Understanding Assumptions

Q. What is an assumption?

A. An assumption is just what the name implies: it occurs when a borrower assumes a seller's existing debt on a subject property, and that amount is subtracted from the purchase price. It's a form of leverage, resulting in less financing that the borrower must arrange, or less cash the borrower must to bring to closing. For example, a buyer assuming a $55,000 loan as part of a $100,000 purchase price would only have to make up a difference of $45,000, either in cash or with additional financing.

Q. Are loan assumptions common?

A. They're not nearly as common as they once were, because many of the previous types of assumable loans have gone the way of the dinosaur. Lenders realized that buyers assuming loans were not always as good a risk as the original borrower, not to mention the fact that lenders prefer to make piles of money from the fees and possibly higher interest rates of newly originated loans. While some mortgage loans (such as FHA and VA financing, for example) originated today are assumable for a qualified borrower, most other types are not. "Simple" (or, non-qualifying) assumable loans, once a familiar part of the market landscape, were originated before the mid-1980s; the overwhelming majority of these loans bore high interest rates and have since either been refinanced or paid off.

Q. If a new borrower assumes a loan, would the original borrower automatically be off the hook for responsibility of the loan's repayment?

A. Not necessarily. There are three different types (or levels) of assumptions, each with its own set of obligations and liabilities. These levels are identified as assignment, "subject to," and novation.

Q. Care to explain the three?

A. Certainly. An assignment of mortgage is the first level of loan assumption. Assignment transfers the responsibility to pay an obligation from one party to another. In essence, the assumptor actually steps into the place of the first mortgagor, assuming the repayment of the debt. However, if the assumptor defaults, the original borrower is secondarily liable for paying the remaining balance of the note, but only that amount. For instance, there could be no deficiency judgments against the original borrower for other liens if the property did not sell for enough to satisfy all debts against it.

A bit more common than the assignment, the "subject to" mortgage assumption is one that is made 'subject to' the terms and conditions of the existing loan. This somewhat risky maneuver is very much like the assignment in that it transfers the obligation to pay the debt from one party to another, while going one step further. In addition to being secondarily liable for repayment of the debt should the second borrower default, the original borrower is also responsible for any deficiency (shortfall at the foreclosure sale) against the property. This deficient amount can attach to the first mortgagor in the form of a judgment against him or her, depending on the state in which the property is located (they have different regulations) and the type of security document used (for example, a mortgage or trust deed). In other words, on a sale 'subject to' the loan, the assumptor is liable only for the loss of his or her own equity in the property if he or she defaults.

Assumable loans written today typically contain either assignment or "subject to" clauses. However, with a novation, the original borrower is relieved of both the mortgage payment and personal liability when the assumption is made. The novation creates an entirely new obligation, releasing the original obligor from all further liability on the loan. The buyer steps into the loan, while the seller steps completely out of the picture.

One of the reasons that many sellers erroneously believe that they're receiving a novation is that the lender asks the new buyer 'to qualify to assume' the existing mortgage. This process includes the normal credit check, employment verification and research to ensure that the buyer's financials are within standard guidelines; lenders go through virtually the same qualifying process for all types of assumptions. The seller, however, may not be receiving a novation but merely transferring ownership of the property.

Depending on the loan type, additional paperwork and assumption charges may be involved for a novation, but in most cases the biggest difference comes simply in asking. Many lenders won't grant or process a novation unless one is requested. The rationale, of course, is that the lender made the loan to the original borrower based on that party's qualifying strength, and until the second borrower can provide the information needed to prove that he or she is equally strong, the lender will not relieve the original borrower of secondary liability.

Q. When is the best time to ask the lender about assumption options?

A. The most prudent time to inquire about assumption policies regarding a specific loan is before the loan is originated, not when the property is put up for resale. If the initial borrower requests information concerning the assumption guidelines of a particular loan prior to loan closing, he or she may be able to negotiate to change the loan language and assumption guidelines (depending on the lender and the loan type). The borrower may even ask the lender to hold the loan in portfolio to allow a novation later.

Of course, it may not always be possible to get a definite answer from the lender. The borrower may be told that it depends on how well he or she repays the obligation and to whom the loan is transferred, as well as the institution's policies at the time of the assumption. The borrower can, however, ask what the lender's current assumption guidelines and procedures are for a specific loan. Assumption policies rarely get easier, so if the borrower can live with the current guidelines, chances are that they'll set the basic blueprint for subsequent future policies.

Q. So, a seller retains some liability for the loan under an assignment or "subject-to" sale; would that be reported on his or her credit report?

A. Because the original borrower isn't totally released from liability in an assignment or "subject-to" situation, a lender may report such a contingent liability in that party's name to the credit reporting agencies. While this is not necessarily a common practice, it's easy to see the potential problems that could be created when the seller attempts to qualify for a new loan, only to find that his or her credit report shows an outstanding mortgage. This is why a seller may want to request a novation on an outstanding loan.

If this circumstance should arise, the original borrower should request that the lender remove the posting from his or her credit file, citing the strengths of the second borrower and his or her own positive loan repayment history. The borrower should then check back with the credit bureaus in approximately thirty days to make that the entry has been removed from the record. Needless to say, the best way to protect against this is to obtain a novation when the property is sold.

Q. If the seller can't get a novation, does the lender have an obligation to notify the seller in case of any pending default by the assumptor?

A. Technically, lenders are not required by law to do so. But practically speaking, most lenders will notify the original borrower so that a financial arrangement can possibly be worked out prior to foreclosure proceedings. Because foreclosure is an expensive process for the lender, avoiding it saves time and money. In times of low appreciation or when property values have actually decreased (such as that of the current housing market), lenders will almost certainly notify the seller beforehand, because selling the property at a loss will only work to compound the situation for everyone.

However, if the original borrower had carried back seller financing and that mortgage was recorded, he or she would be formally notified prior to any sale of the property. But even with this, the original borrower should still send a written request by certified mail to the lender, asking that he or she be notified of any potential default on the outstanding loan. This request for notification should also be recorded at the county courthouse. Even though it creates no lien or other encumbrance on the property, it becomes part of the property's record. A lender would later find it very difficult to claim that he or she was not aware that the original borrower wanted to be notified in advance of any pending default.

Along the same lines, some sellers even request that the buyer purchasing with an assumption give the seller a small second mortgage ($100, for example) payable at some point in the extended future, with no payments due until that time. Once this mortgage is recorded, the seller becomes a lien-holder of record and he or she would be notified in the course of any default by the second owner. The seller would have to release the lien before the property could be sold with a clear title.

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