocket” deed) is a deed from the buyer back to the seller that is executed at settlement but held in escrow. The deed is not delivered to the seller — delivery being a requirement for a valid conveyance in most jurisdictions — unless and until the buyer defaults. If the buyer never defaults, the deed is destroyed in accordance with the agreement between the parties and the escrow agent. While I don’t recommend this method because it creates issues relating to the future insurability of the property (from a title insurance perspective), it can achieve at least one desired result. Ordinarily a seller would need to bring an action to foreclose their lien against a defaulting sub-to purchaser in order to repossess the property. Foreclosures take time and foreclosure attorneys cost money. Using a performance deed enables a seller to retake title to the property without going through that process and spending those funds. That can of course save the seller big on costs but it can also lead to other problems. I plan to post on this soon in the context of deeds in lieu of foreclosure executed prior to default.
While the above seller protections are certainly useful, none of them will help if a lender invokes the due on sale clause and accelerates the full balance of the underlying mortgage. The only solution in that unfortunate event is money. I discussed that issue in my prior posts on the dangers of subject-to. I recommend you read those posts.