The Perils of Purchase Money Paper – May 2010

May 25, 2010

In today’s real estate market, a Seller may be faced with the opportunity to take back a purchase money mortgage from the Buyer for a portion of the purchase price. With more and more adjustable rate mortgages being assumable with qualification, some device must be available to make-up the difference between the principal balance of the existing first mortgage and a ten or twenty percent down payment which the Buyer has available in cash. If a property has increased in value since the adjustable rate mortgage was executed, this difference can be substantial.

It seems that a Seller has an easy task. Accepting a purchase money mortgage secured by the Buyer’s new residence sounds like a safe investment. If the interest rate is equal to the current market, the Seller may have a better investment in the purchase money mortgage than in the stock market, a certificate of deposit, or other investment.

What Sellers and their real estate brokers overlook are the perils of purchase money mortgages. We often forget that sometimes, the Buyer will not pay their mortgage as it becomes due. This is particularly true of a balloon mortgage, the useful device whereby the Seller receives monthly payments over three to five years, and then gets the remaining principal balance in one lump sum.

What happens if the Buyer doesn’t make his payments? The Seller has one choice: a mortgage foreclosure action.

If the Seller commences a mortgage foreclosure, the Seller can expect to spend four to eight months tied up in legal proceedings while the Buyer could be living in the property rent-free. In addition, if the Seller acquires the property at the foreclosure sale, the Seller may be faced with unpaid taxes, a bill for legal fees and costs, and perhaps a property in a shambles.

An even more important problem is that first mortgage which the Seller thought they were relieved of. If the transaction was properly handled at closing, the first mortgagee is aware that the Seller is holding a second mortgage and will give notice of any default before the loan is accelerated and the first mortgagee commences foreclosure. If the Seller is not so lucky, the first mortgage may start foreclosure proceedings even before the purchase money mortgage is foreclosed, and the Seller may be in jeopardy of losing his interest in the property completely.

Even where the Seller is lucky enough to have given notice to the first mortgagee, and where the first mortgagee is intelligent enough to notify the Seller prior to commencing a foreclosure action, that Seller holding the purchase money mortgage must now make that first mortgage payment in order to protect his position. This leaves the holder of the purchase money mortgage in a horrifying position of making the payments not only on the house he owns, but also on the house he thought he sold.

The problem may be less severe where the Seller of an encumbered property takes back a first mortgage. That Seller will still have the same burdens of taxes, the costs of the foreclosure action, and the deteriorated property. While that Seller will not have the worry of a first mortgage, there will be the lost income from a mortgage which is generally larger in amount than a purchase money second mortgage.

How can a Seller protect himself? The simple solution is to use the same rules as an institutional lender. Spend the money for a credit report. Make sure that the total of the existing first mortgage and the purchase money second mortgage do not exceed eighty percent of the property value.

Make certain that the first mortgagee (if any) knows that there is a second mortgage, and agrees to give notice of any default.

Seller financing is a useful tool to market property; but it is also a dangerous trap for an unwary person, which should only be entered into with full knowledge of the facts and the risks.

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The Perils of Purchase Money Paper – May 2010

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